The three-judge panel of the D.C. Circuit for the Court of Appeals unanimously ruled on Friday that collateralized loan obligations are not subject to the risk retention rules mandated by the Dodd-Frank Act.
The ruling was in response to a lawsuit brought by the Loan Syndications and Trading Association against the Federal Reserve Board of Governors and the Securities and Exchange Commission, the two federal agencies that placed CLOs among covered asset classes required to keep "skin in the game" of securitizations that they sponsor.
The original lawsuit was filed in October 2014, shortly after the Fed and the SEC adopted the rules and set an enforcement date of December 2016. CLO managers have retained 5% of the notional value of the $130 billion of new CLOs issued since, either on their own books or through an affiliated capitalized entity.
The agencies were following a Dodd-Frank Act requirement designed to align the interests of all kinds of lenders with those of investors in bonds backed by these assets. Before the financial crisis, the ability to quickly securitize mortgages and other kinds of loans gave lenders little incentive to maintain underwriting standards.
“What [the appeals court] said is that the statutory language did not cover managers as securitizers,” said LSTA general counsel Elliot Ganz, who spearheaded the trade group’s challenge. “That’s the bottom, bottom line.”
The appeals court decision reverses a December 2016 decision by district federal court, which found that CLO managers were covered by the risk-retention statute since they are in charge of investment and performance-monitoring decisions in the portfolio, despite having no role in the origination of the leveraged-loan assets in their portfolios.
The decision will not go into effect for another 45 days, presenting the federal agencies the opportunity to appeal the decision.
Whether they will or not may be in question. In a statement, the Structured Finance Industry Group said it "will be following this issue closely and provide any additional updates, but the U.S. government has very limited options to overturn the court's decision and it seems unlikely, under this administration, that they would attempt to do so."
A spokesperson for the Federal Reserve Board said the agency is reviewing the decision; the SEC declined to comment.
The LSTA, SFIG, and other trade groups have expressed concerns that the risk-retention requirements would disrupt the market and throttle leveraged-loan issuance, potentially cutting off an important source of financing for speculative-grade-rated companies.
This did not happen, however. To the contrary, the CLO market in 2017 had its second-busiest year, post-crisis, with $124 billion of new issuance.
In its decision, the appeals court panel wrote that “[t]he agencies’ interpretation seems to stretch the statute beyond the natural meaning of what Congress wrote.”
“CLO managers neither originate the loans nor hold them as assets at any point,” the ruling stated. “Rather, like mutual funds or other asset managers, CLO managers only give directions to an SPV [special-purpose vehicle] and receive compensation and management fees contingent on the performance of the asset pool over time.”
The appeals court essentially “pooh-poohed the government position on a policy basis,” said Ganz. “Even if there had been policy concerns that were substantive, we still have to follow what the words of the statute say.”
The appeals court decision also vacates a portion of the district court ruling favoring the agencies’ preference to require managers to hold a 5% stake of the portfolio’s fair value. The LSTA and other structured-finance trade groups that filed amicus briefs in the case had argued the agencies could have instead used a lower figure, such as a 5% share of the equity — or ownership stakes — of a deal.
The gap between those figures is enormous. A 5% stake in a $500 million CLO would require a manager to retain a $25 million stake, as opposed to an equity tranche that usually represents less than 10% of a deal’s notional value.