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On October 21-22, 2014, the federal regulatory agencies responsible for implementing regulations under The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) finalized rules for risk retention requirements in asset-backed securities (as further defined below, “ABS”) transactions.1 The final rules (the “Final Rules”)2 contain clarifications and revisions to the reproposed rules (the “Reproposed Rules”)3 highlighted in Part II–Executive Summary of Significant Changes from the Reproposed Rules below, but in most respects the Final Rules are substantially the same as the Reproposed Rules. Parts III through VII below are a restatement of our prior Clients & Friends Memo4 updated to reflect the Final Rules.
As required by the Dodd-Frank Act, the Final Rules become effective with respect to residential mortgage-backed securities (“RMBS”) one year after publication in the Federal Register, and with respect to all other ABS two years after such publication.
The highlights of the Final Rules, including the most significant changes between the Reproposed Rules and the Final Rules are:
Section 15G generally requires the applicable Agencies to jointly prescribe regulations (i) to require a securitizer to retain at least 5% of the credit risk of any asset it, through the issuance of ABS, transfers, sells, or conveys to a third-party, and (ii) to prohibit a securitizer from directly or indirectly hedging or otherwise transferring the credit risk that the securitizer is required to retain under Section 15G and the rules implemented thereunder.
The Final Rules generally require sponsors to satisfy the 5% risk retention requirements for assets they securitize and provide some alternatives for retention by majority-owned affiliates, originators, originator-sellers, and third parties purchasers as discussed below. The party or parties required to hold retained credit risk are generally prohibited from directly or indirectly hedging or transferring the credit risk required to be retained. However, as described below, the Final Rules permit transfers, under limited circumstances, among the sponsor and qualified third-party purchasers in CMBS transactions after a five year holding period. The Final Rules also restrict hedging or transferring the retained risk, subject to sunset provisions, the terms of which differ for RMBS and all other ABS. The Final Rules also contain some exemptions that eliminate or reduce the required risk retention for certain ABS.
The Final Rules apply to a sponsor of an ABS offering regardless of whether such offering is registered with the SEC under the Securities Act of 1933 (the “Securities Act”) or is exempt from registration.
Under the Final Rules, sponsors (and originators, B-piece buyers and their respective majority-owned affiliates) are prohibited from pledging any retained interest as collateral for any non-recourse financing.8
Under the Final Rules, the “sponsor”9 of a “securitization transaction”10 in which “asset-backed securities” (“ABS”)11 are issued is required to retain an economic interest in the credit risk of the “securitized assets”,12 unless otherwise exempted under the Final Rules. If there is more than one sponsor of a securitization transaction, each sponsor is required to ensure that at least one of the sponsors (or at least one of their majority-owned or wholly-owned affiliates) retains an economic interest in the credit risk of the securitized assets which satisfies the Final Rules.13
Note: Status as the “sponsor” has significant Volcker Rule implications. The Volcker Rule per se deems the “securitizer” under the Final Rules (which includes any “Sponsor”) to be the equivalent of the “organizer and offeror” of the issuer. This means that, if the issuer is a “covered fund” (for example, a fund under Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act of 1940 that fails to qualify for the Volcker Rule’s securitization-of-loans exemption), then the amount of ownership interest in the issuer that may be held by the sponsor (and its affiliates) will be capped by the Volcker Rule at 3% or such greater amount as required by the Final Rules. In addition, status as the “sponsor” of the issuer that is a covered fund would restrict the ability of the sponsor or its affiliates to enter into certain transactions with the issuer (such as a loan to, swap with, guarantee on behalf of, or purchase of assets from, the issuer).
The Final Rules permit a sponsor to allocate its risk retention obligations to originator(s)14 of the securitized assets (or a majority-owned affiliate of the originator) in certain circumstances and subject to certain conditions.
For purposes of the Final Rules, an “originator” is the original creditor of a loan or receivable (i.e., the entity that “created” such loan or receivable), and not a subsequent purchaser or transferee. A sponsor that satisfies its risk retention requirement by holding either an eligible vertical interest or an eligible horizontal residual interest (including funding an eligible horizontal cash reserve account) would be allowed to allocate a portion of its risk retention obligation to any originator of underlying assets in the securitization transaction that contributes at least 20% of the underlying assets to the pool by selling a portion of the retained interest to the originator for cash or a reduction in the price paid by the sponsor to the originator for the securitized assets.
The amount of risk retention that an originator may assume must be at least 20% but cannot exceed the percentage, by unpaid principal balance, of securitized assets it originated. The risk retention that an originator may assume must also be held in the same manner and proportion (as between horizontal and vertical interests) as the sponsor.
The originator would be subject to all of the same requirements for holding the risk retention amount and would be subject to the same restrictions on transfer, hedging and financing imposed on the sponsor as summarized in Part V.H of this memo. Although a sponsor may transfer a portion of the retained risk to an originator, the sponsor is obligated to monitor compliance by the originator with the requirements of the Final Rules and to notify the holders of ABS interests of any instances of noncompliance by the originator. The sponsor is also required to disclose to investors, a reasonable period of time prior to sale of the ABS and, upon request, to the SEC and its applicable Federal banking regulators, certain information about the originator and the form, amount and nature of payment for, the interest retained by the originator.
Note: Although the percentage of the risk retention requirement that can be allocated to an originator cannot exceed the percentage of securitized assets originated by such originator, the risk retention by such originator is with respect to the entire pool of securitized assets, not just the assets originated by such originator.
As discussed below, the sponsor could satisfy its risk retention obligations if risk is retained by B-piece buyers or originators in CMBS transactions, originator-sellers in certain asset-backed commercial paper conduits or lead arrangers of CLO-eligible tranches in certain Open Market CLOs (or their majority-owned affiliates).
Unless one of the exemptions described in Parts VI or VII of this memo applies to reduce or eliminate the risk retention requirement, generally, the sponsor of a securitization transaction (or a majority-owned affiliate of the sponsor) is required to retain an economic interest in the credit risk of the securitized assets equal to at least 5% of all ABS interests in the issuing entity issued as part of the transaction, including those retained by the sponsor (other than certain non-economic residual interests)15.
A sponsor may satisfy its risk retention requirements by retaining an “eligible vertical interest” or an “eligible horizontal residual interest” or any combination thereof that satisfies the risk retention requirements described below, determined as of the closing date of the securitization transaction.
A reasonable time after the closing of the securitization transaction, the sponsor is required to disclose:
Note: The Final Rules do not specify what constitute a “reasonable time”.
If the sponsor retains risk through the funding of an eligible horizontal cash reserve account, the sponsor must disclose:
A reasonable time after the closing of the securitization transaction, the sponsor is required to disclose the amount of the vertical interest the sponsor retained at closing, if that amount is materially different from the amount previously disclosed.
For CMBS transactions,19 the Final Rules allow a sponsor to satisfy all or a portion of its risk retention obligation if a third-party purchaser (“B-piece buyer”), or a majority owned affiliate thereof, purchases and holds (for its own account) an eligible horizontal residual interest in the same form, amount and manner as would be held by a sponsor under the horizontal risk retention option. The Final Rules permit the use of the B-piece buyer retention option for either the entire risk retention obligation or for a portion of the risk retention obligation in combination with a vertical interest held by the sponsor.
The eligible horizontal residual interests can be acquired by up to two B-piece buyers as long as each interest is pari passu with the other interest.20 Each B-piece buyer would be required to satisfy, and would be subject to, all of the requirements set forth in the Final Rules that would otherwise apply to a sponsor that was retaining an eligible horizontal residual interest, including the prohibitions on hedging and transferring any portion of the risk required to be so retained, except as set forth below.
Note: As opposed to the Reproposed Rules, the Final Rules provide that a “commercial real estate” loan includes a loan made to the owner of a fee interest in land that is ground leased to a third party who owns the improvements on the property.
Note: There is no requirement for an operating advisor if a sponsor retains a horizontal residual interest even if the interests held by the sponsor grant it control over special servicing activities.
Note: The Final Rules require the disclosure of the purchase price of each B-piece. Issuers, underwriters and investors generally consider that information as proprietary and confidential.
Revolving master trusts and similar revolving pools of assets are often used for securitizations when the underlying assets consist of revolving lines of credit (e.g., credit card accounts) or to create ABS having longer maturities than the short-term assets securitized by using the proceeds of maturing assets to acquire new assets during an initial non-amortization period. These pools issue multiple series of ABS interests that are backed by a single pool of assets that are expected to change in composition over time. The sponsors of these trusts typically hold a direct interest in the assets backing the ABS interests. Prior to the occurrence of an early amortization event, the sponsor’s interest in the assets backing the ABS interests is typically pari passu with the interests of the holders of the ABS interests.
