[00:00:02] Speaker 00: Case number 17-50-04, the Loan Syndications and Trading Association Appellant versus Securities and Exchange Commission at L. Mr. Klingler for the Appellant, Mr. Chadwick for the Appellees. [00:00:15] Speaker 04: Good morning. [00:00:17] Speaker 02: Good morning, Your Honor. [00:00:22] Speaker 02: May it please the court, I'm Richard Klingler for the LSTA. [00:00:26] Speaker 02: The agencies made two basic errors in addressing the statutory requirement that securitizers retain a portion of credit risk. [00:00:35] Speaker 02: They misconstrued securitizer and they failed to focus retention on credit risk. [00:00:40] Speaker 02: A securitizer, under the second prong of the definition, is limited to one who sells or transfers an asset to the issuer. [00:00:48] Speaker 02: The asset manager [00:00:50] Speaker 02: is the transferee, controls the asset only after the transaction is completed and before the transaction has nothing to sell or to transfer. [00:00:59] Speaker 02: The manager is the issuer's agent, not a counterpart. [00:01:04] Speaker 02: And the ordinary usage of the terms support this. [00:01:07] Speaker 02: If I say to you, my employer would like to buy your house, causing you to sell it, you are the one who transfers title and possession and sells the interest. [00:01:17] Speaker 02: I'm not the transferer. [00:01:18] Speaker 02: Likewise, we don't usually speak of a purchaser as a transfer, as the agency's view would have it. [00:01:25] Speaker 02: Instead, the transfer of possession and title and the sale of the interest are bound together on the other side of the transaction. [00:01:33] Speaker 02: And it's not a reasonable result. [00:01:36] Speaker 02: that the agencies have reached because managers aren't part of the loan origination problem that Congress sought to address. [00:01:43] Speaker 02: In fact, they're part of the solution. [00:01:45] Speaker 02: Congress sought to provide a disincentive for loan originators to use captured SBBs to shift bad loans onto the market. [00:01:53] Speaker 02: The agent, the asset manager, however, is contrary, is adverse to that dynamic. [00:01:59] Speaker 02: It has nothing to do with loan origination. [00:02:02] Speaker 02: In fact, it's paid by the investors to select good loans and to reject bad loans. [00:02:11] Speaker 02: There's no misalignment of incentives to fix here. [00:02:14] Speaker 02: And to the extent that regulation is extended to managers, the effect is to require them to tie up capital, to squeeze them from the market, and to cause the cost to efficiency and competition to the agencies themselves, acknowledge and to remove a counter [00:02:30] Speaker 02: weight or origination. [00:02:33] Speaker 02: In this respect, they're like mutual fund managers, which Congress saw no need to regulate. [00:02:38] Speaker 06: I was a little puzzled at the way that in responding to the argument that transfer encompasses causal transfer, your response in terms of whether one should use a colloquial or a legalistic [00:02:57] Speaker 06: set of applications of the word transfer. [00:03:03] Speaker 06: Are you actually worse off using colloquial terms? [00:03:07] Speaker 02: No, and I apologize if we were a bit unfocused in that response. [00:03:12] Speaker 02: In the context of this statute, which involves an asset transfer to the issuer in the context of structuring or securitization, the natural meaning of the terms, rather than any technical meaning, is entirely sufficient to support our argument. [00:03:30] Speaker 02: There are, in their definition, frankly, there are plenty of parties who may cause a particular asset transaction, but not all parties who cause it. [00:03:43] Speaker 02: The transaction may necessarily be called a transfer. [00:03:47] Speaker 02: Their dictionary definition simply doesn't address who the transferor is. [00:03:51] Speaker 02: For example, in my example, [00:03:54] Speaker 02: I approach you on behalf of my employer causing you to transfer. [00:03:59] Speaker 02: You could sell your house for any reason. [00:04:02] Speaker 02: It may be that your kids have left. [00:04:04] Speaker 02: It could be that your financial advisor advises you to. [00:04:07] Speaker 02: All of those parties may cause the sale in some colloquial sense, but we wouldn't call them a transfer. [00:04:16] Speaker 03: Mr. Kleiner, in the commission's approach, or the interagency agency's group, who is the issuer in part A of the securitizer definition? [00:04:28] Speaker 02: In the first prong, well, there's an issuer in both prong one and prong two. [00:04:35] Speaker 02: We believe, and the agencies agree, that in prong two it's clearly the issuing entity. [00:04:40] Speaker 02: We also believe that it's the issuing entity in Pong 1 as well. [00:04:45] Speaker 02: And the Exchange Act definition, the first portion of the Exchange Act definition, indicates that the issuer is the party that issues the securities, which would make it the issuing entity. [00:04:57] Speaker 03: Well, in, okay, so and in B, which ends with to the issuer, that's back to the issuing entity. [00:05:05] Speaker 02: That's right, to the special purpose vehicle. [00:05:07] Speaker 02: And that's the agency's view of that as well. [00:05:10] Speaker 03: But the agency's view doesn't make... I actually couldn't find in the agency's presentation what they thought of in A, but okay, it's not a dispute between you. [00:05:19] Speaker 02: Well, no, there is a dispute about wrong one. [00:05:22] Speaker 02: In prong two, there's no dispute that the transfer of the asset is to the issuing entity, to the SPV, because the manager's obligation turns on the fact that it selects, under the agency's rationale, that it selects the loans for purchase by the SPV. [00:05:37] Speaker 03: What do you make of indirectly in here? [00:05:39] Speaker 03: Why isn't that sufficient to support the commission's, the agency's view that when you direct [00:05:49] Speaker 03: the purchase you are indirectly transferring or so. [00:05:56] Speaker 02: Right. [00:05:56] Speaker 02: Well, as Honeycutt recently reminds us, Congress's use of indirectly or directly doesn't change the nature of transfer. [00:06:04] Speaker 02: And it's clear that, yes, it doesn't change the nature of the word transfer. [00:06:09] Speaker 02: And it's clear that indirectly here does independent meaning. [00:06:12] Speaker 02: or does independent work and has meaning to ensure that where there is an intermediary involved, as there is in most securitizations but not for CLOs, that there may be a direct sale to the issuer, but the indirect sale or transfer may be the party that actually initially holds the loan and directs the transaction. [00:06:34] Speaker 02: There's nothing about indirectly that takes transfer out of the context of a securitization structuring where there's a property interest that is being transferred or sold to the issuer. [00:06:50] Speaker 04: Can you give me a specific example of indirect? [00:06:52] Speaker 04: I'm not sure I followed what you said there. [00:06:54] Speaker 02: So for many, many securitizations – well, let me give you two examples. [00:06:59] Speaker 02: For many securitizations, there's an intermediary, particularly in the context of real property interests. [00:07:05] Speaker 03: Between who? [00:07:07] Speaker 02: Between the party that originally holds the loan, probably originated the loan – may have originated the loan. [00:07:15] Speaker 02: passes it to the depositor, in that case, the intermediary, who actually sells it to the issuer. [00:07:22] Speaker 02: So that would be the kind of indirect transaction that Congress described. [00:07:29] Speaker 02: And in fact, they use the term, including by an affiliate. [00:07:33] Speaker 