Impact of Dodd-Frank’s Risk Retention Rules on CLOs: Regulatory Agencies’ Failure to Account for Crucial Differences among Asset Classes has Potential to Stunt CLO Market

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The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) was signed into law on July 21, 2010. Among many other sweeping changes to the securities and banking laws, section 941 of the Dodd-Frank Act inserted a new section 15G into the Securities Exchange Act of 1934, which, among other things, requires securitizers to retain some portion of the credit risk of any asset-backed security (“ABS”) they bring to market. Risk retention is the notion, born of the lessons from the recent economic crisis, and especially the housing market collapse, that those who sponsor securitization transactions should be required to retain a financial stake, or “skin in the game,” as a means to encourage honest dealing and adherence to prudent underwriting standards in the extension of credit.

As enacted, the Dodd-Frank Act leaves much of the detail to be supplied by key federal regulatory agencies. Congress did, however, leave critical signposts in the law to direct the agencies in their difficult task. In the case of the risk retention rules, among other instructions, Congress directed the agencies to differentiate among asset classes and provide appropriate exceptions to, and exemptions from, their rules to “(A) help ensure high quality underwriting standards for the securitizers and originators of assets that are securitized or available for securitization; and (B) encourage appropriate risk management practices by the securitizers and originators of assets, improve the access of consumers and businesses to credit on reasonable terms, or otherwise be in the public interest and for the protection of investors.”

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