The Final Rules would allow a sponsor of a revolving asset pool securitization to satisfy the risk retention requirement by maintaining a “seller’s interest” in an amount not less than 5% of the aggregate unpaid principal balance of all outstanding investor ABS interests issued by the issuing entity.25 The seller’s interest may be retained by one or more wholly-owned affiliates of the sponsor, including one or more depositors of the revolving pool securitization.
The Final Rules define a “revolving pool securitization” as an issuing entity that is established to issue on multiple issuance dates more than one series, class, subclass, or tranche of ABS that are collateralized by a common pool of securitized assets that will change in composition over time, and that does not monetize excess interest and fees from its securitized assets. This definition is intended to be consistent with market practices and is intended to include revolving trusts that securitize short-term loans, such as insurance premium finance loans, and use the proceeds of maturing loans in order to acquire new loans to collateralize longer-term securities.
Note: The definition of “revolving pool securitization” has been expanded from “revolving master trust” in the proposed rule in order to include revolving securitization structures that are commonly referred to as “master trusts” but do not use issuing entities organized in the form of a trust.
Note: The securitization structure need not specifically state its intention to issue multiple series in its organizational documents, as long as the entity has the ability, under its constituent legal powers, to issue more than one series.
The Final Rules define a “seller’s interest” as an ABS interest or ABS interests (i) collateralized by the securitized assets and servicing assets owned or held by the issuing entity, other than certain assets not considered a part of seller’s interest; (ii) that is either pari passu with each series of investor ABS interests issued, or partially or fully subordinated to one or more series in identical or varying amounts, with respect to the allocation of all distributions and losses with respect to the securitized assets prior to early amortization of the revolving securitization (as specified in the securitization transaction documents); and (iii) that adjust for fluctuations in the outstanding principal balance of the securitized assets in the pool.
Note: Both the definition of “revolving pool securitization” and “seller’s interest” are intended to be consistent with market practices. The definition of “seller’s interest” is also designed to make sure that the interest retained by the sponsor would be aligned with the interests of investors at a series, rather than a pool, level.
Note: Assets not considered part of the seller’s interest are (i) servicing assets that have been allocated as collateral only for a specific series in connection with administering the revolving pool securitization, such as a principal accumulation or interest reserve account; and (ii) assets that are not eligible under the terms of the securitization transaction to be included when determining whether the revolving pool securitization holds aggregate securitized assets in specified proportions to aggregate outstanding investor ABS interests issued.
The seller’s interest must satisfy the 5% test at the closing of each issuance of ABS interests to investors by the issuing entity, and at least monthly at a seller’s interest measurement date specified under the securitization transaction documents, until no ABS interest in the issuing entity is held by any person not a wholly-owned affiliate of the sponsor.
Note: In determining the percentage of seller’s interest at the closing of each issuance, sponsors can use a specified “as of” date or cut-off date for data about the pool’s assets. This cut-off date must be no more than 60 days prior to the date of first use of the related disclosures with investors, or for securitizations with quarterly or less frequent distribution, no more than 135 days prior to the date of first use of the disclosures. A sponsor must describe its use of specified dates in its disclosures to investors.
In the case of a revolving pool securitization that holds collateral certificates issued by another revolving pool securitization having the same sponsor, the Final Rules allow the sponsor’s risk retention to be met by retaining a seller’s interest for the assets represented by the collateral certificates through either revolving pool securitization. The proportion of the seller’s interest retained at the level of the pool securitization that issued the collateral certificates must equal the proportion that the collateral certificates represent of the principal balance of the securitized assets of the pool securitization that issues the ABS interests as of each required measurement date.
The 5% seller’s interest required on each measurement date may be reduced on a dollar-for- dollar basis by the balance, as of such date, of an excess funding account in the form of a segregated account that (i) is funded in the event of a failure to meet the minimum seller’s interest requirements under the securitization transaction documents by distributions otherwise payable to the holder of the seller’s interest; (ii) is invested only in the types of assets in which funds held in a horizontal cash reserve account are permitted to be invested; and (iii) in the event of an early amortization, makes payments of amounts held in the account to holders of investor ABS interests in the same manner as payments to holders of investor ABS interests of amounts received on securitized assets.
Note: The Final Rules have removed the requirement that the excess funding account be pari passu to each series of investor ABS interests with respect to allocation of losses.
The Final Rules clarify that for a sponsor of a pool securitization, a reduction in the seller’s interest below the percentage required by the Final Rules after the revolving pool securitization commences early amortization, pursuant to the terms of the securitization transaction documents, of all series of outstanding investor ABS interests, will not violate the sponsor’s risk retention requirement if (i) the sponsor was in full compliance with its risk retention requirement on all measurement dates prior to commencement of early amortization; (ii) the terms of the seller’s interest continue to make it pari passu with or subordinate in identical or varying amounts to each series of investor ABS interests issued with respect to the allocation of all distributions and losses with respect to the securitized assets; (iii) the terms of any horizontal interest relied upon by the sponsor to offset the minimum seller’s interest amount continue to require the interests to absorb losses in accordance with the requirements specified by the Final Rules for the combination of a seller’s interest with a horizontal interest; and (iv) the revolving pool securitization issues no additional ABS interests after early amortization is initiated to any person not a wholly-owned affiliate of the sponsor, either at the time of issuance or during the amortization period.
A sponsor must retain the required disclosures in written form in its records and must provide the disclosure upon request to the SEC and its appropriate Federal banking agency, if any, until three years after all ABS interests are no longer outstanding.
A sponsor of an eligible asset-backed commercial paper conduit (“eligible ABCP conduit”) that issues commercial paper that has a maturity at the time of issuance not exceeding 397 days, exclusive of days of grace (“ABCP”), may satisfy the risk retention requirements if each originator-seller26 that transfers assets to collateralize the ABCP retains an economic interest in the credit risk of such assets in the same amount and manner as would be required using the standard risk retention27 or revolving pool securitizations28 options.
Note: This risk retention option is narrow in scope and would not be available to many ABCP programs, including structured investment vehicles, securities arbitrage programs and other arbitrage programs and other programs that do not satisfy the “eligible ABCP conduit” criteria.
The Final Rules define “eligible ABCP conduit” as an entity that issues ABCP meeting each of the following criteria:
1. The ABCP conduit is bankruptcy remote or otherwise isolated for insolvency purposes from the sponsor and from any intermediate SPV from which it acquires any ABS interest.2. The ABS interests acquired by the ABCP conduit are:(i) ABS interests collateralized solely by assets originated by an originator-seller and by servicing assets:(ii) Special units of beneficial interests (or similar ABS interests) in a trust or special purpose vehicle that retains legal title to leased property underlying leases originated by an originator-seller that were transferred to an intermediate SPV in connection with a securitization collateralized solely by such leases and by servicing assets;(iii) ABS interests in a revolving pool securitization collateralized solely by assets originated by an originator-seller and by servicing assets;(iv) ABS interests described in paragraphs (i), (ii) or (iii) above that are collateralized, in whole or in part, by assets acquired by an originator-seller in a business combination that qualifies for business combination accounting under U.S. GAAP, and, if collateralized in part, the remainder of such assets are assets described in paragraphs (i), (ii), or (iii) above, or(v) Acquired by the ABCP conduit in an initial issuance by or on behalf of an intermediate SPV (A) directly from the intermediate SPV, (B) from an underwriter of the ABS interests issued by the intermediate SPV, or (C) from another person who acquired the ABS interests directly from the intermediate SPV;
Note: Paragraph (2) above clarifies that the assets being financed have been originated by the originator-seller and not purchased and aggregated. In general, eligible ABCP conduits may not purchase ABS interests in the secondary market; provided, however, that at any time, an eligible ABCP conduit that acquired an ABS interest in accordance with this option may transfer to another eligible ABCP conduit if (x) the sponsors of both eligible ABCP conduits are in compliance with this option and (y) the same regulated liquidity provider has entered into one or more commitments to provide 100% liquidity coverage to all the ABCP issued by both eligible ABCP conduits.
Note: ABCP conduits may have different regulated liquidity providers and, if they do, it is unclear why, in order to transfer ABS interests between eligible ABCP conduits, that the same regulated liquidity provider must provide 100% liquidity to both eligible ABCP conduits, especially when a regulated liquidity provider already covers 100% of the credit risk, well above the requisite risk retention already retained by the originator-seller required by the Final Rules.
3. The ABCP conduit is collateralized solely by ABS interests acquired from intermediate SPVs as described in paragraph (2) above of this definition and servicing assets.
Note: Not all ABCP conduits utilize the intermediate SPV structure. This provision also prohibits intermediate SPVs from acquiring assets from non-affiliates or in the secondary market, except as provided in the second note above.
