A ruling on the LSTA’s suit against regulators over CLO risk retention may not be reached until just before the regulation is due to go into effect on December 24.
Much will depend on which court has the jurisdiction to hear the suit, a topic that was heavily debated at last Friday’s oral arguments at the D.C. Appeals Court.
If the appeals court has jurisdiction, a ruling could be expected by June or July, but it’s also possible that the case gets transferred to the lower D.C. District Court, pushing any ruling very close to the December 24 deadline.
In that latter scenario, the LSTA would likely try to speed things along, requesting an expedited hearing in addition to negotiating with the government to use the same briefs that were submitted to the appeals court to save time, but nonetheless another date would have to be set in the district court for oral arguments.
Adding to the timeline is the likelihood that the decision in the district court would be appealed regardless. The case would then return to the appeals court where a different panel of judges would ultimately rule on the merits.
The LSTA could also ask for a stay of the final rule from the judge, meaning that the deadline for CLO managers to comply with risk retention would not go into effect until the case is decided in the appeals court.
Friday’s developments mean that any relief for the CLO market around risk retention remains a long shot, but there was at least some encouragement that the justices on Friday seemed open to some of the LSTA’s arguments.
To recap, the LSTA is challenging the Federal Reserve and Securities and Exchange Commission (SEC) on three fronts related to the 5% retention requirement in December.
The LSTA argues that the regulators are misinterpreting the definition of a “securitizer,” not properly defining “credit risk,” and failing to consider potential alternatives such as the Qualified CLO.
If the courts rule that CLO managers are not “securitizers,” CLOs would likely be exempt from risk retention, while a ruling that the regulators failed to either properly define credit risk or consider alternatives would mean regulators may have to re-propose risk retention.
When the lawyer for the Federal Reserve explained the securitization process of CLOs and how the risk is transferred from the balance sheets of the banks to CLO investors, a judge asked, “but you weren’t saying these risky loans were ever on the balance sheet of the manager, right?” To which the Fed’s lawyer replied, “They never put them on their balance sheet your honor, that is correct.”
Thus supporting the LSTA’s argument that the CLO manager is not a “securitizer” because it has no ownership, possession, or control of the underlying loans assets when they are purchased and put into a special purpose vehicle (SPV).
The definition of credit risk was prominently debated in the latter part of the hearing. The LSTA argues that the government is under obligation to explain its rulemaking, and the agencies fail to clearly define credit risk, using only the term “fair value.” And while CLO managers can comply with the 5% risk-retention rule through a vertical slice, horizontal slice, or a mix of both, justices acknowledged their awareness that the horizontal tranche is composed entirely of the “first-loss” piece. Lawyers for the LSTA pointed out that the same 5% held in a vertical slice has a different risk profile because almost 80% (the AAA tranche) has very little credit risk.
While one of the judges appeared sympathetic to the LSTA’s argument on credit risk, another seemed to suggest that the government may have met its burden by proposing the 5% vertical slice.
The audio of Friday’s hearing hearing can be found here.
The case is The Loan Syndications & Trading Association v. SEC, 14-1240, U.S. Court of Appeals, District of Columbia Circuit (Washington). — Andrew Park
Follow Andrew on Twitter for CLO market news and insights.
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