We don't need to keep skin in the game, since we were never in the game.

That's the central argument in a federal lawsuit challenging rules requiring CLO managers to retain a portion of the risk in their deals. 

If oral arguments at a hearing last week are any indication, this line of reasoning might carry some weight with the U.S. Court of Appeals in Washington. 

Collateralized loan obligations pool below-investment-grade corporate loans, slicing them into securities with varying amounts of risk and rates of return. But unlike lenders who securitize their own auto or student loans, CLO managers aren’t in the origination business. Instead they acquire the collateral for their deals, either when the loans are issued or in the secondary market.

The Loan Syndications and Trading Association’s lawsuit hinges on this distinction. The trade group argues that a rule requiring sponsors of securitizations to hold 5% of the economic interest of these deals unfairly penalizes CLO managers, which do not engage in the “originate to distribute” lending that the rule, enacted under Dodd-Frank, was designed to curb.

The lawsuit asks the court to vacate the risk retention rule as it applies to CLOs backed by loans acquired in the open market.

During oral arguments at a three-judge panel Friday, senior U.S. circuit judge Stephen F. Williams studiously grilled a senior attorney with the Federal Reserve Board of Governors on the distinction between the roles of a CLO manager and an originator that issue securities backed by their own loans.

“They [banks] are originating to distribute, now the manager here is different. There is some overlap in legal interest, but it’s different from the loan generating banks,” Williams pointed out in an audio file released by the court.

“Only in a narrow respect, your honor,” said Fed senior counsel Joshua Chadwick, noting that a manager is “serving the same purpose” as an originator, to offload risk to investors whether acting as an in-house arm of an investment bank or an independent firm.

“You weren’t saying these risky loans were ever on the balance sheet of the manager?” Williams asked. “I’m not sure that makes a big substantive difference, but there is a difference.”

The risk retention rule takes effect for CLOs in December. But the court is not expected to decide on the LSTA’s petition before this summer, and that is only if the court ultimately decides to take on the decision. The court must first decide whether it should remand the case to the District Court level for a hearing.

CLO managers aren’t waiting around to find out. The rule, which would require the sponsor of a $500 million deal to hold $25 million on-balance sheet, is considered so onerous that investors are loathe to participate in deals from small and mid-sized managers that haven’t demonstrated their ability to comply.

Even some of the largest managers are exploring alliances with firm that have deeper pockets. In January, CIFC Corp., which has $14.2 billion under management, said it had retained JPMorgan to explore a possible sale of the company.

In its filings with the court, the LSTA argues that federal agencies misapplied the term “securitizer” to CLO managers; it also argues that it is inappropriate to require managers to hold a 5% slice of the entire notional value of a CLO. Holding 5% of the riskiest securities issued by CLOs would be more appropriate.

Even before Friday’s oral arguments, the two sides traded broadsides. In a briefing filed with the court in July 2015, the LSTA charged the agencies with being “remarkably cavalier” about Congressional intent in the statutory language of Dodd-Frank, “and the actual rationales of their order.”  

The agencies responded that the “LSTA’s argument fails because it relies on an unnaturally narrow interpretation of the term ‘transfer.’ There is no evidence that Congress intended to bury such an exemption in the statutory definitions.”

In oral arguments, Richard Klingler, a partner at Sidley Austin LLP who represents the LSTA, urged the court to consider that a CLO is an “arms-length” transaction with an open-market CLO acting on behalf of investors.

The Fed’s attorney “frankly was blurring the distinction between a balance sheet and an open market CLO,” Klingler said. “The crucial element here is the CLO manager acts essentially like an expert fund manager. They’re not in the business of running a balance sheet. They’re not in the business of originating loans.”

Klingler was challenged by Chief Judge Merrick B. Garland, who took issue with the lack of clarity as to whether a CLO manager has control of loans that are first warehoused using a line of credit from an investment bank and then placed into an affiliated special-purpose vehicle.

“We have a lot of difficulty understanding…how the designation on somebody’s books or [how] electronically the loan moves from the open market or from a bank to through the manager, to/through until the SPV, is set up,” Garland asked.

When Klingler acknowledged he could not answer “where the loans were parked,” Garland deadpanned, “Neither do we.” 

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