It is finally settled that the Credit Risk Retention Rule, adopted pursuant to Section 941 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, does not apply to open market CLO managers. On April 5, 2018, in accordance with the mandate issued by the District of Columbia Circuit on April 3, 2018, and the opinion of the D.C. Circuit issued on Feb. 9, 2018 (see 882 F.3d 220 (D.C. Cir. 2018), the U.S. District Court for the District of Columbia ordered that the Credit Risk Retention Rule be vacated insofar as it applies to open market CLO managers.
A CLO is a type of securitization backed by loans made to corporate borrowers. Balance sheet CLOs are typically sponsored by large institutions, securitizing loans originated by such institutions. In contrast, in an open market CLO, a collateral manager directs the purchase of loans through a special purpose vehicle in the open market, which loans meet certain investment guidelines. After loans are selected for the CLO, the collateral manager operates and manages the loan portfolio.
In 2011, the Securities and Exchange Commission and the Board of Governors of the Federal Reserve System, along with other relevant agencies, issued a joint notice of proposed rule-making and solicited comments on the Dodd-Frank Act's credit risk retention provisions. Under the proposed rules, a "securitizer" — defined as including a person who organizes and initiates an asset-backed securities transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the issuer — would be required to retain at least 5% of the credit risk of the securitized assets. The proposed rules generated thousands of comments. Open market CLO participants expressed concern with the application of the Credit Risk Retention Rule to a CLO manager who is unaffiliated with the origination of the loans and purchases loans on the open market. Notwithstanding a raft of opposition, in adopting the final Credit Risk Retention Rule, the agencies reaffirmed their determination that the term "securitizer" covers CLO managers.
In 2016, the Loan Syndications and Trading Association (LSTA), representing members participating in the syndicated corporate loan market, brought an action against the SEC and the Fed challenging the applicability of the Credit Risk Retention Rule to open market CLOs.
The District Court granted summary judgment to the defendant agencies. The agencies successfully argued that "the agencies did not act arbitrarily, capriciously, or otherwise unlawfully in declining to provide an exemption or adjustment to the credit risk retention rules for open market CLOs." See Loan Syndications & Trading Ass'n v. SEC, 223 F. Supp. 3d 37 (D.D.C. 2016). The Court of Appeals, ruling de novo, reversed.
The Court's Analysis
On appeal, the LSTA renewed its argument that, given the nature of the transactions performed by open market CLO managers, the extension of the Credit Risk Retention Rule to open market CLOs lacked a statutory basis.
The Credit Risk Retention Rule requires a "securitizer" to retain an economic interest. The question is whether managers of open market CLOs are "securitizers," as defined in the statute.
Section 941 of the Dodd Frank Act directs the agencies to issue regulations —
to require any securitizer to retain an economic interest in a portion of the credit risk for any asset that the securitizer, through the issuance of an asset-backed security, transfers, sells, or conveys to a third party.
The statutory definition of "securitizer" reads in relevant part as follows:
(A) an issuer of an asset-backed security; or (B) a person who organizes and initiates an asset-backed securities transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the issuer."
The two key words on which the D.C. Circuit focused in analyzing whether the Credit Risk Retention Rule can be reasonably read to encompass open market CLO managers were "transfer" and "retain." The court observed that "[t]he two subsections quoted above have the effect of authorizing requirements that an entity which transfers assets to an issuer retain a portion of the credit risk from the underlying assets that it transfers." To be a "securitizer" for purposes of the Credit Risk Retention Rule, "a party must actually be a transferor, relinquishing ownership or control of assets to an issuer," such that it can retain a portion of what it transfers.
Open market CLO managers neither own nor control assets that are transferred to a CLO issuer, and thus there are no assets for them to transfer or to retain. As such, the appellate court concluded that open market CLO managers are not "securitizers" for purposes of the statute, and are therefore not subject to the risk retention requirements set forth in the Credit Risk Retention Rule.
It is now the law that open market CLO managers do not have to comply with the Credit Risk Retention Rule. Many CLO managers have invested a lot of time and money in creative structures to ensure compliance with the Credit Risk Retention Rule and to enable securitizers to leverage their retained piece of the CLO structure. It remains to be seen whether managers will abandon the new structures or whether they will use them as a selling point to distinguish themselves in the market. Deals may continue to be structured as risk retention compliant, but without the formal disclosure requirements and filings.
Also, smaller market participants that did not have the resources to comply with the Credit Risk Retention Rule, and therefore exited the business, may now re-enter the market, and new participants may enter as well.
Only time will tell how different managers, investors and the market react to the D.C. Circuit's interpretation of Section 941, and the exclusion of open market CLOs from the Credit Risk Retention Rule.
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