4. A regulated liquidity provider29 has entered into a legally-binding commitment to provide 100% liquidity coverage (in certain specified forms) to all the ABCP issued by the ABCP conduit by lending to, purchasing ABCP issued by, or purchasing assets from, the ABCP conduit in the event that funds are required to repay maturing ABCP issued by the ABCP conduit. With respect to the 100% liquidity coverage, in the event that the ABCP conduit is unable for any reason to repay maturing ABCP issued by it, the liquidity provider must be obligated to pay an amount equal to any shortfall, and the total amount that may be due pursuant to the 100% liquidity coverage must be equal to 100% of the amount of the ABCP outstanding at any time plus accrued and unpaid interest (amounts due pursuant to the required liquidity coverage may not be subject to credit performance of the ABS interests held by the ABCP conduit or reduced by the amount of credit support provided to the ABCP conduit and liquidity support that only funds performing loans or receivables or performing ABS interests does not meet the requirements of the eligible ABCP conduits section of the Final Rules).
Note: Not all ABCP conduits have 100% liquidity coverage and, if they do, it is not clear why a “regulated” (as defined in the Final Rules) liquidity provider is required so long as such provider has a high enough credit standing.
Note: Not all ABCP conduits have liquidity coverage that covers the credit risk of the ABS held by the ABCP conduit and it is unclear why the Federal banking agencies would want the regulated provider to cover 100% of the credit risk when the originator-seller already covers the requisite risk retention required by the Final Rules.
Note: If the ABCP conduit does not satisfy the “eligible ABCP conduit” criteria, the sponsor must retain credit risk in accordance with another risk retention option included in the Final Rules (unless an exemption for the transaction exists).
Note: The terms and conditions of the eligible ABCP conduit risk retention option are designed to ensure that the assets of “eligible ABCP conduits” have low credit risk and that originator-sellers have incentives to monitor the quality of such assets. However, sponsors may have difficulty monitoring compliance by the originator-sellers with the requirements of this option.
Note: As is customary in the ABCP market, the names of any originator-seller are not required to be disclosed to investors under the Final Rules. However, under the eligible ABCP conduit option, the sponsor must promptly notify investors, and upon request, the SEC and its appropriate Federal banking agency, if any, of the name of any originator-seller that fails to retain risk in accordance with this option or hedges its risk retention in violation of this option.
Guarantees provided by Fannie Mae or Freddie Mac (each, a “GSE”) while operating under the conservatorship or receivership of the FHFA with capital support from the United States will satisfy the risk retention requirements of such GSE with respect to ABS issues if the guarantee is of the timely payment of principal and interest on all ABS interests issued by the issuing entity. The Agencies note that because the GSEs fully guarantee the timely payment of principal and interest on their ABS, GSEs are already exposed to the entire credit risk of the mortgages backing those ABS. An equivalent guaranty provided by a limited life regulated entity that has succeeded to the charter of a GSE and that is operating under the direction and control of the FHFA with capital support from the United States will also satisfy the risk retention requirements. If either GSE or limited-life regulated entity begins to operate other than under the conservatorship or receivership of the FHFA, such GSE or entity will no longer be able to avail itself of this option.
Note: With respect to certain ABS sponsored by the GSEs, only a portion of the related securities are fully guaranteed, with the balance of the securities (generally a relatively small junior interest) not having the benefit of any GSE guaranty. Guidance from the Agencies is needed on whether risk retention requirements would apply in any such circumstance, and if so, how the required retention should be calculated.
Note: With respect to certain ABS sponsored by third parties, the GSEs will sometimes acquire the senior tranche and then sponsor a fully guaranteed ABS collateralized by that senior tranche, while the third-party sponsor sells the unguaranteed junior tranche (which is relatively small) to investors. The GSE-guaranteed ABS would presumably be exempt from credit risk retention because it is the only ABS-interest in the related issuing entity. However, a question arises as to whether the third-party sponsor of the issuing entity that issued both the senior tranche that collateralizes the GSE’s guaranteed ABS and the unguaranteed junior tranche should be required to hold a retained interest based on the fair value of both ABS interests or just the junior tranche.
Note: The Agencies noted the ongoing efforts to reform the operations of the GSEs and expressed an intent to revisit and, if appropriate, modify the provisions of the Final Rules applicable to the GSEs once the future of their statutory and regulatory framework become clearer.
Notwithstanding the extensive commentary received by the Agencies on the Reproposed Rules, the Final Rules, as they relate to CLOs, are largely identical to the Reproposed Rules. As discussed in more detail below, the Final Rules provide two options for risk retention for CLOs30, 31: (i) CLO Manager risk retention (by itself or through a majority-owned affiliate) and (ii) CLOs composed exclusively of CLO-eligible loan tranches that otherwise meet the “lead arranger” risk retention criteria. In the Preamble, the Agencies make the following observations:
Note: The Agencies’ concern with promoting such discipline and reducing such risk appears to be an outgrowth of what they see as recent developments in the leveraged loan market. The Agencies note that “[h]eightened activity in the leveraged loan market has been driven by search for yield and a corresponding risk appetite by investors” and that evidence exists of a “widespread loosening of underwriting standards” that coincides with such activity.32
In addition, as discussed in Part II of this memo, the Final Rules remove the proposed cash flow restrictions on payments to an eligible horizontal residual interest retained by a sponsor. This change from the Reproposed Rules is particularly significant for CLOs, since compliance with such restrictions was seen by the market as commercially unfeasible, given that investors in the “equity tranche” of a CLO require that excess interest spread be paid to them in accordance with the CLO’s priority of payments on a current basis.
Agencies’ Perspective – The Agencies acknowledge that requiring open market CLO Managers to satisfy the risk retention requirement under the Final Rules could result in fewer CLO issuances and less competition in the CLO market.35 In this regard, the Agencies make the following observations:36
Market’s Perspective – Market participants are still analyzing the Final Rules and the impact such rules will have on the CLO market going forward. After considering the Final Rules and obtaining preliminary feedback from market participants, we offer the following observations on the potential consequences of risk retention on open market CLOs:
Note: The use of the originator structure for open market CLOs may prove very challenging. Under a plain reading of the Final Rules, it should be quite simple to set up a warehousing entity that “initiates the securitization by transferring” loans to the CLO. However, the Agencies went to great lengths to explain that the sponsor of a CLO needs to be the entity responsible for loan credit selection, which seems to be only the true, original lender of the loans or the CLO Manager that is selecting the loans.37
Note: As needed, CLO Managers are expected to work with their accountants to create structures that permit investors to participate in, and help fund, such CLO Managers’ risk retention requirements via a majority-owned affiliate. Whether such structures are considered a majority-owned affiliate of the CLO Manager under the Final Rules will be a function of whether “majority control” exists as determined in accordance with GAAP. In this regard, we note that the control rules under GAAP are in the process of being republished. Hence, structures being considered will need to take this into consideration. We also note that if at any point during the required retention period the affiliate is no longer considered to be “majority-owned” as described above, the CLO Manager will technically no longer be in compliance with the risk retention requirements.
Post-Effective Date – It is too early to definitively say how issuance of open market CLOs will be impacted by the Final Rules, given that market participants need a period of time to fully analyze and adjust their businesses and market practices in response to such rules. However, unless material forms of capital can be raised by CLO Managers to finance their retention requirements and/or novel originator structures that are compliant with the Final Rules are created, overall issuance of open market CLOs may be materially lower than it is today.39
Note: A strong argument can be made that a CLO Manager should not be deemed to be a sponsor under the Final Rules for purposes of triggering risk retention with respect to a grandfathered CLO, solely by virtue of the issuance (or deemed issuance) of securities over which the CLO Manager has no direct control.
Note: Although not clear from the language of the Final Rules, it may be possible that a refinancing or re-pricing could be effected in such a way (such as refinancing one or more outstanding CLO tranches with the proceeds of a loan or re-pricing one or more outstanding CLO tranches through a supplemental indenture, in either case without the issuance of new or replacement notes) that such action would not, in and of itself, cause the sponsor of a grandfathered CLO to be subject to the risk retention requirements under the Final Rules.
If the risk retention requirements of the Final Rules are determined to apply to otherwise grandfathered CLOs, as the result of the exercise of additional issuance, refinancing or re-pricing features, market participants will need to consider a number of issues. For example, CLO Managers generally do not have specific approval or veto rights in respect of refinancings or re-pricings (although CLO Managers may have rights to approve supplemental indentures entered into in order to effect such actions; and most CLO indentures generally prohibit the issuer from entering into a supplemental indenture that would have a material adverse effect on the CLO Manager without its consent). Given the potential application of the risk retention rules and the related consequences for a CLO Manager that would result from the exercise of any such feature, CLO indentures for transactions that will close prior to the effective date of the Final Rules will need to be expanded in order to permit compliance with the Final Rules, if such compliance is determined to be necessary and acceptable to the CLO Manager.
