Investment managers that wish to manage newly formed CLOs will need to have sufficient capital to retain the risk they are required to retain under the Rule.
A version of this article was published in the June 2017 issue of The Banking Law Journal. It is reprinted here with permission.
On December 22, 2016, the U.S. District Court for the District of Columbia released its decision in Loan Syndications and Trading Association v. Securities and Exchange Commission. In the case, the Loan Syndications and Trading Association (LSTA) challenged the “CLO Risk Retention Rule” (the Rule) promulgated by several federal regulators, including the Securities and Exchange Commission (SEC) and the Board of Governors of the Federal Reserve System pursuant to Section 941 of the Dodd-Frank Act (which created Section 15G of the Securities Exchange Act). In particular, the LSTA challenged the application of the Rule to Open Market CLOs (as described below) and their investment managers. The district court upheld the Rule, and it became effective as scheduled on December 24, 2016. The Rule is generally prospective.
What Is a CLO?
A CLO is an investment vehicle that invests primarily in leveraged loans. “CLO” is an acronym for collateralized loan obligation. The leveraged loans themselves are typically originated by commercial and investment banks, although the loans may be originated by hedge funds, other types of investment vehicles and non-bank lenders. CLOs finance themselves by issuing various classes or tranches of securities with varying levels of seniority in the private and 144A markets. Some of these securities are essentially equity. Other, more senior, classes are essentially bond-like, with a stated rate of interest and principal balance. The more senior classes are usually rated by an independent rating agency. The income from the pool of loans owned by a CLO is used to make interest and principal payments on the senior securities issued by the CLO, while the remaining income is paid partially to the junior (equity-like) securities issued by the CLO and partially to the investment manager of the CLO (essentially as a performance or incentive fee). The leveraged loans CLOs invest in are originated for various reasons, including for use as working capital or for capital expenditures of the borrower. They are also commonly used in leveraged buyouts.
The CLO Risk Retention Rule
The Rule implements Section 15G of the Securities Exchange Act and requires the "sponsor" of a CLO to retain, and to refrain from transferring, selling, or hedging, an economic interest in the credit risk of the securitized assets (the leveraged loans owned by the CLO) in an amount equal to at least 5 percent of the CLO securities issued in the transaction. “Sponsor” is defined in the Rule to be “a person who organizes and initiates a securitization transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the issuing entity.” The investment activities of a CLO are directed by an investment manager, which is typically registered under the Investment Advisers Act. Many CLOs can be described as “Open Market CLOs” because the majority of the loans they invest in are purchased on the primary or secondary markets in accordance with the particular CLO’s investment guidelines. An Open Market CLO is distinguished from a CLO in which the leveraged loans that are the CLO’s assets were originated primarily by an affiliate of the CLO’s investment manager. In an Open Market CLO, the investment manager is not involved with the origination of the loans purchased by the CLO. While it may not be obvious when reading the definition of “sponsor” that it includes the investment manager of an Open Market CLO, the guidance included in the final release of the Rule makes it clear that it does.
The Impact on Investment Managers and the LSTA’s Challenge
The Rule holds that (1) Open Market CLOs are within the Rule’s scope, (2) the investment manager of an Open Market CLO is the “sponsor” of the Open Market CLO, and (3) in certain cases, the Rule’s risk retention requirements can be satisfied through the retention of appropriate “fair value” risk as opposed to “credit risk.” The combination of these three Rule elements imposes on the investment manager a requirement to retain a 5 percent “credit risk” interest in an Open Market CLO that it manages. The LSTA challenged all three of these Rule elements.
Since Open Market CLOs are commonly large in size, an investment manager must have significant capital in order to be able to satisfy the Rule. Some investment managers are part of larger organizations and have access to large amounts of capital. For these managers, the Rule may be an increased cost of doing business. Some investment managers have always invested in the riskier securities issued by the CLOs they manage, and for them, the Rule may have limited or no impact.
However, many CLOs are managed by smaller investment managers, with limited access to capital. The Rule has already had a very significant impact on their business, forcing some investment managers to refrain from managing new CLOs while forcing others to sell themselves to larger investment managers with superior access to capital. In addition, a wide variety of structures have been proposed and in some cases implemented that are intended to permit an investment manager to satisfy the Rule with reduced capital. These structures are so far untested and unchallenged.
