Regulators relent; no appeal of CLO exemption from risk retention
By next Monday, CLO managers will be freed from a requirement, enacted as part of Dodd-Frank, to hold onto 5% of the economic risk in their deals.
The deadline for federal regulators to seek an en banc hearing of the D.C. Circuit Court of Appeals to reconsider a Feb. 9 ruling by a three-judge panel expired at midnight last night. The result will be the vacating of an earlier U.S. District Court ruling that upheld the rules, in place since December 2016. This should take place no later than April 2.
At that point, managers of collateralized loan obligations will be free to issue new deals without tying up any of their own capital. They will also be free to unload stakes they are holding in existing deals that comply with the rules, assuming that deal documents allow them to do so.
This is true even under the remote possibility that the Federal Reserve Board of Governors and/or the Securities and Exchange Commission opts to directly appeal the case to the U.S. Supreme Court.
“The bottom line is that the biggest hurdle has passed, since the government has not appealed,” said Elliot Ganz, general counsel of the Loan Syndications & Trading Association, which brought the October 2014 lawsuit against the agencies. “The order will be issued relatively soon to vacate risk retention, and managers will be free to issue new CLOs or revise old ones without risk retention.”
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.
The appeals court decision reverses a December 2016 decision by the D.C. circuit's 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 even though they have no role in the origination of the leveraged-loan assets in their portfolios.
The risk-retention standards, which required U.S. CLO managers to maintain a 5% stake in notional value of the portfolios they sponsored, had been in effect since December 2016. An earlier D.C. District Court ruling had ruled in favor of keeping the rules set by the Fed and SEC.
The LSTA had filed suit, concerned about the impact the new standards would have on CLO issuance – as well as on borrowing costs for for speculative grade companies, whose leveraged loans are predominantly securitized in CLO portfolios.
The LSTA argued that managers of open-market CLOs, which do not originate the loans that they securitize, should have been excluded from the Dodd-Frank rules.
Spokesmen for the Fed and the SEC declined comment Tuesday.
While both agencies still have another 45 days to choose to appeal directly to the U.S. Supreme Court, Ganz said he doubts they will do that.
“Typically the agencies would go for an en banc review, and only when the circuit court turned them down would they go to cert petition for Supreme Court review," he said. “They would want to show they went through every avenue before going to the Supreme Court, to show the court they are not being cavalier."