Loan Syndications and Trading Association v. Securities and Exchange Commission (2018)

The DC Circuit saves ‘market makers’ for Collateralized Loan Obligations (CLO’s) from a “skin-in-the-game” rule imposed by the SEC.

Why does this decision matter?

For the context that illustrates the importance of this decision, we'll explore The Economist's analysis on the rising economic risks that the Federal Reserve's policy of low interest rates (artificially cheap credit) are causing in corporate debt markets.

Economic Growth of Corporate Debt

Since 2012, American corporations have taken advantage of low interest rates to finance their operations and investments, and to rebalance their debt/equity profile. This uptick in their use of leverage has resulted in the doubling of the average ratio of net debt to earnings (specifically EBITDA).

More Leveraged Corporate Debtors

On average, American companies are well positioned to service this debt with their steady and growing profits. However, as the Economist reports, “about $1trn of this debt is accounted for by firms with debts greater than four times EBITDA and interest bills that eat up at least half their pre-tax earnings. This pool of more risky debt has grown faster than the rest, roughly trebling in size since 2012. All told such debts are now roughly the same size as subprime mortgage debt was in 2007, both in absolute terms and as a share of the broader market in which it sits.”

Speculative Instruments Used to Fuel Growing Debt

Fueling this growing, more speculative debt market, are instruments called Collateralized Loan Obligations (CLO’s), which are similar to the Collateralized Debt Obligations (CDO’s) that were implicated in the subprime mortgage crisis of 2008.

Similarities to CDOs of the Great Recession

These CLO’s have three characteristics, shared with CDO’s, which make them concern to some economists: “securitisation, deteriorating quality of credit and insufficient regulatory oversight.”

Securitization:

CLO organizers/managers collect investor funds to purchase an assortment of 100 to 250 “very large loans made to already highly leveraged companies, often in the retail or manufacturing sectors of the economy.” The CLO managers issue debt-like securities to these investors, using these corporate loans as collateral. “These debts are divided into tranches which face varying risks from default. According to the Bank of England, nearly $800bn of the leveraged loans outstanding around the world have been bundled into CLOs.”

Deteriorating Quality of Credit:

Covenant-lite: A growing proportion of the loans backing the CLOs are issued without the protection of debt covenants which obligate the debtors to keep their overall level of debt to a specified limit. These “covenant-lite” loans “make up around 85% of new issuance in America.”

Add-back earnings: There are concerns that the loans are increasingly made to firms that flatter their earnings by including projected earnings before the earnings materialize. “When Covenant Review, a credit research firm, looked at the 12 largest leveraged buy-outs [(the leveraged buy-out debt obligations are sometimes included in CLO pools)] of 2018 it found that when such adjustments were stripped out of the calculations the deals’ average leverage rose from 6.1 times EBITDA to 8.7.”

Regulatory Oversight:

Regulatory “Debt Covenants” Struck Down: “In 2013 American regulators issued guidance that banks should avoid making loans that would see companies’ debts exceed six times EBITDA. But this was thrown into legal limbo in 2017 when a review determined that the guidance was in fact a full-blown regulation, and therefore subject to congressional oversight. The guidance is now routinely ignored. The six-times earnings limit was breached in 30% of leveraged loans issued in 2018, according to LCD.

“Skin in the game rule” struck down for CLO managers: It is this regulation created by the Dodd-Frank financial reform of 2010 that generated the case, Loan Syndications and Trading Association v. Securities and Exchange Commission (2018), which in turn resulted in the striking down of this rule.

We turn now to the case itself:

LSTA v. SEC

Issue/Conclusion

In one of Judge (now Justice) Kavanaugh’s last decisions for the DC Circuit, (though the actual opinion was authored by Judge Douglas Ginsburg), the Court considered a provision of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which of course, was enacted in the wake of the 2007-08 financial crisis.

Specifically, the Court considered 15 U.S.C §78o-11, which directed, inter alia, the Securities and Exchange Commission and the Board of Governors of the Federal Reserve System to prescribe regulations to require “any securitizer” of an asset-backed security to retain a portion of the credit risk for any asset that the securitizer “transfers, sells or conveys” to a third party, specifically “not less than 5 percent of the credit risk for any asset.” These regulations came to be known as “skin-in-the-game” rules because, as the Court noted, “[t]he reasoning was that “[w]hen securitizers retain a material amount of risk, they have ‘skin in the game,’ aligning their economic interests with those of investors in asset-backed securities.”

The dispute underlying the case, was that the agency wrote the Credit Risk Retention Rule, 79 Fed. Reg. 77,601 (Dec. 24, 2014) to apply the rule to managers of CLO’s.

