By Kristen Haunss
NEW YORK (LPC) - A legal victory for Collateralized Loan Obligation (CLO) funds may help President Donald Trump’s efforts to dismantle the Dodd-Frank Act, a massive regulatory package that was signed into law by his predecessor, President Barack Obama.
CLO funds, one of the largest lenders to U.S. companies including retailers Toys “R” Us and J. Crew Group, are celebrating the win, which exempts the $501 billion asset class from the Dodd-Frank risk-retention rules that require managers to hold some of their funds’ risk.
The decision last Friday in the three-year legal battle helps Trump’s call to roll back regulation, which critics say stifles lending and limits economic growth, without having to wrangle Congressional votes or send morning tweets.
The legal victory may help other asset classes to argue that they should also avoid risk-retention requirements, which was a key argument made by regulators who said that exempting CLOs would drive a freight train through the rule.
The court ruling could apply to other securitizations structured in a similar way to CLOs, according to Travis Norton, counsel at Brownstein Hyatt Farber Schreck. These could include residential mortgage-backed securities, commercial mortgage-backed securities and asset-backed securities, according to Barclays (LON:BARC) analysts.
Dodd-Frank introduced the ‘skin-in-the-game’ rules for some funds, including CLOs, banned banks from speculating with their own money and created the Consumer Financial Protection Bureau.
CLOs were lumped in with more exotic Collateralized Debt Obligation (CDO) funds, which were widely blamed for causing 2008’s meltdown, forcing managers to hold 5% of their fund although CLOs suffered minimal losses during the recession.
The Loan Syndications and Trading Association (LSTA), the trade group representing the US CLO and leveraged loan markets, sued the Federal Reserve (Fed) and Securities and Exchange Commission (SEC) in 2014 saying risk retention was “arbitrary, capricious" and "an abuse of discretion,” and could cut off funding to the neediest companies.
On February 9 the US Court of Appeals for the District of Columbia Circuit agreed, saying that the agencies went beyond their statute and ruled that CLOs are exempt from risk retention.
Regulators have 45 days to seek an en banc review, a hearing in front of the active DC Circuit Appeals Court judges. The government also has a 90-day window to seek review from the Supreme Court, Richard Klingler, a partner at law firm Sidley Austin and the LSTA’s counsel, said.
Managers of US CLOs will no longer need to hold retention in around two months if regulators do not appeal. This will benefit smaller funds most, which do not have the capital to rework old deals or raise new funds.
“We are reviewing the court’s decision,” a Fed spokesperson said in an e-mailed statement. An SEC spokesperson declined to comment.
LOOPHOLE
The case largely centered on the use and differing interpretations of the word “transfer” in the Congressional text. The three-judge Appeals Court panel agreed with the LSTA’s argument that CLO managers do not transfer loans into their funds.
The ruling may open the regulation up to challenges from other asset classes, including CDOs, which use similar structures, a concern shared by Joshua Chadwick, the regulators’ counsel.
“If you accept [the LSTA’s] reading of transfer, it would drive a freight train through what Congress intended to do,” Chadwick told the Court of Appeals judges last year.
Some of the most “dangerous, toxic assets of the financial crisis” such as ‘CDO Squared,’ a CDO, composed of other CDOs, use the same management structure and also buy debt in the open market to be transferred into a securitization vehicle, he said.
Regulators’ concerns about loopholes were overstated and to an extent a problem of the agencies’ making, Senior Circuit Judge Stephen F. Williams said in his opinion last week.
Law firm Sidley is studying the implications of the ruling for CLOs as well as other products.
“Could you now seek to design a [Collateralized Mortgage Obligation] CMO with a manager structure akin to the CLO one that was exempted? Absolutely,” said Karen Petrou, a co-founder of consulting firm Federal Financial Analytics. “I’m sure hard thinking is already at work on that score.”
A White House spokesperson did not respond immediately to an email requesting comment.