The Boundaries of Risk Retention Now That the D.C. Circuit Has Spoken

by Dechert LLP
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In February, the D.C. Court of Appeals ruled in The Loan Syndications and Trading Association v. Securities and Exchange Commission and Board of Governors of the Federal Reserve System, No. 17-5004 (D.C. Cir. Feb. 9, 2018) (the “LSTA decision”) that a manager of an open market CLO is not required to retain risk under the Dodd-Frank Act and Regulation RR, because only a securitizer which transfers financial assets into a securitization vehicle must retain risk.  No transfer, no risk retention.

In its decision (joined by Judge Brett Kavanaugh), the Court was very clear in its analysis.  Essentially, the decision said “thank you very much, we can read simple English sentences, and the law is crystal clear on this point (if not on much else).”  The regulators may not elide the transfer requirement of the Dodd-Frank Act by calling managers of open market CLOs securitization sponsors, when they don’t transfer assets to a securitization vehicle.  The Court went on to point out that if this was a loophole, it needed to be fixed by Congress, not the regulators.  Blessedly, a satisfying, albeit rare, victory for a plain reading of our mother tongue.  The regulations actually mean what they say!

The broadly syndicated CLO business has taken this ruling to heart and has been beavering away on transaction structures that no longer provide for the retention of credit risk. One big issue in that space now is whether you can square the circle about avoiding risk retention in the US, while somehow meeting the EU risk retention criteria.  But that’s a bit of legerdemain for discussion another day.  What I want to talk about is the utility of the LSTA decision in spaces other than the broadly syndicated CLO space—particularly for commercial real estate single-asset, single-borrower (SASB) securitizations, a product representing almost half of all CRE securitization offerings this year.

I have been told by some self-proclaimed serious adults in the room that we lawyers should not be inventive here and should not endeavor to extend the protective ambit of this decision outside the factual boundaries of the case at hand.  The argument runs that attempting to apply the reasoning of the Court more broadly would somehow…I don’t know, cause another court to reconsider this decision; cause the regulators to react with fury and begin to put the regulatory stick about?  These commentators say don’t rock the boat, don’t be inventive.  Good heavens!  Infelicitous innovations!  Isn’t doing that sort of my job?

I don’t share the concern that extending the guidance of the LSTA decision to other transaction structures will somehow extirpate the judicial benefits it provided to the CLO industry.  Plain language is plain language and, given the prominence of the D.C. Circuit, it’s unlikely that the decision will be challenged by the regulators.

So, let’s think through the guidance of the LSTA decision in a SASB deal.  Does it translate?  Got legs?  The $64,000 Question[1] is: can we transact based on the assumption that, if there’s no transfer of a financial asset to a securitization vehicle, risk retention is not required?  Of course we can.  Will the regulators (or maybe the Russians) try to steal one back by asserting that these factual differences should lead to different legal conclusions?  As we regularly chide the regulatory state for overreach in this column, it’s hard to comfortably conclude that the regulatory apparatchiki won’t overreach here.  But a strong case can be made that they shouldn’t, and an almost equally strong case that they won’t.

Consider if, in a SASB transaction, the borrower decides to borrow funds directly from the capital markets and does not just go out and find a loan.  It will use securitization technology to place its debt directly with investors.  Why?  Because the debt, made immediately liquid and tranched as to credit risk across a spectrum of investors through securitization, will produce a lower cost of funds than would be provided by negotiating a traditional loan.

In this sort of direct-issuance SASB transaction, the bankers merely assist the user of capital in the transaction and facilitates the issuance of debt.  The debt comes into existence only when the notes or certificates are acquired by investors in the capital markets. Neither the bank providing structuring and distribution services, nor any other party, lays off risk it owned using nefarious securitization technology.

If the D.C. Circuit’s decision means anything—if the plain reading approach to interpreting the law means anything—this is not a risk retentive transaction.  There is no transfer of a financial asset.  Period.

This conclusion is not only supported by our sometime fickle friend, the English language, but is also almost perfectly aligned with the policy objectives of Congress embodied in Dodd-Frank.

Stay with me here.  The perceived evil that Dodd-Frank was intended to address was that a party which owns a financial asset could lay off the risk of ownership through the technology of securitization to some poor hapless investors (really?), without retaining any material risk.  The purported villain that animated our duly elected leaders was a bank that originated a loan with the intention of selling it through securitization.  In their fevered imagining, a lender which originated a loan for sale didn’t care about the credit quality of the loan and would make any dodgy loan as long as it could sell it to those hapless investors.  Gotcha!  (One could argue that this take on the entire securitization industry is a fairly unreflective embrace, by a largely economically illiterate political class, of a superficially attractive narrative without much of a factual underpinning.  That it was embraced like a shield and buckler by our glorious elected representatives against the slings and arrows of an enraged electorate.  Perhaps too cynical?  No…I don’t think so.)

Regardless of whether Dodd-Frank was the product of a somewhat misguided but nonetheless principled view of the world, or something less noble, it was certainly true that no one was concerned that the Rule would not only impact the originate-to-sell business model (the designated villain), but would also impact any lender that used securitization to lever its portfolio or mediate its risk.  Whoops!  Collateral damage.

Taking the notion at face value that if you are long a risk, it’s not fair that you can unload it through securitization without retaining some part of that risk, transactions where deal sponsors never had the risk in the first place should not be subject to the risk retention rule.

Some might object, saying, “okay, but isn’t this doing something indirectly that a bank could not do directly?” That argument simply does not hold up.  Certainly, if a bank agreed to make a loan, and was contractually obligated to do so, and the bank then flipped that commitment to some borrower-related entity organized for the sole purpose of selling bonds in the marketplace, the case is muddied, to say the least.  But if the bank merely facilitated the transaction and had neither a contractual commitment nor even an intention to make a loan, risk retention simply does not apply.  Look: a direct-issuance SASB transaction is a fundamentally different transaction from a traditional mortgage loan for both the lender and the borrower.  The borrower might get better execution, but it pays a price.  That price is certainty.  The borrower foregoes the certainty of a lender commitment.  In direct-issuance, the borrower takes the full risk of closing, pricing and proceeds, not some lender.

So…direct issuance is not subject to risk retention.  Can we just agree on that?  This is not some unseemly and indecorous misuse of the guidance of the D.C. Circuit.  It’s not too clever by half.  It’s not a workaround.  It’s a perfectly straightforward application of the law to a legitimate and sound business transaction which doesn’t involve one party making a loan and selling it to another.  No transfer of a financial asset, no laying off of risk, no risk retention.

We should not lack the courage of our convictions here.

[1] Sidebar:  The expression, “The $64,000 Question” clearly had more punch back in 1955 when it was the title of a game show made notorious by a cheating scandal.  It says something about that time, and perhaps this time as well, that cheating on a TV game show would become an issue riveting the Country that apparently had nothing else to worry about—except, perhaps, nuclear annihilation.

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