In December 2014, the credit risk retention rule, 79 Fed. Reg. 77,601 (the credit risk retention rule), was adopted pursuant to Section 941 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). The credit risk retention rule requires any “securitizer” of asset-backed securities (or other related parties) to acquire and retain either (i) 5 percent of the face amount of each class of notes issued by the collateralized loan obligation (CLO), (ii) notes of the most subordinated class issued by the CLO representing 5 percent of the fair value of all CLO notes, or (iii) a combination of (i) and (ii) representing 5 percent of the fair value of all CLO notes. The rule was designed to align the interests of the managers and investors in a CLO deal.
CLOs, the largest purchasers of leveraged loans, are generally classified into one of two types: open-market CLOs or middle-market CLOs. Open-market CLOs acquire their assets from third parties on the open market. Middle-market, or balance sheet, CLOs are created by a CLO manager or a related party transfering the loans off its balance sheet and into the securitization vehicle. Until a recent D.C. Circuit Court decision, the credit risk retention rule applied to managers of both open-market and middle-market CLOs.
In 2014, the Loan Syndications and Trading Association – the trade group representing the CLO and leveraged loan markets – filed a lawsuit against the Federal Reserve and the SEC, arguing that the credit risk retention rule was arbitrary, capricious, and an abuse of discretion. In December 2016, a D.C. District Court held that collateral managers of open-market CLOs were considered securitizers for purposes of the credit risk retention rule. Loan Syndications & Trading Ass’n v. SEC, 223 F. Supp. 3d 37 (D.D.C. Dec. 22, 2016).
On February 9, 2018, the D.C. Circuit Court reversed the district court’s 2016 ruling, and found that open-market CLO managers are no longer obligated to abide by Dodd-Frank’s risk retention requirements because CLO managers do not originate or hold assets and therefore do not qualify as “transferors” of assets or securitizers under Section 941 of Dodd-Frank. The case is Loan Syndications and Trading Association v. SEC, No. 17-5004, and the decision is available at https://www.cadc.uscourts.gov/internet/opinions.nsf/871D769D4527442A8525822F0052E1E9/$file/17-5004-1717230.pdf
The Circuit Court focused on Dodd-Frank’s definition of a securitizer as being an entity that transfers assets to an issuer of securities, and it noted that open-market CLO managers typically do not own the assets underlying the CLO and therefore do not transfer them to the issuer. Decision at 8-9. Rather, these managers select assets to be purchased by the issuer from third parties on the open market. Id. at 16. Therefore, because open-market CLO managers are not securitizers, they are not obligated to retain any credit risk in the CLOs they manage. Id. at 17.
The D.C. Circuit Court’s decision effectively groups open-market CLO managers with other asset managers rather than with securitizers of asset-backed securities. Wall Street’s reaction to this recent ruling has been positive, as this exemption is expected to grow the market, especially benefiting smaller managers who were most challenged by coming up with the capital to buy the required retention when issuing new deals.
However, the D.C. Circuit Court’s decision applies only to open-market CLOs. Middle-market CLOs will remain subject to the credit risk retention rule. The Federal Reserve and SEC have 45 days to seek en banc review of the decision before the D.C. Circuit Court and 90 days to seek certiorari from the U.S. Supreme Court. If regulators do not appeal the decision, open-market CLO managers can then begin structuring new deals without holding the credit risk.