02: Sometimes that intermediary may be affiliated, and sometimes it's not. [00:07:36] Speaker 02: Another example might be if a parent company [00:07:41] Speaker 02: and the subsidiary are involved, the subsidiary may actually hold the asset. [00:07:46] Speaker 02: It may be the one that actually sells the interest or transfers possession and title, but if it's a controlled subsidiary, it's the parent that may be indirectly doing the transfer sale. [00:07:58] Speaker 02: And if I could also just note that the transfer and sale of Congress, as with indirectly and directly, is Congress is trying to capture all the interests involved. [00:08:06] Speaker 02: We normally speak of the transfer of title and possession and sale of an interest. [00:08:12] Speaker 02: So the natural meaning of the terms, Congress is simply capturing all of the [00:08:18] Speaker 02: portions of the transaction, the elements of the transfer to the issuer and making sure that it does that. [00:08:25] Speaker 02: In other portions of the statute, it also packs on the phrase conveyance, which is usually associated with a real property interest. [00:08:34] Speaker 03: The agencies seem to be concerned, and they say so in part, that if you're correct here, then other types of issuers may be able to restructure along the same lines as you are and avoid what was more clearly the intended credit risk retention purpose of the statute. [00:08:56] Speaker 02: I also didn't understand them making that argument with respect to CLO managers. [00:09:01] Speaker 02: They certainly have, all the agencies have, a whole range of anti-avoidance mechanisms. [00:09:06] Speaker 02: So to the extent that the concern is that an entity that actually originates loans somehow gets a straw [00:09:16] Speaker 02: manager and there's an evasion process taking place, then the agencies have the ability to do that and the statutory terms capture that. [00:09:26] Speaker 02: The party that has the loans and would be using the manager in that way would itself be the party that's transferring or selling assets to the issuing entity. [00:09:38] Speaker 06: If I understand your argument that your view is that [00:09:42] Speaker 06: the agencies could clearly cover the CLO as an issuer. [00:09:51] Speaker 02: No? [00:09:51] Speaker 02: Did I get that wrong? [00:09:52] Speaker 02: We think that the statute clearly indicates that prong one does, but the agencies didn't reach that conclusion. [00:09:58] Speaker 06: Well, but your argument encompasses the proposition that they could. [00:10:02] Speaker 02: That's absolutely right. [00:10:03] Speaker 02: The Congress provided a mechanism by which [00:10:07] Speaker 02: All securitizations would be captured. [00:10:09] Speaker 02: If you simply read, issue in prong one is issuing entity, every securitization has an issuing entity. [00:10:16] Speaker 02: So there was no need to expand the stretch transfer unnaturally or stretch prong two to cover the waterfront. [00:10:24] Speaker 06: adverse economic consequences that you point to follow completely from, as completely from that as from what the agencies did? [00:10:35] Speaker 02: I don't believe so, Your Honor. [00:10:36] Speaker 02: I mean, all of this is hypothetical because the agencies candidly admit they gave Prongman no independent effect. [00:10:44] Speaker 02: So in further proceedings, they may tee up the policy issues. [00:10:48] Speaker 02: But I don't think it does for the following reason. [00:10:51] Speaker 02: The manager is not the regulated party under prong one. [00:10:56] Speaker 02: It's the issuer. [00:10:57] Speaker 02: And by passing on risk to the issuer, as the agencies indicate, you're effectively passing it on to the equity holders, and we would say not passing it on to the manager. [00:11:10] Speaker 02: Unlike the manager, which has no [00:11:13] Speaker 02: business based on balance sheet investing or taking positions, equity holders by definition are doing that. [00:11:20] Speaker 02: They are in the business of taking and holding interests, so there's no disincentives from that point of view. [00:11:27] Speaker 02: They're also a more logical party because it's actually the equity holders who drive the transaction and set very detailed investment parameters that the manager executes. [00:11:39] Speaker 03: Am I correct in thinking that you sought but were denied an exemption? [00:11:44] Speaker 02: That's right. [00:11:44] Speaker 02: I mean, we had a whole set of alternatives that we tried to put in front of the agencies. [00:11:50] Speaker 02: As soon as there was a suggestion in the initial order in note 42 that CLO managers might be captured, we started a series of letters. [00:12:03] Speaker 02: both said that the statutory language doesn't encompass us, and to the extent you find that it does, for all the reasons of the structural protections and the adversity of CLOs, open market CLOs, to core origination, we should have an exemption. [00:12:18] Speaker 03: Did you separately seek review of the denial of the exemption, or is that not a separate order? [00:12:23] Speaker 02: It's not a separate order. [00:12:25] Speaker 02: In fact, most of the cost-benefit analysis that the agencies undertook addresses why there shouldn't be a complete exemption. [00:12:32] Speaker 02: They give very little attention to why our other alternatives weren't addressed. [00:12:39] Speaker 02: If I could turn to credit risk for just a second. [00:12:44] Speaker 02: The agencies should have narrowed the horizontal component of their rule to focus on an adequate level of credit risk based on their own reasoning and conclusions. [00:12:54] Speaker 02: The agencies concluded that retaining 5% of credit risk was sufficient to align securitizer and investor interests and to meet the statutory objectives of the statute. [00:13:06] Speaker 02: They also concluded that retaining more than 5% credit risk [00:13:12] Speaker 02: risked and would result in the managers tying up too much capital, being squeezed from the market, and incurring costs of efficiency, harm to capital formation, and competition. [00:13:25] Speaker 03: Well, they didn't say too much. [00:13:26] Speaker 03: They just said more. [00:13:27] Speaker 02: Pardon? [00:13:28] Speaker 03: More capital, but not too much. [00:13:30] Speaker 03: They didn't say too much. [00:13:31] Speaker 03: We'd tie up more capital. [00:13:32] Speaker 03: We'd tie up more capital. [00:13:34] Speaker 03: The agencies didn't say we'd tie up too much. [00:13:37] Speaker 02: Well, they did in the sense of they expressly struck a balance in the 5% benchmark. [00:13:45] Speaker 02: They said amounts below that amount would be insufficient to align the securitizer investor interest. [00:13:53] Speaker 02: But amounts above that much would incur the harms to competition and efficiency. [00:13:58] Speaker 03: Right, and they thought that wasn't too much. [00:13:59] Speaker 03: It was worth it. [00:14:01] Speaker 02: Well, when they came to their cost benefit analysis, they said it was worth it. [00:14:06] Speaker 02: for a very poor reason. [00:14:08] Speaker 02: The only reason that they gave in rejecting the alternatives that would have had the securitizer clearly retain 5% of credit risk was that the securitizers would not be retaining an interest that was 5% of fair value, economic value. [00:14:25] Speaker 03: Well, the concern was also, pardon not the concern, they drew on their authority to require more than 5%. [00:14:33] Speaker 03: That's a minimum in the statute. [00:14:36] Speaker 06: Well, they also invoked issues of transparency and measurement. [00:14:43] Speaker 02: Well, they did not with respect to CLOs for good reason. [00:14:47] Speaker 02: Well, I'm sorry. [00:14:48] Speaker 