23 July 2010
The newly signed Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) will have a significant and wide-reaching effect on the finance markets generally and collateralized debt obligations (CDOs) and collateralized loan obligations (CLOs) specifically. In particular, the risk-retention requirement in the Dodd-Frank Act could prove to be problematic for CDOs and CLOs.
The Dodd-Frank Act requires the Securities and Exchange Commission, Federal Reserve Board, Federal Deposit Insurance Corporation and Office of the Comptroller of Currency (collectively, the “Regulators”) to enact rules within 270 days of enactment of the Dodd-Frank Act requiring a “securitizer” of an asset-backed security (other than a residential mortgage-backed security) to retain at least 5 percent of the credit risk in any asset that the securitizer, through the issuance of an asset-backed security, transfers, sells or conveys to a third party. With respect to these rules, the Dodd-Frank Act sets forth a transition period after the final rules are issued of one year for residential mortgage-backed securities and two years for other asset-backed securities. The Regulators may reduce the risk-retention requirement of the securitizer by allocating the risk-retention obligation to the originator. In defining “asset-backed security,” the Dodd-Frank Act expressly references CDOs. As there is no explicit exemption for CLOs, it appears likely that CLOs also would be included in the definition.
CDOs and CLOs will likely face distinct difficulties when attempting to interpret the risk-retention requirement, potentially to a much greater degree than other asset-backed securities. In a CDO or CLO, it is unclear what entity would constitute a securitizer and therefore be subject to the risk-retention requirement. The Dodd-Frank Act defines a securitizer as either (i) an issuer of an asset-backed security or (ii) a person who organizes and initiates an asset-backed securities transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the issuer.
If the requirement is meant to apply to the CDO issuer or CLO issuer itself, it is unclear how the obligation would work, as the issuer is generally a special purpose vehicle that already holds the loans or other assets and arguably already holds the credit risk. Similarly, if the Regulators allocate a portion of the risk retention obligation to the applicable originators, the effect and application of the obligation is still unclear: with regard to CLOs, it could be read to require any entity that makes a loan that is, or may be, sold to a CLO to satisfy the risk retention requirement (in which case, the market for syndicated loans will be dramatically affected) or might be read to refer to the manager, arranger or, in the case of a “reverse inquiry” CDO or CLO, the sponsoring investor (in which case, the economics for the affected party will be dramatically different and possibly unattractive).
The Dodd-Frank Act does, however, permit the Regulators to clarify or modify the requirements in their regulations. In recognition of the fact that CDOs are different from other traditional asset-backed securities, the Dodd-Frank Act specifically requires that the regulations establish an appropriate standard for retention of an economic interest with respect to CDOs. Furthermore, the Regulators may issue exemptions to the risk-retention requirement for classes of assets if it (i) helps ensure high quality underwriting standards and (ii) encourages appropriate risk management practices by the securitizers and originators of the assets, improves the access of consumers and businesses to credit on reasonable terms or is otherwise in the public interest and for the protection of investors. The Loan Syndication & Trading Association has indicated they will argue for CLOs to receive a full exemption.
Therefore, during the time period following enactment of the Dodd-Frank Act, and prior to the enactment of the regulations, the Regulators may recognize the distinct difficulties CDOs and CLOs would face with respect to the risk retention requirement and create an applicable exemption, or otherwise clarify the requirement in a way that would not hinder the CDO and CLO market. Until that time, however, uncertainty will exist with respect to the final structure, application and effect of the regulations that are required by the Dodd-Frank Act, and such uncertainty may have an impact on the finance market and, in particular, the loan and CLO markets.
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