The LSTA Case: DC Circuit Court Delivers Victory for CLO Industry, with Some Broader Ramifications

The Loan Syndications & Trading Association prevailed in its quest to eliminate credit risk retention requirements for open-market CLO managers, in a ruling that has other important implications.

The US Court of Appeals for the DC Circuit (the Court) ruled on February 9 in favor of the Loan Syndications and Trading Association (LSTA) in its lawsuit against the US Securities and Exchange Commission (SEC) and the Board of Governors of the Federal Reserve (Federal Reserve Board),[1] concluding that managers of open-market collateralized loan obligations (CLOs) are not subject to the credit risk retention rules adopted[2] pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 ( Dodd-Frank Act).[3] In its ruling (the Ruling), the Court directed the District Court to enter judgment in favor of the LSTA and to invalidate the credit risk retention rules as they relate to open-market CLOs.

Under the credit risk retention rules, a sponsor of a securitization generally is responsible for retaining not less than 5% of the credit risk of any asset that, through the issuance of asset-backed securities (ABS), is transferred, sold, or conveyed to a third party. Sponsors and other parties that retain ABS interests to satisfy the credit risk retention requirements generally are prohibited, for a specified period, from transferring the retained interests (other than to majority-owned affiliates), hedging the retained credit risk, or pledging the retained interests on other than a full recourse basis.[4]

The LSTA and other commenters on the rules were of the view that an open-market CLO manager is not a “sponsor” because it does not sell or transfer assets to the issuing entity. However, the Agencies rejected this interpretation, stating that a “CLO manager indirectly transfers the assets to the CLO issuing entity because the CLO manager has sole authority to select the commercial loans to be purchased by the CLO issuing entity for inclusion in the CLO collateral pool, directs the issuing entity to purchase such assets in accordance with investment guidelines, and manages the securitized assets once deposited in the CLO structure.”[5] The LSTA challenged the Agencies’ interpretation and appealed to the Court after the District Court decided in favor of the Agencies. The Ruling vindicates the views of the LSTA and those other commenters.

While the Ruling directly addresses only the need for open-market CLO managers to hold risk retention, its holdings may affect many other issues that have permeated risk retention analysis since adoption of the rules, including whether other structures also may be exempt from the credit risk retention requirements, and the identification of the appropriate sponsor that is required to hold risk retention.

Section 15G of the Exchange Act imposes risk retention requirements on any “securitizer” of ABS. As defined, a “securitizer” includes “an issuer of an asset-backed security,” which the Agencies interpreted as referring to the ‘‘depositor’’ of the securitization transaction, as well as a “person who organizes and initiates an asset-backed securities transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the issuer,” a phrase which is substantially identical to the definition of “sponsor” under Regulation AB. The Agencies generally applied the risk retention requirement to the sponsor, because of the active and direct role that a sponsor typically has in arranging a securitization transaction and selecting the assets to be securitized.

A CLO is a type of ABS that acquires and is typically collateralized by portions of tranches of senior, secured commercial loans of borrowers who are of lower credit quality or that do not have a third-party evaluation of the likelihood of timely payment of interest and repayment of principal. The LSTA case deals with a type of CLO known as an open-market CLO, which the Ruling described as CLOs that “acquire their assets from, as the name implies, arms-length negotiations and trading on an open market.”[6]

CLOs usually are organized and initiated by a CLO manager when the CLO manager engages an investment bank that, in addition to providing structuring and placement services, assists in financing asset purchases during the warehousing phase prior to the sale of the ABS in the capital markets. A special purpose CLO issuing entity is formed to warehouse the assets and issue ABS backed by commercial loans that the CLO manager has selected and directed the CLO issuing entity to purchase. After the terms of a CLO transaction, including investment guidelines, are agreed upon with key investors, and following the closing of the CLO transaction, the CLO manager usually has sole discretion to actively manage the asset portfolio (including conducting asset acquisitions and dispositions), in accordance with the agreed investment guidelines, and earns management and performance fees for management services provided.

For open-market CLOs, the Agencies required the CLO manager to satisfy the risk retention requirements. In their view, the CLO manager generally acts as the sponsor by selecting the commercial loans to be purchased by the issuing entity and managing the pool assets once deposited in the CLO structure. According to the Agencies, this constitutes an indirect transfer of the securitized assets.

The LSTA and other commenters on the rules disagreed, asserting that open-market CLO managers are not ‘‘securitizers’’ and are, therefore, not subject to Section 15G of the Exchange Act. According to these commenters, under plain language of Section 15G, open-market CLO managers cannot ‘‘sell’’ or ‘‘transfer’’ the assets securitized through the CLO because they do not own, possess, or control the assets. Additionally, commenters asserted that the open-market CLO manager acts as an agent to the CLO issuing entity in directing the purchase of assets, so it could not sell or transfer the assets to a third party to meet the definition, because it would be equivalent to selling or transferring the assets to itself. According to these arguments, the use of ‘‘indirectly’’ in the definition of “securitizer” was intended to prevent the party that originates a loan from avoiding risk retention obligations by passing the loan through an associated intermediary that organized and initiated the securitization.

In the LSTA case, the LSTA continued to press the arguments that it and other commenters made during the comment process for the credit risk retention rules. The District Court granted summary judgment in the Agencies’ favor, finding that they could reasonably read Section 15G to treat open-market CLO managers as “securitizers.”[7] The Court disagreed...