02: For transparency, they did not. [00:14:50] Speaker 02: For measurement, they did. [00:14:52] Speaker 02: Transparency, there's no issues for CLOs. [00:14:53] Speaker 02: It's an absolutely transparent disclosure of the investment. [00:14:57] Speaker 02: For the benefits of fair value, however, they did refer to [00:15:02] Speaker 02: the ability to compare and the industry or the market understanding of that. [00:15:07] Speaker 02: They did not, however, use that as a reason not to focus the horizontal component on the amount of credit risk. [00:15:17] Speaker 02: And let me give you, let me focus on an example that illustrates this. [00:15:21] Speaker 02: The structured finance industry group [00:15:24] Speaker 02: proposed or urged the agencies to focus the horizontal component on credit risk. [00:15:29] Speaker 02: They proposed that the agencies do that by having securitizers retain 1% of the securitization value in a horizontal form measured by fair value. [00:15:40] Speaker 03: At the bottom tranche? [00:15:41] Speaker 02: Yes, in the bottom tranche. [00:15:42] Speaker 02: Sorry, I was using in the horizontal, in the bottom tranche. [00:15:45] Speaker 02: With the result then, because it's the bottom tranche, [00:15:48] Speaker 02: that the securitizer would retain roughly 10% of the transaction's credit risk and would have a capital outlay of only 20% of what the rule would have otherwise required. [00:16:01] Speaker 02: And other of the proposals were designed to do the same thing. [00:16:05] Speaker 02: But what that shows is that there's nothing magical or special about fair value. [00:16:09] Speaker 02: The agencies still could have used their fair value determination. [00:16:13] Speaker 02: But had they just focused on credit risk, they would have avoided all of the harms that they themselves identified. [00:16:23] Speaker 06: Isn't the proposition that 2% of the lowest tranche would [00:16:35] Speaker 06: encompass 10% of the credit risk. [00:16:38] Speaker 06: Isn't that a highly fact-intensive proposition? [00:16:42] Speaker 02: Well, the agencies have never disputed that credit risk is highly concentrated in the support net tranche. [00:16:50] Speaker 02: We had an expert that calculated and provided the basis for indicating [00:16:57] Speaker 02: how much the equity component of securitization reflects in terms of credit risk. [00:17:04] Speaker 02: And the SFIG, the Structured Finance Industry Group, in setting the amount at 1%, [00:17:12] Speaker 02: doubled the amount that the agencies indicated was reasonable. [00:17:16] Speaker 02: Now, the agencies, however, they never undertook, they certainly never contested that, but they also never undertook their own examination of how much credit risk was embodied in their proposal, or how much credit risk would have been embodied in the ESFIC proposal. [00:17:32] Speaker 02: They simply never examined the issue. [00:17:35] Speaker 02: that they didn't focus on the statutory factor in reaching their determination, contrary to Michigan, the EPA, and State Farm. [00:17:43] Speaker 02: The inconsistency in their decision-making between indicating that 5% of credit risk [00:17:50] Speaker 02: was sufficient to meet the statutory objectives and then dismissing the alternatives based on insufficient economic value was an inconsistency that's contrary to State Farm. [00:17:59] Speaker 02: The measurement of costs and benefits and not selecting the most pro-competitive and pro-efficiency rule that would have met the statutory benchmark [00:18:09] Speaker 02: under their own reasoning is particularly a problem for the Commission, which has a statutory obligation to do exactly that. [00:18:16] Speaker 02: And the agencies never explained, they were urged to focus the horizontal component on credit risk, and there's nowhere in the order that indicates why they didn't do that. [00:18:28] Speaker 02: They were also presented with a set of alternatives that would have [00:18:33] Speaker 02: that would have accomplished that result. [00:18:35] Speaker 02: And the only discussion that they give of those alternatives that would have had the security hazard purchase equity to assure the world's investors that it had 5% of credit risk was dismissed in two sentences. [00:18:48] Speaker 02: And one of those sentences was, this is insufficient because [00:18:52] Speaker 02: It doesn't have sufficient economic risk. [00:18:55] Speaker 02: The basic cost-benefit analysis turned on an acknowledgement of the very significant costs that the rule would impose and indicated that those costs were acceptable because otherwise there would be insufficient alignment of interest between the securitizer and investors. [00:19:14] Speaker 02: But here, [00:19:15] Speaker 02: The benchmark that the agencies themselves, and that clearly the statute indicates is the appropriate mechanism for alignment, is the quantum of credit risk, not the quantum of economic value. [00:19:26] Speaker 02: And this is particularly important in the context of seeing whether there's sufficient alignment of interest. [00:19:35] Speaker 02: The agencies never identified any gap or any failure of alignment of interest between the CLO manager and the [00:19:44] Speaker 02: And the investors, as we said in the context of the securitization issue, the ZLO manager is entirely aligned, is rewarded only for delivering results to the investor. [00:19:57] Speaker 02: It does that by ensuring that there is good origination rather than bad origination. [00:20:03] Speaker 02: There's no problem to fix. [00:20:05] Speaker 02: And that's particularly the case once the securitizer demonstrates to the agency and to the world that it's retaining 5% or more of the credit risk, which is what the agencies themselves concluded was a sufficient amount to align interest. [00:20:27] Speaker 03: Before we lose the opportunity, I wanted to go back to where we started with looking at the statute again. [00:20:33] Speaker 03: with the issuer in Part A being the CLO, basically. [00:20:43] Speaker 03: Who is the issuer in Part B, as you see it? [00:20:46] Speaker 03: Is it the originating bank? [00:20:48] Speaker 02: No, no, the issuer in Part B is also the issuing entity. [00:20:51] Speaker 02: Okay. [00:20:52] Speaker 02: Because the transfer of the asset has to be to the issuer of the CLO notes. [00:20:59] Speaker 02: And I think the agencies agree with the Prong B point on that. [00:21:03] Speaker 02: One other point about credit risk, the principal argument other than something special about fair value was that it was enough to offer up the vertical option alone. [00:21:19] Speaker 02: And for that, the agency's own order [00:21:22] Speaker 02: clearly indicates quite the contrary. [00:21:25] Speaker 02: The order concluded that both the horizontal and the vertical had to be offered and that not to offer the horizontal would have incurred costs to competition and efficiency in light of market dynamics that required certain parties to hold in the horizontal form. [00:21:43] Speaker 02: The vertical choice also isn't [00:21:46] Speaker 02: the relevant choice for purposes of what the issue before the agencies was and the issue that were challenging. [00:21:54] Speaker 02: As in the question of choosing vertical versus horizontal, what was requested was a way to be able to hold a horizontal interest with much less capital outlay, one-fifth, one-ninth as much under the different alternatives. [00:22:10] Speaker 02: and still meet the requirements for alignment of interest and adequate risk retention that the agencies themselves included was the appropriate amount. [00:22:21] Speaker 02: Nothing about providing a choice between horizontal and vertical would have enabled [00:22:27] Speaker 02: the