United States: D.C. Court Of Appeals Decides To Exempt CLOs From Dodd-Frank Risk Retention Rules

A three-judge panel of the U.S. Court of Appeals for the D.C. Circuit ruled in favor of the Loan Syndications and Trading Association ("LSTA") in its litigation against the SEC and Board of Governors of the Federal Reserve System ("FRB") over the application of risk retention rules to managers of collateralized loan obligations ("CLOs").

The Court concluded that "open-market CLO managers" are not subject to the credit risk retention rules mandated under the Dodd-Frank Act, which require firms to hold 5% of their fund. The Court explained that because CLO managers are not "securitizers" under Dodd-Frank Section 941, managers have no requirement to retain any credit risk.

The LSTA, which represents participants in the syndicated corporate loan market, first sued the SEC and FRB in 2014. On December 22, 2016, the United States District Court for D.C. ruled against LSTA. In overturning that ruling, the Court of Appeals agreed with LSTA's primary contention that "given the nature of the transactions performed by CLO managers, the language of the statute invoked by the agencies does not encompass their activities."

If the decision stands, (i) managers of open market CLOs will no longer be required to comply with the U.S. Risk Retention Rules, (ii) there may be no "sponsor" of this type of securitization transaction needed, and (iii) no party may be required to acquire and retain an economic interest in the credit risk of the securitized assets of such a transaction.

Implementation of the decision reached by the Panel could be delayed, modified, or reversed if the SEC and FRB seek rehearing in the Appellate Court or petition the United States Supreme Court to accept the case. 

Commentary / Nathan Spanheimer

The SEC and Federal Reserve have limited options to overturn the Court's decision. It is unlikely that the government would seek rehearing or that, if it did, rehearing would be granted. The appellate court has no obligation to consider a request for rehearing and the Supreme Court accepts very few of the petitions filed every year. Furthermore, there is no conflict between the LSTA decision and decisions from other federal courts.

Prospective investors should assume that the government will not prevail on any rehearing or appeal and that neither the collateral manager nor any of its majority-owned affiliates will be required to acquire or hold any notes in order to comply with the U.S. risk retention rules.

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