I don’t think risk retention is applicable to a direct issuance securitization.  Many single asset, single borrower (SASB) transactions can be structured to avoid the need to retain risk under the Dodd-Frank Act and the attendant Risk Retention Rule.  There.  I’ve said it.  Read on.

I assume you’ve all seen or heard about the recent decision of the Court of Appeals for the District of Columbia captioned The Loan Syndications and Trading Association v. Securities and Exchange Commission and Board of Governors of the Federal Reserve System.  This decision arose out of an action filed by the LSTA against the SEC and the Federal Reserve Board asserting that the agencies had exceeded their authority in designating collateral managers of open market CLO transactions as “sponsors” with risk retention responsibility under the Rule.  The Court, in perhaps a shockingly man bites dog decision, ruled unanimously that LSTA was right, and there was no basis in the Risk Retention Rule to treat collateral managers of open market CLO transactions as having responsibility for risk retention.

Essentially, the Court concluded that the Rule meant what it said when it said that only a party who transfers a financial asset to an issuing entity in order to organize and initiate a securitization transaction, is a party responsible for risk retention.  As the court noted in its decision, in order for a party to act as a transferor, “the party must actually be a transferor, relinquishing ownership or control of assets to an issuer” – “a person with no possessory interest cannot effect a transfer.”  Every so often, the law and common sense converge.

The collateral manager in a broadly syndicated CLO identifies bits of loans in the open market to be acquired by a CLO issuers.  The issuer sells debt and uses the proceeds to acquire those assets directly.  The collateral manager in an open market CLO does not, at any time during the transaction, obtain or hold any interest in the loans purchased by the issuer.

Based on a plain reading of the Rule, the Court held that a CLO collateral manager does not transfer financial assets, and therefore cannot be deemed a sponsor required to comply with the Rules.  No transfer of a financial asset, no risk retention.

So why should we require risk retention in SASB transactions if the loan is directly funded and priced in the capital markets at the time of the securitization?

There are several ways to engineer this (there may be lots of ways around this particular barn).  In all direct issuance transactions, a bank is retained for advice and distribution of the bonds.  The bank, working with the underlying borrower, facilitates the design of a mortgage loan or indenture to be funded through the securitization process, using its market knowledge of terms and conditions in the SASB marketplace and investor appetites but does not make a loan.

The bank or borrower affiliate might act as an “accommodation party” on behalf of the borrower, entering into loan documents as a named “lender”, but not funding the loan (this could be driven by state lending license issues).

The other, and perhaps the cleanest, option is a true direct issuance by the issuer.  The issuer in this scenario would issue notes to investors under an indenture and loan agreement, secured and backed by the cash flows of the underlying property.

In each of these solutions, no “financial asset” is created or transferred prior to the closing of the securitization.  The loan is funded exclusively from the proceeds of the securitization with the loan proceeds conveyed to the borrower.  Although the arranging bank and the borrower play some “organization and initiation” role in the securitization, the Court noted that “a person’s playing any casual role in any transfer” does not cause that person to have “transferred” the asset for purposes of the Rule.

The Court’s ruling suggests that it thought that perhaps the regulators hadn’t really understood broadly syndicated CLO transactions at the time the Rule was created, but that lack of understanding was not something that the Court would or should fix.  Indeed, to me, it’s not clear that the regulators or the Court could stretch the Dodd-Frank statute to the extent necessary to capture broadly syndicated CLOs or direct issuance SASB transactions in any event.   Is this shocking?  If Congress wants to stick someone with a risk retention obligation in every securitization transaction, it had the opportunity to do so in the Dodd-Frank Act and then it did not.  Moreover, at least in SASB transactions there is someone with huge skin in the game:  the borrower!

Is this matter entirely without doubt?  Hey, let’s agree that nothing touching risk retention is ever entirely without doubt.  However, this decision provides robust guidance to the industry.  This is arguably the second most important circuit court in the country and as such its decisions carry considerable weight.  Also, the heft of its argument that rules mean what they say is compelling.

Talk is that the agencies don’t have their heart in a further appeal and, indeed, the Court left very little room for appeal.  It’s also hard to believe that the agencies will go back and try to amend the Rule, given the fact that the law itself doesn’t provide a strong basis to extend risk retention obligations to, shall we call them “facilitation parties” to a securitization.  And all that’s not to mention the Treasury’s public animas to the Risk Retention Rule in general and, shall we say, the philosophic predilections of the current Trump administration.

This ruling does not help conventional bank funded SASB transactions nor conventional CMBS transactions in which an institution goes long in credit exposure and then uses securitization technology to transfer that exposure to third party investors.  However, this decision does provide a straightforward path for transactions that do not involve the transfer of financial assets.

It will take some courage to confront pouty and annoyed regulators who may ferociously defend regulatory turf.  Moreover, if investors think structures without risk retention are bad or even less good, classic market factors may result in SASB transactions continuing to include a risk retention component, but hey, I’m always in favor of the market forces.  To the extent avoiding the drag of risk retention is important and accretive, we now have a roadmap.  There’s a pony in here somewhere.