agencies to escape the API obligations regarding consistent decision making, focusing on the statutory factor of credit risk, implementing the cost benefit analysis and the conclusions and articulating the basis for why they declined to narrow the horizontal component and reject the alternatives. [00:22:51] Speaker 03: failed to meet its obligation to adopt the most pro-competitive and efficient outcome, right? [00:23:01] Speaker 03: But you're drawing on the four factors in the 96th Amendment, is that right? [00:23:06] Speaker 02: Well, this would be Section 23A2 of the Exchange Act. [00:23:10] Speaker 02: Yeah. [00:23:11] Speaker 03: And particularly the sentence that... Is that the one that lists the four factors, in fact, on capital formation and so on? [00:23:17] Speaker 02: No, that's... [00:23:20] Speaker 02: I believe that section, I'm sorry, there's one you need to consider the four factors. [00:23:27] Speaker 02: And there's another that says that, actually let me just turn to this rather than wasting your time on this. [00:23:40] Speaker 02: So Section 23A2, Section 3F of the Act is the four factors. [00:23:45] Speaker 02: The agencies must consider efficiency, competition, capital formation, and so on. [00:23:49] Speaker 02: Section 23A2 includes the sentence that the commission, again, it's not all the agencies, just the commission, [00:23:56] Speaker 02: shall not adopt any such rule or regulation which would impose a burden on competition not necessary or appropriate in the purposes of this chapter. [00:24:05] Speaker 02: And this is a very unusual case in that usually the 3F is more important because the agency needs to demonstrate that it turns its mind to the issue [00:24:16] Speaker 02: and has the flexibility of achieving a range of countervailing statutory objectives. [00:24:25] Speaker 02: Here, however, this 2382 provision is triggered because the Commission itself concluded that the statutory objectives were met by retention of 5% of credit risk. [00:24:39] Speaker 02: So once it concluded that 5% retention of credit risk was sufficient, it did have an obligation to craft or to adopt only a rule that would be the most pro-competitive and most pro-efficiency that met that objective. [00:24:58] Speaker 02: And by ensuring, by declining to tailor the horizontal component, in other words, to have securitizers [00:25:06] Speaker 02: a tie-up capital with 5% of securitization, $25 million out of a $500 million securitization, rather than tie up $3 million or $5 million, as the ESPEC proposal would have done, they were adopting a rule that wasn't the most efficient and wasn't the most pro-competitive, because they themselves indicated that if you tie up additional capital, that's what creates the inefficiency for those who remain and squeezes out [00:25:35] Speaker 02: managers who either may have difficulty raising the money or may choose simply to manage a different type of asset that doesn't have the risk retention obligations. [00:25:45] Speaker 04: Why don't we hear from the government? [00:25:46] Speaker 04: We'll give you a few minutes on rebuttal. [00:25:47] Speaker 02: Thank you very much, Your Honor. [00:26:02] Speaker 01: Good morning. [00:26:03] Speaker 01: May it please the Court, Joshua Chadwick, for the Federal Reserve Board and the Securities and Exchange Commission. [00:26:09] Speaker 01: I'd like to make three points this morning. [00:26:11] Speaker 01: First, that LSTA's unduly narrow reading of the statute's securitizer definition would substantially undermine Congress's risk retention mandate. [00:26:21] Speaker 01: Second, that the agencies were tasked with promulgating a workable rule for all asset-backed securitizations, not just CLOs. [00:26:30] Speaker 01: And the fact that certain CLO managers find one of the options presented by the agencies to be too conservative [00:26:37] Speaker 01: does not render that approach arbitrary. [00:26:39] Speaker 03: Does it have to be the same for all of the different types? [00:26:44] Speaker 01: It does not have to be the same, Your Honor, but there's obviously a need for a workable rule. [00:26:50] Speaker 01: These are regulating asset-backed securitization structures that can be collateralized with any number of things. [00:26:57] Speaker 01: CLOs just happen to be one small component. [00:27:01] Speaker 03: Have the representatives in any other type of issuance sought review? [00:27:06] Speaker 01: No, this is only CLOs, Your Honor. [00:27:10] Speaker 03: So one rule versus two? [00:27:14] Speaker 01: Well, the agencies, I will take this up and point out, Your Honor, the agencies did give careful consideration to the CLO issuer comments and did provide a separate lead arranger option for CLOs. [00:27:29] Speaker 01: There's also a separate component of the rule that relates to underwriting standards for commercial loans that would be [00:27:36] Speaker 01: exempt from risk retention at all. [00:27:39] Speaker 01: And the agencies carefully considered the exemption request that the CLO managers put in. [00:27:45] Speaker 01: So the only case that's challenged the rule is from CLOs. [00:27:51] Speaker 01: But there's lots of comments from other parts of the security system. [00:27:54] Speaker 03: Any other types of SSS securities, backed securities, actively managed? [00:28:01] Speaker 01: Uh, in a actively managed in a pool of assets. [00:28:06] Speaker 01: Well, there's certainly they could be. [00:28:08] Speaker 01: There's nothing stopping, uh, an actively managed asset. [00:28:12] Speaker 01: I believe that there are other securitizations and one's not coming to mind. [00:28:16] Speaker 04: On the statute, uh, subsection a and issuer. [00:28:23] Speaker 04: Does that encompass yellows? [00:28:26] Speaker 01: Well, [00:28:28] Speaker 01: So the term issuer does appear in both prongs of the statute. [00:28:33] Speaker 01: As the agencies read those two prongs of the definition, they certainly determined in the second prong that the issuer was the entity that was issuing securities. [00:28:44] Speaker 01: In the US securitization market, that's invariably a special purpose vehicle that the sponsor of securitization creates purely for bankruptcy remoteness purposes to facilitate the transaction. [00:28:57] Speaker 01: So as to the first prong, the agencies – well, let me say something about the second prong. [00:29:03] Speaker 01: The language of that second prong was adopted virtually word for word by Congress from the Commission's Reg AB, which would already crystallize the concept of sponsor. [00:29:17] Speaker 04: And the agencies – The regulation wouldn't have covered the managers, however, correct? [00:29:22] Speaker 01: That's correct, Your Honor, but only because the regulations definition of asset-backed security excluded managed pool assets. [00:29:29] Speaker 01: When Congress modified the Exchange Act for the purposes of Dodd-Frank and for this rule requirement, they provided a different definition of asset-backed securities. [00:29:41] Speaker 01: And it provides a list, one of which includes CDOs, which CLOs are clearly [00:29:48] Speaker 01: a subset of. [00:29:48] Speaker 01: So there's no question that when Congress modified the asset-backed security definition in the Exchange Act that they were clearly intending to contemplate. [00:29:57] Speaker 01: Let's get back to A, because my question was about A. Yes. [00:30:00] Speaker 01: So the agencies took a cue from another set of Exchange Act regulations, which defined issuer to mean depositor, which is oftentimes an entity that [00:30:15] Speaker 01: that's actually making the deposit of collateral and certain securitization structures. [00:30:21] Speaker 01: But agencies also determined that the second prong of the definition, that