Hence, a CLO Manager (or its majority-owned affiliate) generally may be able to borrow (directly or indirectly through its parent) in order to fund the acquisition of a retention interest mandated by the risk retention requirements, but the financing must be on a full recourse basis if the retention interest is pledged as collateral for such financing. This raises an interesting question of what the consequences would be to a sponsor if a lender attempted to foreclose on the retention interest held by a CLO Manager (or its majority-owned affiliate). Although the Final Rules do not expressly address the foreclosure of a pledged retained interest, in its commentary on the Reproposed Rules the Agencies stated that, where a pledge of an interest or asset to support full recourse financing subsequently results in such interest or asset being taken by the counterparty to the financing transaction (whether by consent, pursuant to exercise of remedies or otherwise), the sponsor will be viewed as having violated the prohibition on transfer.40 The foregoing suggests that any retention interest financing arrangements by a CLO Manager (or its affiliate) should not permit foreclosure on such retention interest until the expiration of the related retention period.
Note: In Europe, for purposes of compliance with Article 405 of the Capital Requirements Regulation, financing of a retention interest in a CLO by an eligible retention holder is not uncommon. Article 12(2) of Commission Delegated Regulation (EU) No 625/2014 of 13 March 2014 provides that the retainer may use any retained exposures or securitization positions as collateral for secured funding purposes, as long as such use does not transfer the credit risk of these retained exposures or securitization positions to a third party. In light of the requirement that the use of any retained exposures or securitization positions does not transfer the credit risk to a third party, these financing arrangements are typically on a full recourse basis. Such arrangements may involve a guaranty by the borrower’s parent and typically involve financing a portion of the vertical interest represented by the investment grade tranches and, potentially, below investment grade tranche(s), of the related CLO. If a lender enforces its security interest in the retention notes, the related CLO will no longer be compliant with Article 405 of the Capital Requirements Regulation.41
Note: It is anticipated that certain lenders will attempt to develop arrangements to facilitate CLO Managers’ financing of their required retention interests in open market CLOs. As we’ve seen in European CLO transactions, such arrangements will likely involve financing a vertical interest in a CLO. The question remains whether the terms of any such arrangements will be offered on sufficiently attractive terms or whether such arrangements will afford sufficient credit capacity to be a viable source of funding to CLO Managers to finance their future retention requirements.
Note: It is unclear at this point what the consequences will be for a non-US ABS transaction that does not meet all of the technical requirements of the foreign transaction safe harbor. The sponsor (i.e., a CLO Manager in the case of an open market CLO) is responsible for retention compliance under the Final Rules. The consequences to a particular sponsor will depend in part on the what authority the Agencies may have over such sponsor.
Note: The foreign transaction safe harbor would not be available with respect to any transaction or series of transactions that, although in technical compliance with the safe harbor, is part of a plan or scheme to evade the requirements of Section 15G and the Final Rules. In such cases, compliance with Section 15G and the Final Rules would be required.
Note: Should a successor CLO Manager be required, as a condition to its appointment, to acquire the retention interest held by a CLO Manager that is resigning or being removed? In the Preamble, the Agencies emphasize the importance of promoting discipline in the underwriting standards of loans being securitized, monitoring the credit quality of CLO collateral and ensuring that the interests of CLO Managers are adequately aligned with CLO investors.44 Such statements suggest that Section 15G may require a successor CLO Manager to acquire the outgoing CLO Manager’s retention interest as a condition to its appointment, particularly if new loan assets may be acquired by the CLO after such appointment.
Note: Additional guidance from the Agencies likely will be required to clarify how risk retention is satisfied in the context of the resignation or removal of a CLO Manager. We note that the European risk retention rules also do not address this point but we anticipate some guidance from the European Banking Authority over the next few months.
Note: As discussed above, the widespread view of market participants is that the lead arranger option is not workable for banks that arrange loans to commercial borrowers.
A sponsor satisfies its risk retention requirements with respect to Open Market CLOs (as defined below) that purchase and hold only “CLO-eligible loan tranches” (as defined below). The Lead Arranger (as defined below) of each loan in the CLO-eligible loan tranche must retain at least 5% of the face amount of the term loan tranche purchased by the CLO until repayment, maturity, acceleration, payment default or bankruptcy. The Final Rules further require, among other things, that the Lead Arranger of the underlying loan must take an initial allocation of at least 20% of the face amount of the broader syndicated credit facility, and no other member of the syndicate could take a larger share.
Note: The rationale for this provision appears to be that the Agencies believe holding the largest allocation of the credit facility will provide the Lead Arranger with significant influence over the negotiation of the loan terms.
The Final Rules define an “Open Market CLO” as a CLO (1) whose assets consist of senior, secured syndicated loans acquired by such CLO directly from the sellers thereof in Open Market Transactions and of servicing assets, (2) that is managed by a CLO Manager, and (3) that holds less than 50% of its assets, by aggregate outstanding principal amount, in loans syndicated by lead arrangers that are affiliates of the CLO or the CLO Manager or originated by originators that are affiliates of the CLO or the CLO Manager.
To qualify under this alternative risk retention proposal, such Open Market CLO must meet the following criteria:
The Final Rules define an “Open Market Transaction” as either (1) an initial loan syndication transaction or a secondary market transaction in which a seller offers Senior, Secured Syndicated Loans to prospective purchasers in the loan market on market terms on an arm’s-length basis, which prospective purchasers include, but are not limited to, entities that are not affiliated with the seller, or (2) a reverse inquiry from a prospective purchaser of a Senior, Secured Syndicated Loan through a dealer in the loan market to purchase a Senior, Secured Syndicated Loan to be sourced by the dealer in the loan market.
The Final Rules define a “Senior, Secured Syndicated Loan” as a loan made to a commercial borrower that: (1) is not subordinate in right of payment to any other obligation for borrowed money of the commercial borrower; (2) is secured by a valid first priority security interest or lien in or on specified collateral securing the commercial borrower’s obligations under the loan; and (3) the value of the collateral subject to such first priority security interest or lien, together with other attributes of the obligor (including, without limitation, its general financial condition, ability to generate cash flow available for debt service and other demands for that cash flow), is adequate (in the commercially reasonable judgment of the CLO Manager exercised at the time of investment) to repay the loan and to repay all other indebtedness of equal seniority secured by such first priority security interest or lien in or on the same collateral, and the CLO Manager certifies, on or prior to each date that it acquires a loan constituting part of a new CLO-eligible tranche, that it has policies and procedures to evaluate the likelihood of repayment of loans acquired by the CLO and it has followed such policies and procedures in evaluating each CLO-eligible loan tranche.
Note: This is substantially identical to the standard senior secured loan definition currently used by most CLOs.
The Final Rules define a “CLO-eligible loan tranche” as a term loan tranche of a syndicated loan that at all times meets the following criteria:
The Final Rules define “Lead Arranger” as an institution that:
Note: This allocation requirement could preclude all but a handful of the largest banks with respect to very large loan facilities.
Tender option bonds (“TOBs”) involve the creation of a trust that holds municipal securities (typically a single series of a highly rated, tax-exempt municipal bond), and the issuance by the trust of two classes of certificates. One class distributes interest based on a floating rate (the “floaters”); the other class distributes interest based on the inverse of the floating rate security (the “residuals”). The structure is designed to pass through the interest on the municipal securities to the floaters and residuals on a tax-exempt basis and to allow the floaters to be eligible for investment by money market funds.
The holders of the floaters have the right to tender their floaters for purchase at par plus accrued interest, and the payment of the tender price is supported by a liquidity facility delivered by a highly rated provider. Upon the occurrence of a default or bankruptcy of the municipal bond issuer, a downgrade of the bond below investment grade, or certain events adversely affecting the tax-exempt status of the bond (each such event, a “tender option termination event”), each class suffers a loss based on then-current market price of the bond.
Note: While tender option bond issuing entities created prior to effective date of the Final Rules are exempt from the risk retention requirements of the Final Rules, the Agencies have clarified that if a pre-existing tender option bond issuing entity issues additional securities after the effective date of the Final Rules, then notwithstanding the fact that the issuing entity was formed prior to the effective date of the Final Rules, the sponsors of the issuing entity would be subject to the risk retention requirements with respect to the new issuance of bonds.
The Final Rules would allow a “sponsor” of a “qualified tender option bond entity” to use the standard risk retention methods described in Part III.A above, including holding an eligible vertical interest, an eligible horizontal interest, or any combination thereof. The sponsor may retain an eligible horizontal residual interest at issuance that is subsequently converted into an eligible vertical interest upon the occurrence of a “tender option termination event.” The sponsor may also satisfy the risk retention requirement by holding municipal securities from the same issuance deposited into the qualified tender option bond entity in an amount equal to 5% of the face value of the municipal securities deposited. Finally, the sponsor may satisfy the risk retention requirement by holding any combination of the foregoing interests or securities such that the sum of the percentages held in each form equals at least 5%. The fair value of the tender option bonds are calculated as of the closing date; provided that, if the tender option bond issuing entity issues additional tender option bonds after the closing date, the sponsor must recalculate the fair value of the tender option bonds as of the date of the subsequent issuance.
