Enter to open, tab to navigate, enter to select
District Court Rules Against LSTA in CLO Risk Retention Suit
Practical Law Legal Update w-005-1786 (Approx. 5 pages)
District Court Rules Against LSTA in CLO Risk Retention Suit
by Practical Law Finance
| Published on 23 Oct 2017 • USA (National/Federal) |
The District Court for the District of Columbia has ruled against the LSTA in its lawsuit challenging the application of final Dodd-Frank ABS credit risk retention rules to CLOs.
On December 22, 2016, the US District Court for the District of Columbia issued an opinion on competing motions for summary judgment in the Loan Syndications and Trading Association's (LSTA) suit against the Federal Reserve and the SEC (collectively, defendants) in which the LSTA sought relief for collateralized loan obligation (CLO) transactions from the final risk retention rules for asset-backed securities (ABS) issued under Section 941 of the Dodd-Frank Act (see Practice Note, ABS Risk Retention under Dodd-Frank).
The court found in favor of defendants, holding that the risk retention rules apply to CLO transactions.
Update: The LSTA has appealed this ruling. It submitted its opening brief on April 19, 2017 with the US Court of Appeals for the District of Columbia and oral arguments were held on October 11, 2017. The LSTA issued a press release on the oral arguments.
Background
The LSTA's suit was filed in response to the adoption by defendants and other federal regulators (collectively, regulators) of final rules requiring that securitizers, including CLO asset managers, retain 5% of the credit risk of securitized asset pools backing non-exempt ABS (see Practice Note, ABS Risk Retention under Dodd-Frank).
As the court explained in its decision, the core of the case concerned "the operation of the term 'securitizer' and the corresponding joint regulation … implement[ing] the credit risk retention mandate."
This dispute focused on the inclusion of "open-market" CLO managers, in particular, in the definition of "securitizer" under the final risk retention rules. Open-market CLOs securitize assets that are purchased on primary and secondary markets, depending on the investment guidelines of the CLO. A manager of an open-market CLO directs the purchase of loans according to the CLO's investment parameters. These loans are purchased and held by a special purpose vehicle (SPV) formed to issue the ABS. For details on the structure and mechanics of ABS, including CLOs, see Practice Note, Securitization: US Overview.
The LSTA argued that the rules were misapplied to open-market CLO managers and argued three points in support of its position:
- The final rules are "arbitrary, capricious, an abuse of discretion or otherwise not in accordance with law," when including managers of open-market CLOs as securitizers.
- Defendants acted in an arbitrary and capricious manner in using "fair value" as a metric to measure credit risk under the final rules.
- Defendants failed to exempt or adjust the risk retention rules so that open-market CLO managers could manage their CLOs according to industry best practices to retain the benchmark level of risk retention without devoting excessive capital.
Defendants noted that the definition of a "securitizer" in the final risk retention rules (15 U.S.C § 78o-11(a)(3)(B)) was essentially identical to the definition of "sponsor" under SEC regulations governing disclosure for ABS offerings under the Securities Act.
According to defendants, they decided during the rulemaking process that since CLO managers generally act as sponsors of securitization transactions by selecting for purchase and managing the securitized assets in the CLO collateral pool, the definition of a "securitizer" would necessarily include open-market CLO managers, thus subjecting them to the retention requirements.
Outcome
CLO Manager Is a "Securitizer"
The court relied on the "Chevron two-step" process established in Chevron, U.S.A., Inc. v. Natural Res. Def. Council, Inc. (467 U.S. 837 (1984)) in determining the appropriateness of defendants' actions during the rulemaking process:
- If "Congress has directly spoken to the precise question at issue," then "the court, as well as the agency, must give effect to the unambiguously expressed intent of Congress." (Chevron, 467 U.S. at 842-43)
- If "the statute is silent or ambiguous with respect to the specific issue," the court analyzes "whether the agency's answer is based on a permissible construction of the statute." (Chevron, 467 U.S. at 843)
In performing the Chevron two-step analysis, the court noted that the similarity between the second prong of the definition of "securitizer" in the risk retention regulation and the SEC's pre-existing definition of "sponsor" bolstered defendants' argument that Congress intended to "broadly delegate rulemaking authority to [defendants]." Further, the court found that Congress did not unambiguously intend to exclude open-market CLO managers from the "securitizer" definition because Congress chose to incorporate defendants' definition of "sponsor" into the definition of "securitizer" in the risk retention rules.
The court found that Congress did not unambiguously foreclose defendants' construction and therefore found defendants' construction reasonable.
Measuring Credit Risk Under the Rules
The LSTA next argued that defendants erred when they adopted fair value as the measure of the ABS interest to be retained in accordance with the horizontal risk retention option or partial holdings in a combination or hybrid retention option (see Practice Note, ABS Risk Retention under Dodd-Frank: Horizontal Interest and Hybrid Interest) because Congress did not provide clear direction for the defendants to use fair value as a measure for retained risk. However, the court did not find this argument convincing.
The court noted that Congress required defendants to promulgate rules to ensure that securitizers retain an economic interest in a portion of the credit risk of the transaction and that the retained economic interest should be not less than 5%. Congress did not define credit risk or expressly provide a methodology for defendants to employ in measuring the value of the retained interest. The court noted that Congress did, however, intend for securitizers to "retain a 'material amount of risk' sufficient to ensure that securitizers 'align their economic interests with those of investors.'"
Since Congress provided a broad mandate for risk retention without providing a detailed methodology, the court concluded that the use of fair value to measure horizontal risk retention was not precluded by Congress and that the choices made to measuring risk retention was appropriate, reasonable, and supported in the explanatory text of the final rule.
Declining Exemptions for CLOs
The LSTA's final argument was that defendants failed to grant exemptions from or make adjustments to the risk retention rules so that open-market CLO managers could adhere to industry best practices for risk retention while not having to commit excessive capital to do so. The LSTA noted that it had submitted public comment to this effect when the rule was in the proposal stage.
The LSTA argued that by rejecting these comments, defendants failed to "appropriately assess the costs and benefits associated while declining to grant [exemptions and] adjustments." The court found this argument similarly unconvincing.
The court noted that its judicial review on this point is limited, and that agency decisions are "untouchable if [the agency] 'examine[d] the relevant data and articulated a satisfactory explanation for its action.' The court found that defendants rejection of the LSTA's request for exemption was adequately reasoned in the explanatory text of the final rule, in accordance with statutory directives.
Practical Implications
While it is likely that the LSTA will appeal this decision, for the time being open-market CLO managers will continue to be subject to risk retention obligations as securitizers under Dodd-Frank ABS credit risk retention rules.