Risk Retention Rules Do Not Apply to Open Market CLO Managers

Financial Industry Alert | February.14.2018

The D.C. Circuit Court of Appeals on February 9 reversed a summary judgment decision of the U.S. District Court for the District of Columbia and remanded the case with instructions to, among other things, vacate the rule applying Section 941 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Act") to the managers of open-market CLOs ("CLO managers").

The Loan Syndications and Trading Association (the "LSTA") had challenged the application by the SEC and Fed of the credit risk retention requirements of Section 941 of the Act to CLO managers. The LSTA's primary contention was that the definition of "securitizer" in the Act does not encompass the activities performed by CLO managers. The D.C. Circuit Court of Appeals agreed with the LSTA's position. In light of the Court's decision on the first argument, the Court did not address the second contention of the LSTA, that the interpretation of the requirements for a 5 percent horizontal risk retention position exceeded the requirements of the statute.

In agreeing with the LSTA's position, the court stated:

"The statute 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. 15 U.S.C. § 78o-11(b)(1) (emphasis added). And Congress defined a "securitizer" as:

(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 . . . . Id. § 78o-11(a)(3) (emphasis added).

The two key words in determining whether § 941 can be reasonably read to encompass CLO managers are "transfer" and "retain." The 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. In their ordinary meaning, words directing that one who "transfers" an asset must "retain" some interest in the associated risk refer to an entity that at some point possesses or owns the assets it is securitizing and can therefore continue to hold some portion of those assets or the credit risk those assets represent — that is, the entity is in a position to limit the scope of a transaction so that it transfers away less than all of the asset's credit risk."

As described by the Court, CLO managers do not originate or hold the securitized loans and can therefore neither "transfer" the loans nor "retain" a portion of the loans. The Court further addresses the public policy considerations underlying the Act:

"CLO managers are not direct or indirect agents of the originators, but rather negotiate their contracts with investors, usually with compensation based on performance. Open-market CLOs thus mitigate the problems Congress identified with the originate-to-distribute model: (1) The organizers' compensation dependency already gives them "skin in the game." Cf. S. Rep. No. 111-176, at 128–29. (2) Because they purchase relatively small numbers of unsecuritized loans on the open market through arm's-length bargaining, the activities of CLO managers present a far weaker version of the opacity that Congress identified in other ABS markets. Cf. id. And (3) both the superior incentives and relative transparency reduce the likelihood that such financing will generate anything like the decline in underwriting standards that the more famous ABS market is thought to have brought about."

Absent further appeal, the decision, once acted upon by the District Court as directed, would vacate the portion of the risk retention rules as applied to CLO managers. The impact of the decision on individual transactions in the market remains to be seen at this early date.

Please contact any of the attorneys on the Orrick Structured Finance team to discuss any questions you may have with regard to this matter.