U.S. Risk Retention Decision: Credit Risk Retention Rule
In an important decision, the U.S. Court of Appeals for the District of Columbia Circuit (the “Court”) held on February 9, 2018 that the Dodd-Frank Act does not authorize U.S. federal regulators to require that collateralized loan obligation (“CLO”) managers comply with the requirements of the U.S. credit risk retention rule (the “Credit Risk Retention Rule”) where the collateral for the CLO is acquired on the open market. The Court concluded that an open-market CLO manager is not a “securitizer” within the meaning of the Credit Risk Retention Rule, and therefore outside its scope.
Background on CLO Risk Retention
The Credit Risk Retention Rule was adopted by the Securities and Exchange Commission and five other U.S. regulators (collectively, the “Agencies”) to implement Section 941 of the Dodd-Frank Act. It requires that a “securitizer” retain not less than five percent of the credit risk for any asset that the securitizer, through the issuance of an asset-backed security, transfers, sells or conveys to a third party.
The Credit Risk Retention Rule became effective for CLOs on December 24, 2016. Since that date, it has fallen to either the CLO manager or a “majority owned affiliate” of the CLO manager to fulfill the risk retention obligations in respect of a CLO issuance. Because open-market CLOs acquire assets on the open market from potentially multiple sources (i.e., assets are not originated solely for the CLO transaction), critics of the Credit Risk Retention Rule noted that this requirement effectively created a new risk by requiring the CLO manager to purchase a risk retention interest in loans that it had neither originated nor held, rather than fulfilling the stated intent of Congress in requiring originators to keep “skin in the game”. In the case of an open-market CLO, it is the issuer, using investors’ money and operating at the recommendation of the CLO manager, which purchases loans to securitize them.
The Court of Appeals took note of this critique and concluded that, for purposes of Section 941, “a party must actually be a transferor, relinquishing ownership or control of assets to an issuer” in order to be a securitizer. Having reached this conclusion, the Court then remanded the case to the district court with instructions to vacate the Credit Risk Retention Rule as it has been applied to open-market CLO managers.
The LSTA Decision is not immediately effective. The Agencies have 45 days from February 9, 2018 to decide whether to seek review before the full Court of Appeals, and 90 days to ask the U.S. Supreme Court to review the decision. If a review process occurs, the LSTA Decision will not come into effect (depending on the result of the review) until that review process is complete.
- In respect of new open-market CLOs, managers will need to decide whether to launch deals during the next few months and comply with the requirement to retain risk, to build in language to the contracts allowing for the retained risk to be sold if and when compliance is no longer required or to wait until the LSTA Decision becomes effective. We note that some CLO investors may prefer that a risk retention interest be held by the CLO manager.
- For any open-market CLO issued during the next few months, disclosure will need to be amended to acknowledge the LSTA Decision and the possibility that the Credit Risk Retention Rule may not apply to the CLO if and when the LSTA Decision becomes effective.
- CLO managers will need to consider their approach to open-market CLOs issued during 2017 which have complied with the Credit Risk Retention Rule. Pursuant to the terms of those CLOs, CLO managers may be contractually required to retain a risk retention interest, notwithstanding that the legal requirement to do so may have ended. As stated above, CLO investors may prefer that a risk retention interest continues to be held by the CLO manager.
- “Majority owned affiliates” of CLO managers which have made CLO risk retention interest purchases have, in some cases, third-party investors who have their own investment requirements. Such third party risk retention investors may not want to change their investment requirements or have their investments unwound early.
The LSTA Decision only applies to open-market CLOs where a manager arranges for the purchase on the open market of all the assets to be securitized. CLOs created by the originators of loans to transfer off balance sheet and into a securitization (balance sheet CLOs), along with any other type of securitization where assets are originated and either sold or transferred by a sponsor, are still subject to the Credit Risk Retention Rule. Consequently, a large portion of the securitization market, including in CLOs, will be required to continue to comply with the Credit Risk Retention Rule.
The LSTA Decision has no impact on the European Union (“EU”) risk retention rules, which continue to operate unchanged.
Dual compliant CLOs
As a result of the EU risk retention rules remaining unchanged, any CLOs with both a U.S. and EU investor base (“dual compliant CLOs”), where that investor base in the EU is of the kind that requires the EU risk retention rules to be satisfied in order to permit such investment, would continue to need to satisfy the EU risk retention rules regardless of whether compliance is required in the U.S. in relation to the Credit Risk Retention Rule.
Over recent years, in order to facilitate compliance with both the Credit Risk Retention Rule and the EU risk retention rules, there has been a rise in the use of CLO originator entities – i.e., entities which acquire loans for their own account and routinely sell those loans into CLOs. Specific advice should be sought in relation to any CLOs that source underlying loans from such entities, because, while such loans may themselves have been acquired by originator entities in the open market, the acquisition of such loans by the CLO itself from such originator entities could (depending on a number of circumstances) result in the CLO being characterized as a balance sheet CLO and, consequently, subject to the Credit Risk Retention Rule.
As a practical matter, if and when the LSTA Decision becomes effective, it seems reasonable to expect that CLO managers will decide to structure their U.S. CLOs (or the way in which loans are acquired) to avoid having to comply with the Credit Risk Retention Rule.
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