The Court, applying a stringent textual analysis, agreed with the LSTA (the trade group representing CLO managers) that CLO managers could not be reasonably be classified as “securitizers” in the way Congress defined that term in 15 U.S.C §78o-11.

Reasoning

Applying the Chevron standard to the agencies’ Credit Risk Retention Rule, the Court considered whether the agencies reasonably interpreted the term “securtizers” within the statutory bounds set by Congress in its statutory definition of the term.

The Court declared that the term “sercuritizers” must be interpreted in light of “two key words” that Congress used in the statutory definition and statutory context of the term “securitizers.” These key words were “tranfers” and “retain” as used in 15 U.S.C. § 78o-11(b)(1) and (a)(3):

[T]he term “securitizer” means—

… 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

Not later than 270 days after July 21, 2010, the Federal banking agencies and the Commission shall jointly prescribe regulations to require any securitizer to retain an economic interest in a portion of the credit risk for any asset that the securitizer, through the issuance of an asset-backed security, transfers, sells, or conveys to a third party.

The Court first considered the plain meaning of the term “transfer” as defined by Black’s Law Dictionary 1727 (10th ed. 2014) (“to pass or hand over from one to another, esp. to change over the possession or control of”); 18 The Oxford English Dictionary 395 (2d ed. 1989) (“To convey or take from one place, person, etc. to another”; “Law. To convey or make over (title, right, or property) by deed or legal process”).

It reasoned that the plain meaning of the term “transfer” necessarily implies that a person must at some point possess or own the asset it is transferring.

Since CLO managers merely cause the transfer of the loan obligation assets by directing a third party corporation (known as a Special Purpose Vehicle) to purchase the loans, they never actually possess or own the loan obligation assets.

The broader definition, urged by the agencies (that causing a transfer is sufficient to “transfer” something), would according to the Court encompass “any third party who exerts some causal influence over a transaction. It would thus sweep in brokers, lawyers, and non-CLO investment managers who, though they play a part in organizing securities and “causing” the transfer of securitized assets, are clearly not the initiators of securitizations that Congress intended to regulate.”

Ultimately, the Court concluded that, with respect to the statutory term “transfer”, “the agencies’ interpretation sweeps so far beyond any reasonable estimate of the congressional purpose confirms our view that the interpretation is beyond the statutory language.”

The Court then considered the plain meaning of the term “retain” as used in Black’s Law Dictionary 1509 (“To hold in possession or under control; to keep and not lose, part with, or dismiss). Again here, the Court read the plain meaning to necessarily imply “anterior possession”: that someone must possess something to retain it. As the Court noted,

“it is an astonishing stretch of language to read a mandate to “retain” to apply to one who would never hold the item at all apart from the mandate, with no congressional text mandating the prior acquisition … That the agencies’ reading of the statute would require non-transferring parties to obtain large positions in the relevant securities seems too large a surprise to have been intended.”

The Court did acknowledge that its interpretation of the definition of the statutory terms may “creat[e] a loophole that would allow securitizers of other types of transactions to structure around their risk retention obligation.” But the Court responded that “[p]olicy concerns cannot, to be sure, turn a textually unreasonable interpretation into a reasonable one.”

The Court assuaged any concerns about the impact of their decision on the riskiness of debt markets by reasoning, “Open-market CLOs thus mitigate the problems Congress identified with the originate-to-distribute model: (1) The organizers’ compensation dependency [on the performance of the loan pools they assemble] already gives them “skin in the game.” (2) Because they purchase relatively small numbers of unsecuritized loans on the open market through arm’s-length bargaining, the activities of CLO managers present a far weaker version of the opacity that Congress identified in other ABS [asset-backed securities] markets. And (3) both the superior incentives and relative transparency reduce the likelihood that such financing will generate anything like the decline in underwriting standards that the more famous ABS market is thought to have brought about."

Time will tell whether this diagnosis of the economic health of the structure of corporate debt markets was correct.

Ultimately, the growing economic risks come from the Federal Reserve's issuance of artificially cheap credit, which incentivizes less judicious use of credit, and not from downstream transactions in leveraged loans derivatives (CLOs) purchased by hedge funds and other sophisticated investors.

We as a society need to consider alternative mechanisms for economic stability, other than central banking systems whose monetary tools are routinely used to manipulate exchange rates in order to provide advantages to domestic industries. These alternative tools include a global digital currency such as Ethereum with built in inflation-stability mechanisms and imperviousness to geopolitical manipulation so that we can have a truly free and open society.