Court rules to exempt CLOs from Dodd-Frank risk-retention rules

NEW YORK (Reuters) - A US court ruled on Friday that a key lender to some of the largest companies should be exempt from a Dodd-Frank financial reform legislation requirement that investment firms hold some of their funds’ risk.

The US Court of Appeals for the District of Columbia Circuit ruled in favor of the Loan Syndications and Trading Association (LSTA) saying Collateralized Loan Obligations (CLOs), the largest buyers of leveraged loans, should no longer be forced to comply with ‘skin in the game’ requirements meant to align interests between managers and their investors.

The LSTA sued the Federal Reserve and the Securities and Exchange Commission in 2014, arguing that the US$501bn US CLO market should not be subject to risk-retention rules that force firms to hold 5% of their fund, calling the requirement “arbitrary, capricious” and “an abuse of discretion.” The New York trade group has argued risk retention puts pressure on smaller managers that may not have the capital to comply with the rules, which could cut lending to the neediest borrowers.

“Risk retention was a solution in search of a problem that didn’t exist and still doesn’t exist,” Elliot Ganz, LSTA’s general counsel, said in an interview. “The market worked well before and through the financial crisis, and this will allow it to continue as it always has, taking a lot of friction and cost out of the system.”

CLOs, which buy loans extended to companies including Party City and Dunkin’ Brands, which runs the Dunkin’ Donuts chain, sell different tranches of varying risk of their fund to investors. The deals have historically performed well, and between 1993 and 2015 just over 70 of the more than 8,500 tranches issued – primarily the more junior slices of the fund – experienced a principal impairment, according to Moody’s Investors Service.

Despite its performance and structure as a long-term holder of debt, the funds fell under the Dodd-Frank risk-retention rule, forcing managers to hold a portion of their fund.

The LSTA sued and the case bounced through the court system for more than three years. At question was the word “transfer” and who is the transferee and who is the transferor. It also questioned whether CLOs should hold 5 percent of their fund or 5% of the equity tranche, the riskiest slice of the deal.

“The judges recognized that the statutory language did not give the agencies the right to tag managers as securitizers and their analysis was spot on,” Ganz said.

The ruling will allow the CLO market, which has been off to a strong start with more than $9.9 billion of funds arranged through February 8, to save money as managers will no longer have to buy some of their fund in order to meet the risk-retention requirement.

Reporting by Kristen Haunss; Editing by Tessa Walsh and Michelle Sierra