Bell tolls for CLO risk retention following D.C. court order

Risk-retention standards on collateralized loan obligations are officially history.

On Thursday, the U.S. District Court for the District of Columbia ordered a summary judgment for the Loan Syndications & Trading Association in the trade group’s federal lawsuit against federal agencies over the rules.

The D.C. Court’s action followed through on an order to vacate issued Tuesday by the D.C. Circuit’s U.S. Court of Appeals. That stemmed from a Feb. 6 ruling by a three-judge appeals court panel that the standards should not apply to investment managers of CLOs, reversing the district court’s prior ruling that upheld the standards.

The district court dismissal, "for all practical purposes,” ends the LSTA's four-year legal battle to overturn the application of risk-retention standards on open-market CLOs by the Securities and Exchange Commission and the Federal Reserve Board of Governors, according to an LSTA newsletter published Friday.

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The notice to vacate was issued after regulators failed to file an appeal against the upper court's decision by the March 26 deadline.

The LSTA cautioned the government agencies have until May 10 to seek help from the U.S. Supreme Court. “However, there are many steps that the agencies would have taken if they were planning to appeal to the Supreme Court. In turn, we believe it is unlikely that the agencies will seek Supreme Court review and that, if they did, it is unlikely that the Court would grant their petition,” the newsletter stated. “We believe we can exhale.”

The ruling means an end to the interagency risk-retention rules for U.S. CLOs that were adopted in 2014, following through on the agencies' task to enforce the Dodd-Frank Act’s Section 941 regulation requiring 5% risk-retention requirements for securitizations. The rules had been enforced since December 2016.

Since that time, managers of all new-issue CLOs (or in some cases, refinanced CLOs issued before 2016 that had been grandfathered) were required to take up skin in the game to align their interests with investors.

The ruling now frees CLO managers from the obligation of holding skin in the game for both new-issue CLOs and their existing portfolios that were printed or refinanced to meet the standards.

It does not prohibit managers from retaining risk, either, so many may choose to use the nearly $10 billion industrywide that had been raised to acquire risk-retention tranches in 2018.

The standards were contentious from the outset, given that many managers were not originators of the loans, nor did they have the capital to retain 5% on the notional value of broadly syndicated CLO ($25 million on a $500 million portfolio, for example).

The rules' enforcement drove a wave of consolidation in the industry with smaller managers selling or teaming with well-capitalized partners, or establishing arm's-length specialty investment vehicles to retain the hefty stakes required. The industry nonetheless adapted quickly to the changes, with many larger managers since 2015 establishing capitalized investment vehicles to invest or market equity portions of deals. Despite the rules' enforcement, the CLO industry saw its second-busiest year of issuance in 2017.

The LSTA still carried on with its suit, concerned that the rules would (and did) force many smaller managers out of the business, and ultimately limiting a key source of capital for speculative-grade-rated corporate borrowers. CLOs are the largest acquirers of junk-rated leveraged loans, with managers mitigating risk by packaging slivers of several dozen senior loans (usually through a 2-3% loan participation) into an investment-grade portfolio that backs CLO bonds issued in sequential senior- and subordinate-note payment structures.

The LSTA also sought to block the rules through through congressional action and by lobbying the agencies themselves.

The federal agencies' decision to bypass the appeal process had been expected, given the Trump administration's reluctance to carry on an Obama-era regulation. Last year, the LSTA lobbied U.S. Treasury Secretary Steven Mnuchin for changes to the risk retention standards through the SEC’s own enforcement authority. That led to the administration’s recommendation last October to federal agencies to relieve CLOs of the risk-retention burden.

In its summary judgment order, the district court also took the step to overturn the method by which the SEC and the Fed calculated the 5% risk-retention level. While that issue is now resolved simply by exempting CLOs from risk retention, it backed the LSTA’s contention that risk retention should be tied to only the smaller, equity portion of a portfolio that is at the bottom of the payment waterfall — representing the credit risk in a deal.