On February 9, 2018, a three-judge panel of the U.S. Court of Appeals for the District of Columbia Circuit unanimously ruled in favor of the Loan Syndications and Trading Association ("LSTA") in its lawsuit against the Securities and Exchange Commission ("SEC") and the Board of Governors of the Federal Reserve System ("FRB") over the application of U.S. credit risk retention requirements to managers of open-market collateralized loan obligations ("CLOs").1
The Court concluded that managers of "open-market CLOs"2 are not subject to the credit risk retention rules mandated by Section 941 of The Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"), which requires the securitizer3 of an asset-backed security ("ABS") to retain, on an unhedged basis, at least 5% of the credit risk of any asset the securitizer, through the issuance of such ABS, transfers, sells or conveys to a third party.4 The Court reasoned that because CLO managers are not securitizers under Section 941 of the Dodd-Frank Act, they need not retain any credit risk in respect of the CLOs they manage. In reaching its conclusion, the Court agreed with the LSTA's primary contention that "given the nature of the transactions performed by CLO managers, the language of the statute invoked by the agencies does not encompass their activities."
As discussed more fully below, if the ruling of the Court stands, it will have significant repercussions for managers of open-market CLOs and for the CLO market, generally.
The final rules implementing Section 941 of the Dodd-Frank Act (the "Final Rules")5 were issued in October 2014 and became effective with respect to CLOs on December 24, 2016. Under the Final Rules, the sponsor of a securitization transaction (or its majority-owned affiliate) is required to retain an economic interest in the credit risk of the securitized assets equal to at least 5% of all ABS interests in the issuing entity issued as part of the transaction, unless otherwise exempted. "Sponsor" is defined in the Final Rules as "a person who organizes and initiates a securitization transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the issuing entity."
In the preamble accompanying the Final Rules (the "Preamble"), the federal regulatory agencies that jointly prescribed the Final Rules (the "Agencies")6 stated that the manager of an open-market CLO "generally acts as the sponsor by selecting the commercial loans to be purchased by the CLO issuing entity and managing the securitized assets once deposited in the CLO structure, which the [A]gencies believe is a transfer or indirect transfer of the assets."7 The Agencies rejected several definitional and policy arguments that the manager of an open-market CLO is not a statutory "securitizer" under Section 941 of the Dodd-Frank Act, asserting that its interpretation of the term "securitizer" was both "reasonable" and "consistent with the context, purposes and legislative history of the statute."8
The LSTA filed suit against the SEC and the FRB in November 2014, challenging the application of risk retention under the Final Rules to open-market CLO managers. Specifically, the LSTA argued that, in their promulgation of the Final Rules, the Agencies violated the Administrative Procedure Act by arbitrarily and capriciously: (1) construing the term "securitizer" to include open-market CLO managers; (2) requiring securitizers to retain a 5% interest based on "fair value" instead of "credit risk," as required by statute; and (3) declining to exempt open-market CLO managers from the retention requirements or to adjust those requirements to adhere to industry best practices to retain the benchmark level of credit risk without having to commit excessive capital. The U.S. District Court for the District of Columbia granted judgment in favor of the SEC and FRB in December 2016,9 after which the LSTA appealed to the D.C. Circuit.
The Court of Appeals Ruling
The Court of Appeals reversed the District Court decision, agreeing with the LSTA that an open-market CLO manager is not a "securitizer" under Section 941 of the Dodd-Frank Act and, consequently, not subject to the statute's credit risk retention requirements.10 The Court observed that the statute "is designed to reach those entities that 'organize[ ] and initiate[ ]' securitizations 'by transferring' assets to issuers" (emphasis in original). The Court effectively acknowledged that the manager of an open-market CLO "organizes and initiates" a CLO transaction, but it dismissed the notion that a manager's causal role in the acquisition of assets by a CLO issuer amounts to a "transfer" within the ordinary meaning of that term,11 or that a manager can be said to "retain" credit risk within the mandate of the statute by purchasing an asset (i.e., the retention interest) that it has never before held:
"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 representthat 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."12 (emphasis in original)