On February 9, 2018, a three-judge panel of the United States Court of Appeals for the District of Columbia Circuit (the “D.C. Circuit”) issued a major decision regarding credit risk retention requirements. Following the 2007-2008 financial crisis, Congress passed the Dodd-Frank Act (“Dodd-Frank”) in an effort to avert a future crisis and as part of this reform, Dodd-Frank required securitizers to retain 5% of the credit risk of the assets sold into the securitization. This “skin in the game” measure was intended to align the interests of securitizers with those who purchased the asset-backed securities. The Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”), the Federal Deposit Insurance Corporation, the U.S. Securities and Exchange Commission (the “SEC”), the Federal Housing Finance Agency, and the Department of Housing and Urban Development (collectively, the “Agencies”) implemented the credit risk retention requirements of Dodd-Frank. Joint implementing regulations promulgated by the Agencies were published in December 2014.
The final regulations applied the credit risk retention requirements directly to managers of collateralized loan obligations (“CLOs”). CLOs are a type of securitization in which the payments from commercial loans are pooled together and issued as a security to investors. There are two categories of CLOs. A “balance sheet” CLO is one in which the originator or holder of the loans initiates the securitization and the manager is ultimately controlled by that originator or holder of the loans. In contrast, open-market CLOs involve managers acting independently from the banks originating or holding the loans and entering into arm’s-length negotiations with the lending banks. Additionally, open-market CLOs involve loans from multiple financial institutions, while balance sheet CLOs involve loans from a single bank.
The Loan Syndications and Trading Association (the “LSTA”) challenged the SEC and Federal Reserve Board’s application of the credit risk retention requirements to CLO managers in federal court. The district court ruled against the LSTA and in favor of the agencies, finding that the agencies reasonably could read the credit risk retention requirements under Dodd-Frank to include CLO managers as “securitizers.”
The D.C. Circuit, however, reversed the district court’s decision based on a plain-meaning interpretation of the statute. Congress defined a “securitizer” as an issuer of an asset-backed security or a person who organizes and initiates an asset-backed securities transaction by selling or transferring assets to the issuer. Dodd-Frank instructed the agencies to promulgate regulations requiring a securitizer to “retain” an economic interest in the credit risk of securitized assets that it has transferred to a third party. The D.C. Circuit held that this could not reasonably be read to apply to open-market CLO managers, as the managers could not “retain” an economic interest in the securitized loans or be deemed to have “transferred” the assets because at no point do the managers actually hold the loans. The CLO manager’s role is limited to obtaining potential investors for the securitization and establishing the investment criteria for the securitization. It is then a special purpose vehicle, and not the CLO manager, that actually purchases the assets in the securitization on the open market.
The court’s ruling could have implications for other assets beyond open-market CLOs. For instance, actors in the securitization markets could potentially try to use this line of reasoning to eliminate the credit risk retention requirements from balance sheet CLOs as well by restructuring the deals so that the special purpose vehicle directly acquires the assets from the originator.
The D.C. Circuit specifically limited its holding to the CLO managers described above: that is, to open-market CLO managers; the credit risk retention requirements remain in place for managers of balance sheet CLOs.
The agencies have 45 days to seek an en banc review by the entire D.C. Circuit.