April 10, 2017 - In response to an Executive Order issued by President Trump in February, on April 7, 2017, the LSTA submitted an important letter to Secretary of the Treasury Steven Mnuchin suggesting the elimination or modification of the risk retention rules as applied to CLO managers.
The Executive Order on Core Principles for Regulating the United States Financial System (“EO”) has two substantive sections, the first of which enumerates “core principles” by which the administration will be guided in regulating the U.S. financial system. Most relevant to the loan market is a provision to “make regulation efficient, effective, and appropriately tailored.” The EO directs the Secretary of the Treasury to consult with the heads of the member agencies of the Financial Stability Oversight Council (“FSOC”) and report to the president within 120 days on “the extent to which existing laws, treaties, regulations…guidance …and other Government policies promote the Core Principles” and what actions have been and can be taken to promote and support the Core Principles. Finally, the EO requires that the Secretary’s report “shall identify any laws…regulations, guidance…and other Government policies that inhibit Federal regulation in the United States Financial system in a manner consistent with the Core Principles.”
The LSTA letter was written to help the Secretary identify counterproductive financial regulations. The letter observes that applying the risk retention rules to CLO managers provides no benefits because those rules were designed to align the interests of investors with loan originators and to avoid market risks caused by “originate-to-distribute” securitizations. Because CLO managers do not originate loans, the originate-to-distribute concern does not apply. Furthermore, the compensation structure of CLOs already aligns the interests of investors and managers since managers receive most of their compensation only if the CLO performs well. Finally, CLOs are extremely transparent: the underlying loans trade in the secondary market, investors receive very detailed reports on the underlying assets, and CLO indentures impose a range of important constraints upon managers. (The letter also notes that the statutory language of Section 941 of Dodd-Frank arguably does not apply to CLO managers; an issue that is before the U.S. Court of Appeals for the DC Circuit).
The letter identifies the harm to the market, investors, borrowers and consumers that will result from the application of the risk retention rules to CLO managers. First, many CLO managers are thinly capitalized – and even those that are well capitalized have generally pursued a business model predicated on asset management rather than direct investment. Second…