sponsor definition, would cover every asset-backed securitization that's currently in existence in the United States securitization market. [00:30:35] Speaker 01: So it is the case that [00:30:38] Speaker 01: every securitization would be covered by the second prong. [00:30:41] Speaker 04: So what work – I guess I'm still not understanding then. [00:30:44] Speaker 04: What is – two things. [00:30:45] Speaker 04: What does issuer mean in A? [00:30:48] Speaker 04: And I think you're saying it doesn't encompass CLO. [00:30:53] Speaker 04: And then the second thing is, if B covers everything, what was the purpose of that? [00:30:58] Speaker 01: Well, that is a question, Your Honor, and I think that [00:31:02] Speaker 01: The best answer to that is that Congress was providing maximum flexibility to the agencies to ensure that all asset-backed securitizations were covered. [00:31:11] Speaker 01: It happens to be that in the current securitization market that these special purpose vehicles are invariably used, but that's not to say that there aren't other possible structures. [00:31:20] Speaker 01: In other countries, there are securitization structures in which the assets are kept on the balance sheets. [00:31:26] Speaker 01: So it is possible – and that doesn't occur in the United States because of the bankruptcy regime – but it is possible for that issue of prom to be – to do separate work. [00:31:38] Speaker 01: It happens that the agencies didn't need it. [00:31:39] Speaker 04: It's just odd, it seems to me – and you know where I'm coming from – where to [00:31:43] Speaker 04: look at this statue as a issuer means one thing and a different thing and be it's not impossible there are statutes that have that kind of structure not usually so closely put together one thing. [00:31:55] Speaker 04: Yeah, well, that's that is different. [00:31:59] Speaker 04: One thing and being nothing in a but those are different in different meanings. [00:32:04] Speaker 01: It is true that they're used slightly differently in the two prongs, and that is something that the agencies had to reconcile in promulgating the rule. [00:32:13] Speaker 04: Well, the question is whether it's true that they're slightly different in the two prongs, right? [00:32:17] Speaker 01: The agencies read it that way. [00:32:21] Speaker 01: could have read the first prong to mean the special purpose vehicle. [00:32:24] Speaker 01: I think the agencies could have read it that way. [00:32:27] Speaker 01: But the reality of the situation is that that would be a regulatory nullity. [00:32:30] Speaker 01: That would accomplish nothing. [00:32:31] Speaker 01: The special purpose vehicles cannot independently retain risk of the investors. [00:32:37] Speaker 01: It's simply a robot. [00:32:39] Speaker 01: It's a machine by which the investors put in money. [00:32:42] Speaker 01: It retraunches that money. [00:32:45] Speaker 01: It invests the money and then retraunches the risk of the loans it invests in. [00:32:49] Speaker 01: to varying risk-reward ratios for the investors. [00:32:52] Speaker 01: But at the end of the day, the SPD is not an ongoing entity. [00:32:56] Speaker 06: Well, if the rule applied to it, it would become an ongoing entity, would it not? [00:33:02] Speaker 01: No, I don't think so, Your Honor. [00:33:03] Speaker 06: It would still ultimately— If it has to retain, and literally the word retain seems to apply, then there it is holding this asset. [00:33:14] Speaker 01: The SPB retains assets throughout the life of the securitization, which is many years, maybe a decade on average. [00:33:22] Speaker 01: So at some point, whatever investment that's gone into the SPB passes back to the investors in the form of principal and interest payments. [00:33:33] Speaker 01: So at the end of the day, whatever risk or reward is in that SPB ultimately finds its way to one of the classes of investors in the securitization. [00:33:43] Speaker 06: I still don't understand why it couldn't hold the retained asset value or risk-computed asset value for a long enough period to satisfy Congress's stated goals. [00:34:04] Speaker 06: Well... You say they normally don't. [00:34:09] Speaker 06: Well, of course they normally don't. [00:34:11] Speaker 01: Well, I think that there's value is held in the SPV throughout the course of the securitization. [00:34:18] Speaker 01: The loans are held there such that they're sufficient collateral to pay the principal and interest payments to the investors. [00:34:26] Speaker 01: But in the end, if the losses begin to mount in the loans that are collateralizing the structure, that ultimately it's not the SPV that's going to suffer. [00:34:38] Speaker 01: It's the investors in the securitization. [00:34:41] Speaker 06: Right, but they suffer as a result of the risk associated with these assets, right? [00:34:48] Speaker 06: Which I thought was supposed to be the congressional concern. [00:34:52] Speaker 01: Well, I think the congressional concern, Your Honor, is the skin in the game. [00:34:55] Speaker 01: And the only way you can have skin in the game is by investing in the securitization structure. [00:35:00] Speaker 01: Congress wanted the originators or the sponsors of the securitizations to, and that's the term that Congress repeatedly used, [00:35:07] Speaker 01: certainly in legislative history, was to have skin in the game. [00:35:10] Speaker 01: And the SPB can't have skin in the game. [00:35:13] Speaker 06: Yeah, but the parties that own it do, right? [00:35:16] Speaker 01: Well, those are the investors, Your Honor. [00:35:17] Speaker 01: Those are the very parties that the statute's designed to protect, not just for their own interests, but for the financial stability of the entire financial system. [00:35:28] Speaker 01: So they're the protected party. [00:35:30] Speaker 01: They can't hold the race. [00:35:31] Speaker 06: I see. [00:35:32] Speaker 06: I see. [00:35:32] Speaker 06: OK. [00:35:32] Speaker 06: OK. [00:35:32] Speaker 06: I gotcha. [00:35:32] Speaker 03: I thought we were told by the industry that [00:35:37] Speaker 03: Because for market purposes, I mean just market forces as it were, they do sometimes hold a piece of the bottom tranche all the way to the end. [00:35:49] Speaker 01: They do sometimes hold a piece of the bottom tranche, but that's precisely what the horizontal retention option that the agencies have proposed. [00:35:58] Speaker 03: I understand that, but I thought you were just saying to Judge Williams that that's not possible. [00:36:04] Speaker 01: Well, it's the equity holders, that class of investor, that's holding that residual interest in the securitization strategy. [00:36:16] Speaker 03: My understanding from the industry was that the party holding that piece of the bottom tranche [00:36:24] Speaker 03: is indeed the manager? [00:36:28] Speaker 01: I apologize, Chairman. [00:36:28] Speaker 01: Yes, that is correct. [00:36:29] Speaker 01: Oftentimes, the investors in the securities demand that the COO managers do precisely what the agencies have required them to do to the horizontal risk retention option, which is to hold a piece of that first-loss position. [00:36:45] Speaker 03: So I guess you're saying it's not the SPV itself? [00:36:48] Speaker 01: It's not the SPV, it is the manager. [00:36:50] Speaker 01: So the idea that this is somehow a foreign concept and the manager is not an appropriate risk retention candidate, well that's belied by the very market practices that existed prior to this rule. [00:37:02] Speaker 01: Clearly the investors think there's value. [00:37:03] Speaker 03: When the manager does retain some of the bottom tranche, prior to this rule, is the rule operating right now? [00:37:10] Speaker 01: It is, Your Honor, since