Even under Trump, SEC unsympathetic to reg relief for CLOs

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The Trump administration’s anti-regulatory agenda has yet to permeate the Securities and Exchange Commission, which remains opposed to relief for collateralized loan obligations.

Hoping for a more sympathetic ear, the Loan Syndications and Trading Association wants to reinstate a federal lawsuit that seeks to overturn, or at least modify, ‘skin-in-the-game’ rules for CLOs.

Federal regulators aren’t buying it.

In a response brief filed Wednesday in the D.C. Circuit Court of Appeals, the Federal Reserve and the Securities and Exchange Commission jointly argued that the court should uphold a lower federal district’s Dec. 22 dismissal of the 2016 lawsuit.

“LSTA makes two arguments in support of its effort to insulate open market CLO managers from Congress’s risk retention mandate,” reads an argument summary in the 100-page filing. “Both fail.”

The agencies’ brief comes after the LSTA’s filed to resurrect the suit at the appeals court level. The D.C. appeals court is the same body which had remanded the case to the district court level over a year ago, after the trade group made a long-shot effort at an early favorable ruling from the higher court prior before risk retention rules took effect.

Elliot Ganz, general counsel for the LSTA, said Friday the group plans file its answer to the SEC/Fed response by the July 12 deadline, after which a three-judge panel would be selected for oral arguments.

The decision by the plaintiffs, particularly the SEC, to fight against the LSTA’s efforts might seem puzzling, given the deregulatory stance of new Chairman Jay Clayton as well as other new heads appointed by Trump to lead federal agencies and commissions. Ironically, the LSTA in April stated that its preferred remedy to eliminate or modify the application of risk retention to CLOs was through the SEC’s rule-making authority.

But reversing Obama-era SEC or Fed positions is neither quick nor easy. Clayton has been at his job only a month, and the Fed lacks a forceful voice in regulatory policy after the resignation of Fed Gov. Daniel Tarullo in April.

In addition, much of the staff that helped draft the rules at the SEC and elsewhere are still in place, and “running on inertia” from the previous administration’s policies, according to Ganz. “They haven’t gotten new orders, so they keep going,” he said.

“This isn’t a policy decision” to continue fighting the suit, Ganz said. “It’s the absence of a policy decision.”

Since filing suit in early 2016, the LSTA has sought to either vacate the rules or modify their application to CLOs. The group has primarily sought, through regulatory rule-making or legislative proposals, a “qualified” exemption for CLOs similar to residential loans that mortgage lenders can use to exempt securitized loans from risk-retention.

In the brief filed this week, the SEC and the Fed argued that CLO managers were properly covered as “securitizers” under the risk-retention requirements, in contrast to the LSTA’s argument that CLO managers fall outside the law’s definition because they do not own or transfer assets.
“LSTA is able to reach the opposite conclusion only by divorcing the statutory language from its context and by adopting a highly restrictive reading of the term ‘transfer,’” the brief states. “This strained reading of the statute’s text is at odds with its purpose and would operate both as an unstated exemption from the risk retention requirement for open market CLOs and as a loophole to be exploited by other types of securitizers.”

As for the LSTA’s argument that the risk-retention should only apply to the credit risk in a deal — the smaller equity tranches — rather than the full, fair-market notional value of the securitization, the brief defended the agency staff’s discretion in interpreting Congress’ call for a credit-risk retention of “not less than 5%.”

“Congress neither defined credit risk in the statute nor dictated the method by which securitizers be exposed to it,” it states.

“The agencies linked risk-retention to a percentage of the economic value of the securitization as a method to ensure sufficient exposure to credit risk, and that approach was entirely permissible, perfectly rational, and neither arbitrary nor capricious.”

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