The Risk Retention Rule: LSTA's Victory and What It Means for CLOs and Other Securitizations
In its February 9, 2018 decision, The Loan Syndications and Trading Association v. Securities and Exchange Commission and Board of Governors of the Federal Reserve System (Court Decision), the United States Court of Appeals for the District of Columbia Circuit (DC Circuit) overruled the decision of a United States District Court and decided that collateral managers for open market collateralized loan obligation transactions (Open Market CLOs) are not subject to the risk retention requirements of Section 941 (Section 941) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) and the risk retention regulation (Regulation) promulgated by the Securities and Exchange Commission (SEC), the Board of Governors of the Federal Reserve System (Board), and other regulators (collectively with the SEC and the Board, the Agencies) thereunder. Only the SEC and the Board (Defendants) were defendants in the litigation. The decision will not result in a change in the law until after the period for appeal within the DC Circuit has passed or any such appeal process has concluded.
The Court Decision
The Court Decision was rendered by a panel (Panel) of three judges of the DC Circuit: Circuit Judge Brett Kavanaugh; Senior Circuit Judge Douglas Ginsburg; and Senior Circuit Judge Stephen Williams, who wrote the opinion. The opinion analyzed Section 941, which requires 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.
Section 941 further defines 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 …
The Panel was considering an appeal, filed by The Loan Syndications and Trading Association (LSTA), of a District Court decision issued on December 22, 2016, rejecting a challenge to the Regulation and upholding the Agencies' conclusion in the Regulation that the collateral manager of an Open Market CLO is the party required to comply with risk retention requirements of Section 941 as detailed in the Regulation.
The Panel concluded that to be a "securitizer" under clause (B) of the definition an entity would have to have had a possessory or ownership interest in the assets that it then transferred, directly or indirectly, to the issuer. The Panel rejected the argument that a person could come within the definition merely by causing the transfer to the issuer without itself ever having had any ownership interest in the transferred assets. Accordingly, because the collateral manager of an Open Market CLO only directs and consummates asset acquisitions on behalf of the issuer through open market purchases, it would not be a securitizer and therefore would not be subject to the risk retention requirements. Although the decision did not address whether the issuer of an Open Market CLO may still be a securitizer pursuant to clause (A) of the definition, the discussion in the opinion indicated that, in the view of the Panel, the Regulation effectively eliminated the issuer from the definition.
Note that the Court Decision would not apply to a transaction where the assets come from a financial institution or asset manager involved in the organization and initiation of a securitization with its own assets (Balance Sheet CLO). The Court Decision did not specifically address, and it therefore remains unclear, whether risk retention requirements would apply to transactions in which a portion of the assets acquired in the open market are first acquired by the collateral manager in order to come within certain requirements for European Union risk retention, to so-called "call and roll" transactions in which assets in one Open Market CLO are transferred into a new comparable securitization transaction, or to a securitization of assets acquired in the open market but held by a party other than the issuer under a warehousing arrangement prior to securitization.
Effective Date; Appeal Period
The Court Decision will not become effective until after a period has passed without appeal within the DC Circuit, or an appeal process has been successfully completed. In the event the Defendants decline to appeal the Court Decision within 45 days after the date the decision was issued (such 45th day being March 26, 2018), the decision will become effective on or shortly after April 2, 2018, when the DC Circuit issues its mandate finalizing the decision and the Regulation (insofar as it imposes risk retention requirements on collateral managers of Open Market CLOs) will be vacated when the District Court enters a judgment consistent with that mandate.
Alternatively, the Defendants may petition the Panel to rehear its decision or petition all of the active judges of the DC Circuit for a rehearing en banc or both. In that case, the Court Decision would not become final until late April 2018, at the earliest, or several months after that, at the latest. The DC Circuit may summarily deny the Defendants' petition for rehearing without further briefing a few weeks after the Defendants file their petition on or before March 26, 2018, but if the DC Circuit grants the Defendants' petition or requests additional briefing, the Court Decision may not be finalized for several months after that.
In addition to or instead of filing a petition for rehearing in the DC Circuit, the Defendants could petition the US Supreme Court for a writ of certiorari. In that case, the Defendants must file their certiorari petition within 90 days of the Court Decision or denial of a petition for rehearing by the DC Circuit, whichever is later. Defendants' certiorari petition would thereafter take 44 days to brief and several additional weeks to decide. However, because a certiorari petition does not, by itself, stay the DC Circuit's issuance of the mandate finalizing the Court Decision, unless the Defendants petition the DC Circuit for rehearing or successfully move to stay the mandate pending a response to their certiorari petition to the Supreme Court, the Court Decision could nevertheless become effective as early as April 2, 2018.
The foregoing are only a few of the possible appeal scenarios. The Defendants' and the courts' decisions in the next few weeks will be critical for attempting to determine the timing of an effective date for the Court Decision. Until the appeal process is completed, there can be no assurance that the Court Ruling will stand.