Christmas Eve of 2016. [00:37:13] Speaker 03: Okay, so before that, what proportion were the managers typically, if they held any, how much were they holding? [00:37:27] Speaker 01: The LSTA said in their summary judgment briefing in the court below, Your Honor, that up to approximately 1%. [00:37:31] Speaker 03: So the amount that they say also would give you 5% of the credit risk? [00:37:37] Speaker 01: Well, right, actually, they say a lesser amount, Your Honor. [00:37:40] Speaker 01: They say that 1 percent would be double. [00:37:42] Speaker 01: What they've advocated for the agencies in this Court is a half percent. [00:37:46] Speaker 03: .56 was the third one. [00:37:48] Speaker 01: Which is less than what the market was demanding prior to the rule, which would seem to be an unusual result. [00:37:55] Speaker 04: How do the CLO managers sell or transfer assets to the issuer? [00:38:03] Speaker 04: to the CLO. [00:38:04] Speaker 04: I mean, that's the key point they're making is that this statutory language doesn't fit this situation. [00:38:14] Speaker 01: Well, I think that the language does fit, Your Honor, because the CLO manager is driving this train. [00:38:19] Speaker 01: The CLO manager is causing the assets to be transferred. [00:38:22] Speaker 01: The CLO manager selects the assets, and it directs this ministerial special purpose vehicle, which if the manager itself owns it. [00:38:28] Speaker 04: You call something to be transferred by purchasing it. [00:38:31] Speaker 01: But that's, you wouldn't normally say that's... The SPV is purchasing it as a technical matter, but the, it's only doing so at this express direction of the CLO manager. [00:38:43] Speaker 04: The CLO manager is an agent of the... [00:38:46] Speaker 01: Well, it is true that, in a technical sense, the COO manager is acting as an agent of the SPP, because that's the way the formational documents are structured. [00:38:57] Speaker 01: But as a practical sense, the COO manager is putting this securitization together. [00:39:02] Speaker 01: It's gathering investors. [00:39:04] Speaker 01: The COO manager is packaging the securities, which is what Congress talked about. [00:39:08] Speaker 01: Those who package assets and securities and pass them into the market, those are the people [00:39:13] Speaker 01: that are required to retain risk. [00:39:16] Speaker 03: So is that the same as a sponsor and later advisor to a mutual fund? [00:39:22] Speaker 01: I'm sorry, I'm not sure I understand. [00:39:23] Speaker 03: Is this functions you're describing now as the same functions, or are they not the same functions, that the sponsor of a mutual fund would undertake? [00:39:31] Speaker 01: I do think that they're similar, Your Honor. [00:39:36] Speaker 06: You rely on a dictionary definition of transfer as encompassing cause of transfer. [00:39:42] Speaker 06: Do you have any – any sentence, if you have found any sentence in – written in the real world in which transfer is used to encompass something parallel to the role of the managers here? [00:40:01] Speaker 06: I mean, you invoked actually something about deflecting a remainerman, deflecting a transfer for tax purposes. [00:40:15] Speaker 06: Even in that context, you didn't actually offer a sentence that anyone used in the sense of calling it. [00:40:24] Speaker 06: that remained around making a transfer or transferring. [00:40:28] Speaker 06: So I just wondered, it's one thing to have dictionary language that can be read as encompassing a particular usage. [00:40:39] Speaker 06: But if it's never actually used that way, that suggests we're sort of on the extreme edge of potential meanings for the words. [00:40:48] Speaker 01: Well, I guess, [00:40:51] Speaker 01: You can talk about this in a colloquial sense, Your Honor. [00:40:53] Speaker 01: You can talk about it in the very neurotechnical sense. [00:40:56] Speaker 06: I can't see that that made much difference. [00:41:00] Speaker 01: I'm sorry. [00:41:00] Speaker 06: Go ahead, either. [00:41:02] Speaker 01: You don't think that that makes much difference? [00:41:04] Speaker 06: Well, I didn't find it. [00:41:05] Speaker 06: I mean, it seemed to me, as a practical matter, one has to sort of face it in both terms. [00:41:11] Speaker 01: Well, I don't think it's an ordinary sentence. [00:41:17] Speaker 01: I mean, if things get transferred, could you ask to hostess to transfer your check from a bartender to your waiter? [00:41:28] Speaker 01: To cause the pass from one to another, I think, is... That's sort of what you, in other words, using an intermediary. [00:41:34] Speaker 06: That would seem to me the classic instance of using transfer to encompass the proposition of cause of transfer. [00:41:42] Speaker 06: But this sort of situation seems quite different. [00:41:48] Speaker 01: Let me just say this, Your Honor, and this is an important point. [00:41:52] Speaker 01: If you accept their reading of transfer, it would drive a freight train through what Congress intended to do. [00:42:00] Speaker 01: Because some of the structures that Congress was [00:42:03] Speaker 01: Adamant both not in just the legislative history, but in the text of the statute be covered some of the most dangerous toxic assets the financial crisis such as CDO squared just an asset-backed security that itself Is composed of asset-backed securities if those are the same management structure where? [00:42:21] Speaker 01: They're purchasing on the on the open market causing them to be transferred into a [00:42:26] Speaker 01: a securitization vehicle. [00:42:28] Speaker 01: And if you adopt their very narrow reading of transfer, then those sorts of securitizations would be uncovered and there would not be a way for the agency to fix that problem. [00:42:38] Speaker 04: But even under their interpretation, correct me if I'm wrong, the statute still has a lot of impact on other types of transactions. [00:42:48] Speaker 04: It's not rendered meaningless. [00:42:50] Speaker 01: Well, Your Honor, let me say this. [00:42:51] Speaker 01: There would be some transactions that were left, balance sheet transactions, but agencies also observed that [00:43:00] Speaker 01: once you take this other view of transfer, then now you can structure around that. [00:43:04] Speaker 01: Because if you've got bad assets, you've got risky assets on your balance sheet, all you have to do is find third-party asset manager and say, why don't you take these assets, go find some other assets out there, organize and initiate an asset-backed securities transaction, and sell this stuff out into the market. [00:43:20] Speaker 01: And that sort of structuring and evasion would still be there. [00:43:25] Speaker 01: And the market may adjust in that way. [00:43:28] Speaker 04: But then we still have to stick with the language, as you know. [00:43:31] Speaker 04: And it's just odd to pick up on Judge Williams' point to say that the purchaser's agent is transferring the assets to the purchaser, which is your... Well, I think you could think of examples in which a buyer's agent used the term transfer. [00:43:47] Speaker 01: But I also think that this statute read in the context of what Congress was clearly attempting to do [00:43:57] Speaker 01: necessitates. [00:43:58] Speaker 04: And what's your – under Congress clearly attempting to do, your best evidence of that is? [00:44:05] Speaker 04: To cover all – Apart from the text? [00:44:09] Speaker 01: Well, the text of the statute, I think, is clear that Congress wants to cover all asset-backed securitization, certainly CDOs, of which CLOs are a component. [00:44:16] Speaker 04: Why didn't it just stop with, in subsection B, a person who organizes and initiates an asset-backed securities transaction? [00:44:26] Speaker 