The LSTA’s Policy View
Based on published remarks, in the LSTA’s view it is not desirable public policy to impose risk retention requirements on investment managers of Open Market CLOs. The LSTA has stated that such a policy will result in reduced CLO issuance and increased costs and reduced access to credit for leveraged loan borrowers. In addition, the LSTA argued in the district court that the investment manager of an Open Market CLO can be differentiated from the “sponsor” or “securitizer” of other types of securitization transactions and that it was not reasonable to force the investment manager of an Open Market CLO to retain risk.
In the recent Great Recession, Open Market CLOs generally performed well, with a limited number of defaults and limited losses for investors. Section 941 of Dodd-Frank applies to many types of securitizations in addition to Open Market CLOs. Congress’s rationale in enacting Section 941 was apparently a belief that “sponsors” of securitizations were profiting without having sufficient exposure to the risk of the assets they originated. In particular, some “sponsors” allegedly collected large fees for originating poor quality assets, which resulted in large losses to investors in related securitizations while the “sponsors” suffered no losses at all.
Since Open Market CLOs performed well at a time of great market stress, it seems reasonable that there is no need to have their “sponsor” retain risk. In addition, the risk retention requirements for other asset classes under Section 941 of Dodd-Frank are imposed on parties that are actively involved in originating the assets to be securitized. In that situation, risk retention forces asset originators to monitor credit quality of the assets they originate.
However, in an Open Market CLO, the investment manager is not involved with the loan origination process and has no ability to reduce the risk of a loan. Instead, risk is reduced in Open Market CLOs by virtue of the fact that the future reputation and future success of an investment manager rests on its ability to select good loans for the CLO to invest in. So while risk retention for other types of securitizations may reduce risk by imposing discipline on their “sponsors,” in Open Market CLOs, the investment manager cannot be disciplined to “more carefully” originate loans since it is not involved with loan origination. In addition, historically, a significant portion of the compensation of the investment manager of Open Market CLOs has been an incentive fee that was not paid until the CLO had performed well for a number of years. This back-ended compensation further lessens the likelihood that the investment manager will select poor quality loans for investment by an Open Market CLO.
The LSTA’s Litigation Action
The LSTA’s litigation to overturn the Rule’s application to Open Market CLOs was rooted in a traditional administrative law approach, claiming that the SEC’s and other federal regulators’ promulgation of the Rule with respect to Open Market CLOs was arbitrary and capricious and in violation of the Administrative Procedure Act.
The District Court’s Decision
The district court determined that the SEC’s and other federal regulators’ promulgation of the Rule as applied to Open Market CLOs should be subject to the judicial standard announced in Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984). The key component of the Chevron standard is that where Congress has not expressly spoken by statute on an issue, courts should defer to agency interpretations of such statutes unless they are unreasonable. The level of deference towards administrative agencies under the Chevron standard is high, and the LSTA was unable to overcome this deference with respect to any of its three claims. The district court found the SEC’s and other federal regulators’ rulemaking satisfied the Chevron standard, and the district court upheld the Rule as applied to Open Market CLOs. The LSTA announced in a January 6, 2017 press release that it will appeal the decision to the U.S. Court of Appeals for the D.C. Circuit. During the appeal the Rule will remain in effect.
The LSTA had been attempting to have the Rule overturned before its effective date of December 24, 2016. That did not happen, and the Rule has gone into effect. Perhaps the LSTA will be successful with its appeal.
The LSTA has been attempting to have the Rule modified through legislation. To date, these efforts have been unsuccessful. With the political changes in Washington, perhaps these efforts will be successful.
Even though there may be sound policy arguments against the Rule, the scope of the rule is apparently well within the statute enacted by Congress.
The Rule was promulgated through notice and comment rulemaking. Even with a change of administration and a desire to replace the Rule, it seems likely that it would take several years for a replacement rule to become effective.
In the meantime, investment managers that wish to manage newly formed Open Market CLOs will need to have sufficient capital to retain the risk they are required to retain under the Rule. That is expensive. We expect that managers will use a variety of structures to satisfy those requirements. Some of those structures may be challenged by regulators, and the forthcoming change in administration makes it difficult to predict how likely these challenges are.
We encourage those thinking about the CLO Risk Retention Rule to speak with experienced regulatory counsel to discuss possible strategies for complying with the Rule in greater detail. Pepper Hamilton has experience with financial regulation, the representation of CLO managers, the structuring of CLOs and the creation of alternative finance vehicles.
Research assistance for this article was provided by Theodore D. Edwards, an associate in Pepper’s Philadelphia office.
The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.