The Regulation, to the extent applicable to collateral managers of Open Market CLOs, remains effective until vacated by the District Court as directed by the Panel. The District Court will not have jurisdiction to vacate the applicability of the Regulation to collateral managers of Open Market CLOs until the DC Circuit issues its mandate after the Defendants have exhausted their appellate rights (or the Defendants are unsuccessful in staying the mandate pending a petition for writ of certiorari).
A final decision in the DC Circuit will bind the Agencies, and accordingly there would be no opportunity for a contrary decision in the Court of Appeals of another Circuit absent further rulemaking action by the Agencies.
Impact on Open Market CLOs
If and when the portion of the Regulation applicable to collateral managers of Open Market CLOs is effectively nullified, absent new regulations, Open Market CLOs generally would not appear to be subject to the requirements of risk retention. This would appear to be the case since (i) the statutory requirement, on its face, is dependent on an implementing regulation being in effect, (ii) the portion of the Regulation imposing such requirements on collateral managers of Open Market CLOs will have been invalidated and (iii) under the remaining active components of the Regulation, no other party to a typical Open Market CLO would constitute a "securitizer" as that term was interpreted by the Panel. In respect of outstanding Open Market CLOs, a collateral manager currently holding such a risk retention interest would accordingly appear to no longer be required to retain that interest under the Regulation. Any collateral manager would, however, continue to be subject to the terms of any applicable transaction documents, which may continue to restrict the disposition, hedging and financing of such risk retention interest.
The Agencies would be free to promulgate new regulations consistent with the ruling, although it is not clear upon which other Open Market CLO transaction party the Agencies might attempt to impose an alternative risk retention obligation or what would be the statutory basis for doing so—possibly, the Agencies could promulgate interpretations that impose risk retention obligations on the issuer pursuant to clause (A) of Section 941 quoted above, and impose certain requirements on equity holders thereof or others to give substantive effect to such obligations. The procedural posture and timing of any new regulation is also not clear at this time, and it is not known if the Agencies might seek to issue interpretative guidance in the interim (or what form or substance any such guidance might take).
Possible Impact of Court Decision on Other Types of Securitizations
Although the Court Decision specifically addressed only the treatment of collateral managers of Open Market CLOs, the analysis of the Court Decision may be equally applicable to a number of other asset classes. For example, the Panel's argument may be applied to the following:
- Sponsors of resecuritizations in which the underlying securities are acquired by the issuer in open market transactions rather than from a person holding such securities prior to the securitization who is involved in the securitization transaction;
- Managers of commercial paper conduits that acquire assets in the open market or directly from their customers; and
- Sponsors of conduit securitizations that acquire the assets directly from third party originators rather than hold any such loans on balance sheet.
In each case it would be essential that the issuer acquire the underlying assets directly from third parties, and that the organizer and initiator of the securitization transaction or program not be included in the chain of title. Removing the manager or sponsor of any of these securitizations as a securitizer would, of course, increase the risk that one or more parties transferring assets to the issuer would be characterized as securitizers. That risk would likely be substantially reduced to the extent that the assets so transferred themselves constituted asset-backed securities separately subject to risk retention (as is often the case with resecuritizations or commercial paper conduits).
The Court Decision relied on an interpretation of the language of Section 941, and rejected several policy arguments made by the Agencies, including the concern that the decision would create a loophole for many securitizations that were intended to come within the Regulation but could be structured in a way to come within the Open Market CLO model. The Panel recognized the concern, but nevertheless concluded that "[p]olicy concerns cannot, to be sure, turn a textually unreasonable interpretation into a reasonable one." The opinion further stated that any loophole so created "is one that the statute creates, and not one that the agencies may close with an unreasonable distortion of the text's ordinary meaning."
Notwithstanding the clear conclusions stated in the Court Decision, it should be recognized that the Court Decision, in what is arguably dicta, offered reasons why the decision was appropriate for Open Market CLOs, and that might be used by other courts to distinguish the case in making a comparable decision with respect to other asset classes that do not have a number of the features that are present in Open Market CLOs. The Panel, in particular noted the following with respect to Open Market CLOs:
- The loans are generally large loans, limited in number (typically up to 100 to 250 loans), from companies that are public companies or for which credit information is otherwise available to investors, providing transparency not always available in other asset classes.
- The loans are often portions of larger syndicated loans involving multiple parties as originators.
- The loans are generally of a type actively traded in a secondary market.
- The collateral manager is typically compensated in whole or in part with incentive compensation, and therefore in effect has skin in the game through its compensation structure. As such, it operates much like a mutual fund (which, though not stated in the opinion, is viewed as not subject to risk retention).
- Open Market CLOs performed relatively well during the financial crisis.
Assuming the Court Decision is not appealed, or is upheld on appeal, there will be a desire to extend its applicability to other types of securitizations, to the extent they can be structured in a manner similar to Open Market CLOs. In light of the foregoing, transaction participants would need to conduct a thorough analysis of all the facts and circumstances present in any given transaction, and a careful consideration of the regulatory uncertainties involved, before relying on an extension of the Court Decision's rationale as a basis for not complying with the risk retention requirements in other types of securitizations.
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