Note: The Final Rules provide that the Agencies believe that a residual interest in a qualified tender option bond entity would meet the requirements of an eligible horizontal residual interest before, and an eligible vertical interest after, the occurrence of a tender option termination event if: (i) prior to the occurrence of a tender option termination event, the residual holder bears all the market risk associated with the underlying tax-exempt municipal security; and (ii) after the occurrence of a tender option termination event, any credit losses are shared pro rata between the tender option bonds and the residual interest.
The Final Rules define “qualified tender option bond entity” as an entity that issues ‘tender option bonds” and meets criteria that include:
The Final Rules define a “tender option bond” as a security that has features which entitle the holders to tender such securities to the issuing entity for purchase at any time upon no more than 397 days’ notice, for a purchase equal to the par amount of such securities plus accrued interest.
The name and form of organization of the qualified tender option bond entity.
Prohibited Hedging. Sponsors of qualified tender option bond entities are subject to the prohibitions on hedging and transfer described in Part III.H of this memo. The Agencies do not believe that there is any reason to treat sponsors of tender option bonds any differently from sponsors of other asset-backed securities issuances.
General. Except as described above with respect to the defeasance of certain commercial real estate loans, the Final Rules prohibit a sponsor from transferring any interest or assets that it is required to retain thereunder to any person other than a majority-owned affiliate and expressly states that the prohibition also applies to each such majority-owned affiliate. Even absent a transfer from the sponsor, the Final Rules prohibit affiliates of the sponsor from hedging the credit risk the sponsor or any of its majority-owned affiliates is required to retain under the Final Rules.
Under the Final Rules, sponsors and their affiliates are prohibited from purchasing or selling a security or other financial instrument or entering into an agreement (including an insurance contract), derivative or other position with any other person if:
The Agencies’ stated intention is to focus the hedging prohibition on the credit risk associated with the interest or assets that the sponsor is required to retain, which credit risk is based on the underlying credit risk of the securitized assets backing the ABS interests issued. Therefore, hedge positions that are not materially related to the credit risk of ABS interests or exposures required to be retained by the sponsor are not prohibited by the Final Rules. Examples offered by the Agencies in the release accompany the Reproposed Rules, which, in this regard, are substantially identical to the Final Rules, of hedging activities that would not violate the prohibition are hedges related to (i) overall market movements, such as movements of market interest rates (but not the specific interest rates known as spread risk associated with the ABS interest that is otherwise considered part of the credit risk), (ii) currency exchange rates, (iii) home prices, or (iv) the overall value of a particular broad category of ABS. Hedges tied to securities that are backed by similar assets originated and secured by other sponsors also would not be prohibited. On the other hand, any security, instrument, derivative or contract that references the particular interests or assets or requires payment in circumstances where there is or could reasonably be expected to be a loss due to the credit risk of such interests or assets (i.e., credit default swaps referencing such interests or assets) would be prohibited.
The Final Rules allow certain hedges based on indices that may include one or more tranches from a sponsor’s ABS transactions, such as ABX or LCDX Index hedges, so long as:
According to the Agencies, these limitations are designed to prevent a sponsor from evading the hedging restrictions through the purchase of indexed hedges based to a significant degree on ABS from securitization transactions in which a sponsor is required to retain risk under the Final Rules.
Issuing entities are not prohibited from engaging in interest rate or foreign currency hedging transactions that are for the ultimate benefit of investors in the ABS. However, the Agencies make clear that any credit protection, such as asset-level or pool-level insurance or bond level insurance that covers interests required to be retained by the sponsor, would violate the hedging prohibition unless the sponsor’s right to receive payments under any such credit protection is subordinated to all other investors. For example, if the sponsor elects to satisfy its risk retention obligation by holding an eligible vertical interest representing 5% of each class, an issuing entity may purchase credit protection covering 100% of the tranches, but the sponsor would not be entitled to any payments under such credit protection until all other holders are paid amounts then due them.
The Final Rules also prohibit a sponsor and its affiliates from pledging as collateral for any obligation (including a loan, repurchase agreement or other financing transaction) any interest or asset that the sponsor is required to retain unless the obligation is with full recourse to the sponsor or its affiliate, as applicable.45
Sunset Provisions. The Final Rules specify that the hedging and transfer restrictions expire as follows:
1. In the case of securitizations of assets other than residential mortgages, on or after the date that is the latest of:
(i) The date on which the total unpaid principal balance (if applicable) of the securitized assets that collateralize the securitization transaction has been reduced to 33% of the total unpaid principal balance of the securitized assets as of the cut-off date of the securitization transaction;
(ii) The date on which the total unpaid principal obligations under the ABS interests issued in the securitization transaction has been reduced to 33% of the total unpaid principal obligations of the ABS interests at closing of the securitization transaction; or
(iii) Two years after the date of the closing of the securitization transaction.
2. In the case of securitizations wholly collateralized by residential mortgages, on or after the date that is the earlier of:
(i) the later of (A) five years after the date of the closing of the securitization transaction or (B) the date on which the total unpaid principal balance of the residential mortgages that collateralize the securitization transaction has been reduced to 25% of the total unpaid principal balance of such residential mortgages at the closing of the securitization transaction; or
(ii) Seven years after the date of the closing of the securitization transaction.
Note: Although the sunset provisions do not address the restriction on non-recourse financing, the restriction on such financing only applies to ABS interests “required” to be retained. This suggests that if the ABS interest can be transferred, it should be able to be financed with nonrecourse financing as well.
Under the Final Rules, the risk retention requirements described do not apply to an issuance of RMBS if all of the assets backing the transaction are qualified residential mortgages (“QRMs”) currently performing46 at the closing of the securitization or servicing assets. The Final Rules define a QRM to be the same as a qualified mortgage (“QM”), as defined in Section 129C of The Truth in Lending Act47 and implemented by the Consumer Financial Protection Bureau (“CFPB”) in its ability to repay rule, as amended from time to time. The CFPB issued a final ability to repay rule on January 10, 2013 and issued finalized supplemental rules in May 2013 (together, the “Ability to Repay Rule”).48 The Ability to Repay Rule became effective on January 10, 2014.49 In general, a QM must have the following features:50:
By virtue of alignment of the definition of QRM with QM under the Final Rules, QRMs may consist of both first and junior lien positions and may be any closed-end loan secured by any dwelling (e.g., home purchases, refinances, home equity lines and second or vacation homes). The proposed QRM definition would exclude revolving home equity lines of credit (“HELOCs”), reverse mortgages, timeshares, temporary loans or “bridge” loans of 12 months or less and most loan modifications (unless they satisfy certain requirements).
In order for a QRM to be exempt from the risk retention requirements described above, the Final Rules impose evaluation and certification conditions that must be met by the depositor and the sponsor involved in the securitization. The depositor for the securitization will be required to certify that it evaluated the effectiveness of its internal supervisory controls with respect to the process for ensuring that all of the assets that collateralize the securities issued in the transaction are QRMs or servicing assets, and that it has determined that its internal supervisory controls are effective. Such evaluation must be performed within 60 days prior to the cut-off date (or similar date) for establishing the composition of the collateral pool. The sponsor also will be required to provide a copy of the certification to potential investors within a reasonable period of time prior to the sale of the securities in the issuing entity and, upon request, to the SEC and its appropriate Federal banking agency, if any.
The risk retention requirements described above would not apply or would be reduced for an issuance of ABS if all or a portion of the assets backing the transaction are commercial loans, commercial real estate (CRE) loans, or automobile loans that satisfy specified underwriting standards (“qualifying loans”). The underwriting standards are meant to ensure that the loans that qualify for the exemption are those that pose a very low credit risk.
For pools that are comprised entirely of qualifying loans, the risk retention percentage would be zero. For pools that are partially comprised of qualifying loans, the risk retention percentage would be reduced, but not by more than 50%, by the ratio that the unpaid principal balance of the qualifying loans bears to the total unpaid principal balance of the loans that are included in the pool. For example, if 20% of the unpaid principal balance of a pool was comprised of qualifying loans, the risk retention requirement would be reduced by 20% and therefore would be 4%. In no event, however, can the risk retention be reduced to less than 2.5% for a pool that has a combination of qualifying and non-qualifying loans.
In order to be eligible for the risk retention exemption/reduction, in addition to the specific requirements described below for each asset class, the following conditions must be satisfied:
Under the Final Rules, a “commercial loan” is defined as a secured or unsecured loan to a company or an individual for business purposes, other than (1) a loan to purchase or refinance a one-to-four family residential property; or (2) a commercial real estate loan. For ABS comprised solely of commercial loans to qualify for the risk retention exemption/reduction, in addition to the general requirements described above, such loans must meet the criteria specified in the Final Rules as summarized below.
