U.S. Risk Retention: LSTA v. SEC Concludes; Thoughts on Its Broader Applicability

Conclusion of Litigation

The LSTA v. SEC litigation concerned whether the U.S. risk retention rules apply to managers of open-market collateralized loan obligation transactions (CLOs). The litigation is now effectively concluded.

The Court of Appeals for the D.C. Circuit, in its decision initially released on February 9, 2018, determined that the rules do not apply to those managers. The U.S. federal agencies that were defendants in the case chose not to seek further review of the decision from the panel of judges that issued the decision or from the full (en banc) D.C. Circuit. On April 3, as expected, the D.C. Circuit issued its “mandate” in the case. By that action, the Court of Appeals’ decision and judgment were made effective. The Court of Appeals remanded the case to the District Court that initially considered the challenge to the rules, with directions to enter judgment in favor of the LSTA (the Loan Syndications and Trading Association, which Sidley represented in this litigation).

On April 5, the District Court did so. Its order granted summary judgment in favor of LSTA “regarding whether application of the Credit Risk Retention Rule to investment managers of open-market collateralized loan obligations is valid under § 941 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.” The order further vacated the District Court’s earlier ruling “on the issue of how to calculate the five percent risk retention under the [Rule]” and “ordered that the Credit Risk Retention Rule is VACATED insofar as it applies to investment managers of open-market collateralized loan obligations.”

With this order, the District Court completed the implementation of the D.C. Circuit’s ruling issued on February 9. Although the agency defendants have the right over the next several weeks to seek further review from the U.S. Supreme Court, it is highly unlikely that they will do so, in light of the agencies’ decision not to seek any further review from the Court of Appeals. The Court of Appeals’ decision is now fully effective.

Summary Recap of the D.C. Circuit Panel Decision

The February 9 decision of the D.C. Circuit panel rejected the agencies’ construction of the relevant statute and endorsed LSTA’s arguments. The Court held that the relevant statute does not authorize the agencies to subject managers of open-market CLOs to risk retention regulation, because those managers are not “securitizers” within the meaning of the statute. And they are not securitizers because they are not, within the meaning of the statute, “transferors” of assets backing a securitization.

The Court held that “a party must actually be a transferor, relinquishing ownership or control of assets to an issuer” of the securities issued in the securitization, in order for that party to be a securitizer for purposes of Section 941 of the Dodd-Frank Act. Because managers of open-market CLOs will not have previously owned or controlled assets that are transferred to a CLO issuer and do not otherwise, as a substantive matter, transfer assets to the issuer, they are not “securitizers” for purposes of the statute.

Broader Applicability of the Case

The holding of the D.C. Circuit and the District Court’s order giving effect to it are by their terms limited to managers of open-market CLOs. However, the principles of the D.C. Circuit opinion, as well as the text of the Dodd-Frank Act that the court construed as limiting the agencies’ authority, can be applied to other participants in open-market CLOs and, even more significantly, to participants in other kinds of transactions.

Consider the hypothetical example of a collateralized bond obligation transaction (CBO) that is structurally identical to a CLO, except that it invests in bonds, not loans. If a CBO issuer buys its bonds only through arm’s-length transactions from the market, and its manager plays the same independent role as does the manager of an open-market CLO, the U.S. risk retention rules should not apply to the CBO manager if they do not apply to the CLO manager.

For many other transactions not as similar to CLOs as CBOs are, it may well be that there is a “securitization transaction” within the meaning of the rules but also that there is no “sponsor” of the transaction. The D.C. Circuit’s decision expressly contemplates that this may happen. The question in all cases is whether a party satisfies the “must actually be a transferor” test, directly or indirectly (focusing on the substance of the transaction). There is no reason to limit the LSTA analysis of risk retention obligations to participants in CLOs and their near cousins. (Conversely, the case is not a blanket exemption for all participants in CLOs, because many kinds of CLOs have parties acting as transferors of the securitized loans and otherwise undertaking acts that make them sponsors.)

The market will presumably move carefully, and any application of the “no transferor” principle should be based on substance. Nevertheless, we believe that the market should continue to take note of how the LSTA case has properly grounded the rules in the limiting language of the statute—and how it has served as a reminder that not all “securitization transactions” have a “sponsor.” We are continuing to consider the potential broader applicability of the case.