01: Well, I think the easiest answer to that is because it decided to adopt the definition that the Commission had already promulgated in Reg A.D. [00:44:34] Speaker 04: But then Reg A.B., and this is what I, you, [00:44:38] Speaker 01: explain this to me, did not – would not have covered a person – Only because there's a different definition of asset-backed security in Reg AB. [00:44:45] Speaker 01: Congress did not – chose not to adopt that definition of asset-backed security. [00:44:50] Speaker 04: It chose to write its own definition of asset-backed security, which – But that suggests that Congress just screwed up in borrowing a regulation and then changing part of it and then left a – in your view, left a gap. [00:45:03] Speaker 01: Well, you could view it as a gap. [00:45:06] Speaker 01: The agencies had a task to do to ensure that the securitizations were covered, Your Honor. [00:45:12] Speaker 01: The agencies had to make this best sense of what Congress did, as they possibly could. [00:45:20] Speaker 04: But you – let me just make sure I have it correct. [00:45:21] Speaker 04: But borrow from the regulation. [00:45:24] Speaker 04: The regulation would not cover [00:45:27] Speaker 01: Reg A, Reg A-B, the definition of asset-backed security in Reg A-B does not cover managed legal assets like CLOs, but... Did anyone point that out at the time? [00:45:39] Speaker 04: to come, we're borrowing this regulation, but it won't cover, in your words, something that we're clearly intending to. [00:45:48] Speaker 01: Well, I think there's the concept of a sponsor that they were borrowing, Your Honor. [00:45:53] Speaker 01: Congress had its own definition of asset-backed security in mind. [00:45:55] Speaker 01: What it wanted to capture was the idea of a sponsor, the idea that every asset-backed securitization has someone who is sponsoring it, and an SPV isn't sponsoring it. [00:46:06] Speaker 01: There's either an originator or a manager. [00:46:09] Speaker 04: The sponsor being the manager for current purposes. [00:46:14] Speaker 04: Correct, Your Honor. [00:46:15] Speaker 04: But this manager was not a sponsor under the regulation. [00:46:18] Speaker 01: Well, only for the narrow, just for CLOs, because CLOs or other managed pool assets. [00:46:27] Speaker 01: But there are many other securitization structures for which the sponsor definition would have captured them. [00:46:35] Speaker 04: Okay. [00:46:35] Speaker 04: Do you want to speak to the [00:46:39] Speaker 04: The other issue? [00:46:41] Speaker 01: Well, yes, Your Honor. [00:46:44] Speaker 01: As to the second issue, LSTA's claim that the horizontal risk retention option is arbitrary and capricious merely because it is, quote, non-uniform with the vertical risk retention option. [00:46:57] Speaker 01: But this argument has no basis in the law. [00:47:01] Speaker 01: Congress's statutory requirement was not less [00:47:05] Speaker 01: than 5% risk retention, absent a statutory or agency exemption. [00:47:10] Speaker 01: There's no question the agencies achieve that for all asset-backed securizations, regardless of the type or quality of the underlying assets. [00:47:18] Speaker 01: It's also not disputed that the vertical risk retention option, which agencies provided, provides precisely 5% of the credit risk retention for a pro rata hold-in. [00:47:27] Speaker 01: So the only question is whether offering an additional horizontal retention option, which provided additional flexibility to securitizers, was arbitrary and capricious because it does not necessarily align with the vertical risk retention option. [00:47:45] Speaker 06: But you're skipping the analytical process, right, of determining that this is an optimal trade-off between different values under consideration, with the 5 percent credit risk being a wall. [00:48:07] Speaker 01: Congress made the policy decision of 5% or more. [00:48:10] Speaker 01: The agencies were not able to not sufficient data or were not able to say precisely the amount of retained credit risk. [00:48:17] Speaker 01: They had to rely on Congress's policy judgment that it's got to get to 5%. [00:48:23] Speaker 06: Yeah, nobody's disputing that. [00:48:28] Speaker 06: The question is, why should they pick a [00:48:32] Speaker 06: they picked two techniques which involve much more holding of value than is necessary to meet the 5% or perhaps 10% of the credit risk. [00:48:45] Speaker 01: Well, that's according to [00:48:49] Speaker 01: to a model that LSTA's expert put together that would undertake to take historical performance of loans and to make assumptions about future economic conditions and say, gosh, all of the credit risk is down at the bottom. [00:49:06] Speaker 01: It's all there. [00:49:07] Speaker 06: Never mind. [00:49:10] Speaker 06: baked in, right? [00:49:12] Speaker 06: We call it the lowest tranche because it's the highest risk tranche, right? [00:49:17] Speaker 01: Well, that is definitely true, Your Honor. [00:49:19] Speaker 01: It is the riskiest. [00:49:20] Speaker 01: There's no doubt that, I mean, that's the very purpose of the securitization structure, is to push risk down. [00:49:23] Speaker 01: But risk exists throughout the securitization structure. [00:49:26] Speaker 01: Right, right. [00:49:26] Speaker 03: Well, what's the experience on that? [00:49:29] Speaker 01: In terms of CLOs, Your Honor? [00:49:30] Speaker 01: Yeah. [00:49:30] Speaker 01: Well, CLOs performed quite well during the financial crisis, Your Honor, and the agencies recognized that. [00:49:35] Speaker 03: The agencies also... Was there ever anything, any loss [00:49:41] Speaker 03: that exceeded the equity at the bottom? [00:49:45] Speaker 01: If there were, there were not many, Your Honor, frankly. [00:49:50] Speaker 01: But the agencies examined that and determined that many of the government interventions that occurred during the financial crisis may have precluded what could have been losses that were to show themselves in the seal market. [00:50:08] Speaker 01: Agencies also determined that [00:50:11] Speaker 01: that there's a level of froth in the leverage lending and silo markets as investors search for yield that has caused underwriting standards to drop in the leverage lending and silo market. [00:50:22] Speaker 01: So agencies were concerned that, and this is consistent with the purpose of the rule, that this could be a future problem area in terms of financial stability. [00:50:33] Speaker 01: So the agencies were very, considered that quite carefully. [00:50:41] Speaker 04: Thank you very much. [00:50:48] Speaker 02: Thank you, Your Honor. [00:50:49] Speaker 02: So three quick points on the securitization definition. [00:50:53] Speaker 02: One, the loophole argument and the train driving through a loophole only arises because the agencies gave absolutely no independent meaning to the first prong. [00:51:02] Speaker 02: If they simply read issuer in the first prong as issuing entity, they could reach whatever securitization with whatever authorized regulations that they want. [00:51:13] Speaker 06: So who holds the SBV? [00:51:16] Speaker 02: So the SPV is an entity. [00:51:17] Speaker 02: It holds the loan. [00:51:19] Speaker 06: I understand that. [00:51:20] Speaker 02: And then the note holders have various claims on the income or the return of income and principal from those loans. [00:51:31] Speaker 02: The residual holding [00:51:34] Speaker 02: the amount that is left over at the end of the day is held by the lowest tranche, the equity holders. [00:51:41] Speaker 02: So to the extent that there is an obligation imposed on the issuer, as even in the agency's own brief said, it's the equity note holders who end up bearing that residual risk. [00:51:56] Speaker 02: So a risk