Under the Final Rules, a commercial real estate loan (“CRE loan”) is a loan secured by real property that meets the terms of the definition described in Part V.B. above. The definition of a CRE loan excludes land development loans, construction loans (including one-to-four family residential or commercial construction loans), other land loans, farm loans and unsecured loans to developers. For a CRE loan to qualify as a “qualifying CRE loan” (“QCRE loan”), such loan must meet the criteria specified in the Final Rules as summarized below.
Note: In response to industry comment, the Final Rules provide that if the borrower did not own the property for any part of the last two years (e.g., the borrower is a newly formed SPE), the DSCR calculation should be performed based on the property’s operating income during that period.
Note: The definition of CLTV refers to any junior-lien mortgage loan that is secured by the “same property.” A mezzanine loan that is secured by equity interests in the mortgage borrower should not be included in this calculation.
Under the Final Rules, an “automobile loan” is defined as a loan to an individual to finance the purchase of, and that is secured by a first lien on, a passenger car or other passenger vehicle, such as a minivan, van, sport-utility vehicle, pickup truck, or similar light truck for personal, family, or household use.58
For ABS comprised solely of automobile loans to qualify for risk retention exemption/reduction, such loans must meet the underwriting standards specified in the Final Rules as summarized below.
If a sponsor relied on the qualification of a commercial loan, a CRE loan or an automobile loan for the risk retention exemption/reduction described above but then, after the closing of a securitization, it is determined that one or more loans did not meet the specified standards, the sponsor will not lose the benefit of the exemption/reduction if (1) the failure of such loans to meet such standard is not material or (2) within 90 days after the determination is made the sponsor cures the unsatisfied criteria or repurchases the subject loans from the issuer at a price equal to par plus accrued interest on the loan.
Certain types of ABS or securitization transactions are exempt from the credit risk retention requirements of the Final Rules. These exemptions are intended to be consistent with, and to implement, the applicable requirements of Section 15G.
Under the Final Rules, the risk retention requirements do not apply to the following types of transactions:
Note: For example, the exemption under clause (i) would apply to loans that are insured or guaranteed by the FHA, the Department of Veterans Administration, or the Department of Agriculture and Rural Development. This exemption implements Section 15G(e)(3)(B) of the Exchange Act. Also, the exemption under clause (ii) would apply to securities guaranteed by the Government National Mortgage Association.
Note: Most resecuritizations are structured with at least two senior/subordinate classes. Because the exemption restricts resecuritizations to a single pass-through class, multiclass resecuritizations of underlying ABS that were exempt from, or otherwise satisfied, the risk retention requirements would subject the sponsor of such resecuritizations to the risk retention requirements.
In addition to the exemptions described above, which provide complete relief from the sponsor’s risk retention requirements in the applicable securitizations, the Final Rules also contain reduced risk retention requirements for student loan securitizations collateralized solely by student loans made under the Federal Family Education Loan Program (“FFELP loans”). Specifically, (i) with respect to a securitization transaction that is collateralized solely by FFELP loans that are guaranteed as to 100% of defaulted principal and accrued interest, and servicing assets, the risk retention requirement is reduced to 0%; (ii) with respect to a securitization transaction that is collateralized solely by FFELP loans that are guaranteed as to at least 98% but less than 100% of defaulted principal and accrued interest, and servicing assets, the risk retention requirement is reduced to 2%; and (iii) with respect to any other securitization transaction that is collateralized solely by FFELP loans, and servicing assets, the risk retention requirement is reduced to 3%.
The Final Rules specify that securitization transactions involving the issuance of ABS that are either issued, insured, or guaranteed by, or are collateralized by obligations issued by, or loans that are issued, insured, or guaranteed by, the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, or a Federal home loan bank will not on that basis qualify for exemption under the Final Rules. Nevertheless, although Fannie Mae and Freddie Mac do not independently qualify for an exemption, the Final Rules allow Fannie Mae and Freddie Mac securitizations to be exempt for so long as they are under the conservatorship or receivership of the FHFA with capital support of the United States, as described under “Permissible Forms of Risk Retention—Treatment of Government-Sponsored Enterprises” in Part V.E of this memo.
The Final Rules provide that the Agencies with rule writing authority under Section 15G with respect to the type of assets involved may jointly provide a total or partial exemption of any securitization transaction as such Agencies determine may be appropriate in the public interest and for the protection of investors.
Under the Final Rules, the Federal banking agencies and the SEC, in consultation with the FHFA and HUD, may jointly adopt or issue exemptions, exceptions or adjustments to the risk retention requirements, including exemptions, exceptions or adjustments for classes of institutions or assets in accordance with Section 15G.
The Final Rules provide a “safe harbor” provision intended for certain foreign transactions if all of the following requirements are satisfied:
The safe harbor described above would not be available with respect to any transaction or series of transactions that, although in technical compliance, is part of a plan or scheme to evade the requirements of Section 15G and the Final Rules. In such cases, compliance with Section 15G and the Final Rules would be required.
As expected, the Final Rules are substantially similar to the Reproposed Rules. The noteworthy differences between the Reproposed Rules and the Final Rules are recapped in Part II of this memo. The Final Rules did address in a constructive fashion some of the most controversial elements of the Reproposed Rules, and included many constructive amendments or technical clarifications.
Nevertheless, the Final Rules will still have a significant impact on the ABS markets, market participants and transactions.
1 The Dodd-Frank Act was signed into law by President Obama on July 21, 2010. On April 29, 2011, the Federal banking agencies (the Office of the Comptroller of Currency, the Federal Deposit Insurance Corporation and the Board of Governors of the Federal Reserve System), the Securities and Exchange Commission (“SEC”), the Department of Housing and Urban Development (“HUD”), and the Federal Housing Finance Agency (collectively, the “Agencies”) published a joint notice of proposed rulemaking containing proposed rules (the “Original Proposal”, available at http://www.sec.gov/rules/proposed/2011/34-64148.pdf) to implement the credit risk retention requirements of Section 941 of the Dodd-Frank Act, codified as Section 15G (“Section 15G”) of the Securities Exchange Act of 1934 (the “Exchange Act”).
2 The Final Rules are available at https://www.fdic.gov/news/board/2014/2014-10-21_notice_dis_a_fr.pdf.
3 The Reproposed Rules were released by the Agencies on August 28, 2013 pursuant to a notice of proposed rulemaking after receipt of comments from over 10,500 persons, institutions and groups on the Original Proposal. The Reproposed Rules are available at https://www.sec.gov/rules/proposed/2013/34-70277.pdf).
4 Our prior Clients & Friends Memo, “Reproposed Credit Risk Retention Requirements for Asset-Backed Securities Transactions”, dated September 13, 2013, is available at http://www.cadwalader.com/resources/clients-friends-memos/reproposed-credit-risk-retention-requirements-for-asset-backed-securities-transactions.
5 “Majority-owned affiliate” of a person means an entity (other than the issuing entity) that, directly or indirectly, majority controls, is majority controlled by or is under common majority control with, such person. For purposes of this definition, majority control means ownership of more than 50% of the equity of an entity, or ownership of any other controlling financial interest in the entity, as determined under U.S. GAAP.
6 Throughout this memo, the lowercase use of “open market CLO” denotes an “arbitrage” or “broadly syndicated CLO” (in which the securitized loan assets are purchased on the secondary market), as distinct from a “balance sheet CLO” (in which the securitized loan assets are purchased as a portfolio from a single institution or its affiliates, including the entities that originated such loan assets), while the title case use of “Open Market CLO” denotes a CLO that purchases and holds “CLO-eligible loan tranches” in conformity with §__9 of the Final Rules (i.e., the “lead arranger” option).
7 Note that §__9 of the Final Rules, which sets forth the risk retention requirements for “Open Market CLOs,” defines “CLO manager” as “an entity that manages a CLO, which entity is registered as an investment adviser under the Investment Advisers Act of 1940, as amended (15 U.S.C. 80b-1 et. seq.), or is an affiliate of such a registered investment adviser and itself is managed by such registered investment adviser.” References throughout this memo to “CLO Manager,” solely in the context of “Open Market CLOs,” should be read to include the foregoing definition from §__9 of the Final Rules. See the discussion of “Open Market CLOs and the ‘Lead Arranger’ Option,” below.
8 Although this restriction does not appear to expressly sunset, as is the case for transfer and hedging restrictions discussed in Part V.H, the restriction on non-recourse financing applies to ABS interests “required” to be retained. This suggests that if the ABS interest can be transferred, it should be able to be financed with nonrecourse financing.
9 “Sponsor” means a person who organizes and initiates a securitization transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the issuing entity. Note that the definition of “sponsor” under the Final Rules is different than as used in the Volcker Rule. The Volcker Rule’s definition of “sponsor” focuses on the degree of control over the issuing entity. As a result, a banking entity might be considered to “sponsor” a vehicle for the purposes of the Final Rules, but not for Volcker Rule purposes, and vice versa. Care will be required when drafting documents because the term “sponsor” may be used in different regulatory contexts in the same document.
The Final Rules state that in the context of CLOs, the CLO Manager “typically organizes and initiates the transaction” (by having control over the formation of the CLO collateral pool) and the CLO Manager “indirectly transfers the underlying assets to the CLO issuing entity typically by selecting the assets and directing the CLO issuing entity to purchase and sell those assets”. The regulators expressed concern that exempting CLOs and CLO Managers could allow market participants to avoid the requirements of Section 15G by employing third party agents to select assets to be purchased and securitized. CLO Managers would thus be required to satisfy the applicable risk retention requirements in connection with each CLO transaction they manage unless (x) the transaction is an open-market CLO whose assets and structure permit credit risk retention to be held by the lead arrangers of the loan tranches held by the CLO, as described in Part V.F of this memo, or (y) each loan held by the CLO qualifies for the exemption for “qualifying commercial loans” described in Part VI.B.1 of this memo. As a practical matter, CLO Managers may find it very difficult to structure a CLO transaction that satisfies the commercial loan exemption requirements.
10 “Securitization transaction” means a transaction involving the offer and sale of asset-backed securities by an issuing entity.
11 “Asset-Backed Security” has the same meaning as in Section 3(a)(79) of the Exchange Act, which (a) means a fixed-income or other security collateralized by any type of self-liquidating financial asset (including a loan, a lease, a mortgage, or a secured or unsecured receivable) that allows the holder of the security to receive payments that depend primarily on cash flow from the asset, including: (i) a collateralized mortgage obligation; (ii) a collateralized debt obligation; (iii) a collateralized bond obligation; (iv) a collateralized debt obligation of asset-backed securities; (v) a collateralized debt obligation of collateralized debt obligations; and (vi) a security that the SEC, by rule, determines to be an asset-backed security for the purposes of the Exchange Act; and (b) does not include a security issued by a finance subsidiary held by the parent company or a company controlled by the parent company, if none of the securities issued by the finance subsidiary are held by an entity that is not controlled by the parent company. In the notice of the proposed rulemaking for the Original Proposal, which used the same definition of Asset-Backed Security, the Agencies made clear that “synthetic” securitizations are not within the scope of Section 15G set forth in the Reproposed Rules because the term asset-backed security includes only those securities that are collateralized by self-liquidating financial assets.
12 ”Securitized Asset” means an asset that: (1) is transferred, sold, or conveyed to an issuing entity; and (2) collateralizes the ABS interests issued by the issuing entity. Under the Reproposed Rules, “ABS interest” (1) includes any type of interest or obligation issued by an issuing entity, whether or not in certificate form, including a security, obligation, beneficial interest or residual interest (other than (i) a non-economic residual interest issued by a REMIC or (ii) an uncertificated regular interest in a REMIC that is held by another REMIC, where both REMICs are part of the same structure and a single REMIC in that structure issues ABS interests to investors), payments on which are primarily dependent on the cash flows of the collateral owned or held by the issuing entity; and (2) does not include common or preferred stock, limited liability interests, partnership interests, trust certificates, or similar interests that: (i) are issued primarily to evidence ownership of the issuing entity; and (ii) the payments, if any, on which are not primarily dependent on the cash flows of the collateral held by the issuing entity.
13 Although the Final Rules and the Preamble (as defined below) make it clear that there can be only one party that is acting as the “retaining sponsor” for purposes of the risk retention rules, nothing in the Final Rules or the Preamble seems to prevent a second sponsor that is also an “originator” from taking a portion of the required risk retention in its capacity as an originator.
14 “Originator” means a person who: (1) through an extension of credit or otherwise, creates an asset that collateralizes an asset-backed security; and (2) sells the asset directly or indirectly to a securitizer or issuing entity.
15 The Final Rules modified the definition of ABS interest to exclude non-economic residual interest issued by a REMIC and uncertificated regular interest in a REMIC held only by another REMIC where both REMICs are part of the same structure and a single REMIC issues ABS interests to investors.
16 The Final Rules also permit such funds to be applied to pay critical expenses of the issuing entity unrelated to credit risk on any payment date on which the issuing entity has insufficient funds from any source to pay such expenses, which expenses will be paid prior to any payments to holders of ABS interests (and are made only to parties not affiliated with the sponsor).
17 The Final Rules state that if the specific prices, sizes, or rates of interest of each tranche of the securitization are not available, the sponsor must disclose a range of fair values (expressed as a percentage of the fair value of all of the ABS interests issued in the securitization transaction and dollar amount (or corresponding amount in the foreign currency in which the ABS interests are issued, as applicable)) of the eligible horizontal residual interest that the sponsor expects to retain at the close of the securitization transaction based on a range of bona fide estimates or specified prices, sizes, or rates of interest of each tranche of the securitization. A sponsor disclosing a range of fair values based on a range of bona fide estimates or specified prices, sizes or rates of interest of each tranche of the securitization must also disclose the method by which it determined any range of prices, tranche sizes, or rates of interest. These changes in the Final Rules resolve a potential circularity problem presented in the Reproposed Rules, which arose because the Reproposed Rules presumed that the value of the ABS interests had been determined, when in fact the calculations were required to be performed prior to pricing.
18 To the extent the disclosure required includes a description of a curve or curves, the description is required to include a description of the methodology that was used to derive each curve and a description of any aspects or features of each curve that could materially impact the fair value calculation or the ability of a prospective investor to evaluate the sponsor’s fair value calculation. To the extent a sponsor uses information about the securitized assets in its calculation of fair value, such information shall not be as of a date more than 60 days prior to the date of first use with investors; provided that for a subsequent issuance of ABS interests by the same issuing entity with the same sponsor for which the securitization transaction distributes amounts to investors on a quarterly or less frequent basis, such information shall not be as of a date more than 135 days prior to the date of first use with investors; provided further, that the balance or value (in accordance with the transaction documents) of the securitized assets may be increased or decreased to reflect anticipated additions or removals of assets the sponsor makes or expects to make between the cut-off date and the closing date of the securitization
19 For a discussion of the Final Rules as they relate to CMBS transactions, see our prior Clients & Friends Memo “Risk Retention for Commercial Mortgage-Backed Securities: Fact Sheet,” dated October 29, 2014, available at http://www.cadwalader.com/resources/clients-friends-memos/risk-retention-for-commercial-mortgage-backed-securitiesfact-sheet.
20 In a situation where the risk retention is being held by both a B-piece buyer (in a horizontal interest) and the sponsor (as a vertical interest), even though the sponsor is required to hold a vertical interest in all the CMBS classes issued, including the most subordinate CMBS interests, the sponsor’s vertical interest should not be counted as a B-piece interest and should not prevent two independent third-party B-piece buyers from participating in the retention of the horizontal risk retention interest.
21 “Servicing assets” are rights or other assets designed to assure the servicing or the timely distribution of proceeds to ABS interest holders and rights or other assets that are related or incidental to purchasing or otherwise acquiring and holding the issuing entity’s securitized assets. Servicing assets include amounts received by the issuing entity as proceeds of securitized assets, including proceeds of rights or other assets, whether as remittances by obligors or as other recoveries.
22 “Rental income” means (1) income derived from a lease or other occupancy agreement between the borrower or an operating affiliate of the borrower and a party which is not an affiliate of the borrower for the use of real property or improvements serving as collateral for the applicable loan, and (2) other income derived from hotel, motel, dormitory, nursing home, assisted living, mini-storage warehouse or similar properties that are used primarily by parties that are not affiliates or employees of the borrower or its affiliates.”
23 For more detail on these restrictions and the narrow exceptions thereto, see Part V.H.
24 This provision appears in the context of the B-piece buyer’s transfer restrictions (Section __.7(b)(8)(i)) and arguably does not apply to other risk retention parties. We are unaware of any reason to justify this distinction.
25 A sponsor of a revolving pool may also use either of two forms of subordinated horizontal interest in order to reduce the amount it is required to maintain as seller’s interest in satisfaction of the risk retention rule. A sponsor may hold an eligible horizontal residual interest(as described in Part V.A of this memo) in the securitization’s outstanding series of ABS interests, or alternatively, may also retain a horizontal interest whose claim to any part of the series’ share of the interest and fee cash flows for any interest payment period is subordinated to all accrued and payable interest due on the payment date to more senior ABS interests in the series for that period, and is reduced by the series’ share of losses, including defaults on principal of the securitized assets collateralizing the revolving pool securitization (whether incurred in that period or carried over from prior periods) to the extent that such payments would have been included in amounts payable to more senior interests in the series.
26 “Originator-seller” means an entity that originates assets and sells or transfers those assets, directly or through a majority-owned affiliate, to an intermediate SPV, and includes (except for the purposes of identifying the sponsorship and affiliation of an intermediate SPV pursuant to this option) any affiliate of the originator‑seller. For purposes of this definition, “majority control” means ownership of more than 50% of the equity of an entity, or ownership of any other controlling financial interest in the entity, as determined under U.S. GAAP.