retention obligation imposed on them [00:51:59] Speaker 02: of the risk needs to be allocated to them, and it requires that the equity holders not divest themselves of that risk. [00:52:11] Speaker 02: As to your question, Judge Ginsburg, about different rules for the CLO, [00:52:16] Speaker 02: that the statute, Congress clearly intended that there be different rules for different classes of assets. [00:52:21] Speaker 02: In C2, they indicated that separate rules would be appropriate for separate assets. [00:52:26] Speaker 02: And in C1F, it specifically indicated that the agencies were to develop appropriate standards for risk retention, specifically for the securitization of commercial loans at issue here. [00:52:40] Speaker 02: That's just an indication that they were actually supposed to find the appropriate level of risk retention for different. [00:52:46] Speaker 03: Which was the latter section you referred to? [00:52:48] Speaker 02: C1F. [00:52:50] Speaker 03: And does that include all CDOs or just CLOs? [00:53:02] Speaker 02: collateralized debt obligations, securities collateralized by collateral debt obligations and similar instruments. [00:53:07] Speaker 03: So it's much broader than your initials. [00:53:09] Speaker 02: It's much broader than just open market CLOs. [00:53:14] Speaker 02: That is true. [00:53:15] Speaker 02: But it's an indication that it's courses for courses. [00:53:18] Speaker 02: It uses the word appropriate, which Michigan VEPA tells us requires a cost-benefit analysis for the specific impact. [00:53:26] Speaker 02: It isn't enough to say simply that the agencies could be indifferent to the amount of risk above a 5% level, and the agencies themselves weren't indifferent to that amount of risk. [00:53:35] Speaker 02: they indicated that to have an amount of retention above 5% would incur the costs of tying up too much capital and squeezing managers out of the market. [00:53:46] Speaker 02: And they calculated what, I'm sorry. [00:53:49] Speaker 03: What is it about CLOs that makes this so burdens, uniquely burdensome? [00:53:54] Speaker 03: Why aren't other CDO issues similarly burdened? [00:53:57] Speaker 02: Well, most [00:54:01] Speaker 02: CLO managers play a unique role in the market. [00:54:04] Speaker 02: They're not in the business of using a balance sheet, investing in holding positions. [00:54:11] Speaker 02: They're in the business of providing a service to investors under an established business model that's driven by the equity holders or the note holders who establish a set of investment constraints and the manager then [00:54:25] Speaker 02: is directed to and rewarded for selecting good loans within those rather than others. [00:54:30] Speaker 02: So the fact that they are adverse to the origination and not in the business of holding interests is what does separate them from most securitizations. [00:54:39] Speaker 02: And it certainly separates them from the type of securitization that Congress was most concerned about, where entities with balance sheets who originate loans then use the securitization process to offload those to investors. [00:54:52] Speaker 04: You are talking about what you think Congress intended, and the government's talking about what it thinks Congress intended. [00:54:58] Speaker 04: Why do you say that's what Congress was most concerned about? [00:55:01] Speaker 02: Well, I would note that the legislative history focuses on the originate-to-distribute model, but the language of PROMPT II [00:55:12] Speaker 02: particularly prong one indicates gives the agencies a way to reach all securitizations. [00:55:16] Speaker 02: And then prong two indicates that not only can you regulate the issuer, you can reach back in the transaction and go after the parties who hold loans and are using the issuer as part of the security transaction. [00:55:31] Speaker 02: And that's by transferring and selling loans to the issuer. [00:55:35] Speaker 02: That's the reaching back in the transaction part. [00:55:38] Speaker 02: open market CLO managers aren't part of that part of the transaction. [00:55:42] Speaker 02: They have nothing to do with loan origination. [00:55:45] Speaker 02: So they have nothing to sell or transfer to the issuing agency. [00:55:48] Speaker 02: And that's why they're excluded. [00:55:50] Speaker 02: And part two then is why an indication of Congress's concern about the parties who hold loans, originate loans, doing the transfer and sale to the issuing unit. [00:56:02] Speaker 04: And the government mentioned a few times about the borrowing from the prior regulation. [00:56:08] Speaker 02: Yes, if I could thank you very much. [00:56:11] Speaker 02: Congress rejected their view of sponsor in a couple of different ways. [00:56:15] Speaker 04: Who's the bear there? [00:56:16] Speaker 04: Congress rejected their view. [00:56:17] Speaker 02: Congress rejected the agency's view that a sponsor somehow covered the universe. [00:56:25] Speaker 02: That by grafting prong one onto the definition and not just relying upon something that [00:56:31] Speaker 02: resembled but does not mirror Regulation AB, Congress intended that there be a different mechanism, the regulation of the issuer, that would define the scope of what could be regulated. [00:56:43] Speaker 02: Congress also didn't adopt word-for-word Regulation AB. [00:56:47] Speaker 02: They changed a crucial part of that, that Regulation AB [00:56:52] Speaker 02: has language about transferring and selling to the issuing entity. [00:56:59] Speaker 02: Congress changed that to issuer. [00:57:01] Speaker 02: That's because Congress wanted to avoid exactly what the agency's arguments are, which is some distinction between issuing entity in prong two and issuer in prong one. [00:57:12] Speaker 02: In fact, Congress confirmed by making that change that issuer as issuing entity had to be the same in both prongs. [00:57:19] Speaker 04: Do we have anything, not that it would be especially significant, anything that indicates that some number of Congress actually focused on what you just said and said something about it? [00:57:31] Speaker 04: I'm sure it's in the midst of some conference room in a congressional building. [00:57:38] Speaker 02: No, not beyond there being absolutely no basis for anyone to assert that sponsor extended to active managers and the evidence of Congress changing the rule. [00:57:47] Speaker 04: So you're focused, it's a text-based argument that Congress, which I appreciate, but I just want to make sure there's not something we're missing. [00:57:54] Speaker 02: This is a text-based argument regarding the statute and the change from [00:57:59] Speaker 02: the regulations. [00:58:01] Speaker 04: The point is, your point is, that they couldn't have meant, well, they didn't take the regulation as is. [00:58:08] Speaker 02: They didn't take the regulation as is, and they certainly didn't take it the way the agencies are arguing it now and argued it in their order, which is somehow transfer and prong two needs to be expanded to cover all securitizations. [00:58:19] Speaker 02: It didn't function that way before the enactment, and with prong one, Congress clearly rejected that interpretation. [00:58:28] Speaker 04: You had a third point. [00:58:29] Speaker 04: Maybe that was the third point. [00:58:31] Speaker 02: Yes, the sponsor was the third point. [00:58:33] Speaker 02: Thank you. [00:58:33] Speaker 02: There's no loophole. [00:58:34] Speaker 02: The agency – the CLOs can be differentially regulated, and there was no adoption. [00:58:39] Speaker 02: In fact, there's an objection of the sponsor notion. [00:58:43] Speaker 04: Okay. [00:58:44] Speaker 04: Thank you to both sides for the arguments. [00:58:46] Speaker 04: The case is submitted.