“Intermediate SPV” means a special purpose vehicle that: (1)(i) is a direct or indirect wholly-owned affiliate of the originator-seller; or (ii) has nominal equity owned by a trust or corporate service provider that specializes in providing independent ownership of special purpose vehicles, and such trust or corporate service provider is not affiliated with any other transaction parties; (2) is bankruptcy remote or otherwise isolated for insolvency purposes from the eligible ABCP conduit and from each originator-seller and each majority-owned affiliate in each case that, directly or indirectly, sells or transfers assets to such intermediate SPV; (3) acquires assets from the originator-seller that are originated by the originator-seller or acquired by the originator-seller in the acquisition of a business that qualifies for business combination accounting under U.S. GAAP or acquires asset-backed securities (“ABS”) interests issued by another intermediate SPV of the originator-seller that are collateralized solely by such assets; and (4) issues ABS interests collateralized solely by such assets, as applicable.
27 See Part V.A. above: Standard Risk Retention.
28 See Part V.C. above: Revolving Pool Securitizations (Seller’s Interest).
29 “Regulated liquidity provider” means: (1) a depository institution (as defined in section 3 of the Federal Deposit Insurance Act (12 U.S.C. 1813)); (2) a bank holding company (as defined in 12 U.S.C. 1841), or a subsidiary thereof; (3) a savings and loan holding company (as defined in 12 U.S.C. 1467a), provided all or substantially all of the holding company’s activities are permissible for a financial holding company under 12 U.S.C. 1843(k), or a subsidiary thereof; or (4) a foreign bank whose home country supervisor (as defined in § 211.21 of the Federal Reserve Board’s Regulation K (12 CFR 211.21)) has adopted capital standards consistent with the Capital Accord of the Basel Committee on Banking Supervision, as amended, and that is subject to such standards, or a subsidiary thereof.
30 The Agencies state in the preamble accompanying the Final Rules (the “Preamble”) that they believe it is appropriate to require risk retention for both open market CLOs and balance sheet CLOs. The Agencies note that many commentators to the Reproposed Rules raised a variety of concerns about the application of the risk retention requirements to open market CLOs. Although open market CLOs of broadly syndicated loans account for most of the new issuance activity in the CLO market today, we note that the Final Rules preserve from the Reproposed Rules a provision that permits risk retention by the “originator” of one or more securitized assets that acquires its eligible interest from the sponsor, which acquisition may offset the amount of the sponsor’s risk retention requirements. This provision may have particular value for non-bank middle-market originators and private loan funds that use balance sheet CLOs for long-term financing of their loan portfolios and business platforms. It is not yet clear whether new origination structures can be created such that open market CLOs of broadly syndicated loans also would be able to use this mechanism for satisfying the risk retention requirements.
31 The Final Rules include an exemption from the risk retention requirements (largely unchanged from the Reproposed Rules) for static securitizations of “qualifying commercial loans” (i.e., loans that meet specified underwriting criteria) that meet certain requirements. Although this exemption is theoretically available to CLOs, as a practical matter few (if any) CLOs structured in the market today would be able to satisfy these requirements.
32 See pp. 201-202 and 230 of the Preamble.
33 The Volcker Rule incorporates the definition of “securitizer” under the Final Rules. As a result, a CLO Manager that is a “banking entity” for purposes of the Volcker Rule will need to consider the implications of such rule to the extent that the related CLO it manages is a “covered fund.” See the discussion of “Sponsor” in Part IV.A of this memo.
34 The Agencies also disagree with commentators’ assertions that Congress intended Section 15G to apply primarily to securitizations within the originate-to-distribute model. The Agencies note that Section 15G specifies that retention applies to all securitizers unless they have a specific exemption under the statute or the Agencies provide a specific exemption in accordance with criteria set forth in the statutory text. See 15 U.S.C. 78o-11(b)(1) (“[T]he 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.“), which is cited in footnote 167 of the Preamble. See, also, 15 U.S.C. 78o-11(c)(1)(G)(i) and 15 U.S.C. 780-11(e).
35 See pp. 229-230 of the Preamble.
36 See p. 230 of the Preamble.
37 The originator structure will be a more viable solution to satisfy all or a portion of the risk retention requirements for middle-market CLOs. See footnote 30 above.
38 The Agencies note that many who commented on the Reproposed Rules asserted that imposing standard risk retention requirements could cause CLO Managers to exit the market or be acquired by larger CLO Managers. If the commenters prove to be correct, the CLO market could see consolidation among CLO Managers and, consequently, as the Agencies acknowledge, fewer CLO issuances and less competition in the market. See pp. 203, 207-208 and 229-230 of the Preamble.
39 See The CLO Salmagundi: Risk Retention, Wells Fargo Research (Dave Preston and Jason McNeilis), October 21, 2014.
40 See p. 174 of the preamble accompanying the Reproposed Rules.
41 See, generally, EU Risk Retention Requirement: A workable solution for US CLO collateral managers?, January 23, 2014, at http://www.cadwalader.com/resources/clients-friends-memos/eu-risk-retention-requirement-a-workable-solution-for-us-clo-collateral-managers.
42 “US person” is defined under the Final Rules and is consistent with the definition of “U.S. Person” set forth in Regulation S promulgated under the U.S. Securities Act of 1933, as amended.
43 See pp. 274-275 of the Preamble. An open question is whether it is possible to create a structure that qualifies as an “originator” for purposes of satisfying European risk retention requirements, but also can be treated as the “majority-owned affiliate” of a CLO Manager for purposes of satisfying US risk retention requirements.
44 See, variously, pp. 201, 220, 223-4 and 231 of the Preamble.
45 Although the Final Rules do not expressly address the disposition of a pledged retained interest, the Agencies commented, in connection with the Reproposed Rules, that, where a pledge of an interest or asset to support full recourse financing subsequently results in such interest or asset being taken by the counterparty to the financing transaction (whether by consent, pursuant to exercise of remedies or otherwise), the sponsor will be viewed as having violated the prohibition on transfer.
46 Under the Final Rules, “currently performing” means the borrower in the mortgage transaction is not currently 30 days past due, in whole or in part, on the mortgage transaction.
47 See 15 U.S.C. 1639c.
48 See 12 C.F.R. 1026.43.
49 The definition of QRM will automatically change as the CFPB clarifies, modifies or adjusts the definition of QM.
50 The Ability to Pay Rule includes several additional definitions of QM, all of which are encompassed by the definition of QM in the Rules:
Based upon the current mortgage market conditions and expressed concerns over credit availability, the CFPB finalized a second, temporary definition of QM, pursuant to which a QM must have the following features: (1) regular periodic payments that are substantially equal; (2) no negative amortization, interest only or balloon features; (3) a maximum loan term of 30 years; (4) total points and fees that do not exceed 3% of the total loan amount, or the applicable amounts specified for small loans up to $100,000; and (5) be eligible for purchase, guarantee or insurance by Freddie Mac, Fannie Mae, HUD, the Veterans Administration, the U.S. Department of Agriculture or the Rural Housing Service (“GSE-eligible”).
The CFPB provided additional definitions of QM to facilitate credit offered by certain small creditors that meet certain criteria. These additional small creditor-specific definitions of QM include greater underwriting flexibility (e.g., no quantitative DTI ratio applies) and the ability to originate and hold balloon mortgages, but, because the small creditor is required to keep the loan in portfolio for three years, these would generally be ineligible as QRMs for three years from origination.
51 “Total liabilities ratio” means the borrower’s total liabilities, determined in accordance with U.S. GAAP divided by the sum of the borrower’s total liabilities and equity, less the borrower’s intangible assets, with each component determined in accordance with U.S. GAAP.
52 “Leverage ratio” means the borrower’s total debt divided by the borrower’s EBITDA. “EBITDA” means the annual income of a business before expenses for interest, taxes, depreciation and amortization are deducted, as determined in accordance with U.S. GAAP.
53 For commercial loans, “debt service coverage ratio” means (i) the borrower’s EBITDA as of the most recently completed fiscal year divided by (ii) the sum of the borrower’s annual payments for principal and interest (calculated at the fully-indexed rate) on all debt obligations.
54 For commercial real estate loans, “debt service coverage ratio” (“DSCR”) means (i) the annual NOI less the annual replacement reserve of the CRE property at the time of origination of the CRE loans divided by (ii) the sum of the borrower’s annual payments for principal and interest on any debt obligation. “NOI” means the income a CRE property generates for the owner after all expenses have been deducted for federal income tax purposes, except for depreciation, debt service expenses, and federal and state income taxes, and excluding any unusual and nonrecurring items of income.
55 “Qualifying leased CRE loan” means a CRE loan secured by commercial nonfarm real property (other than a multi-family property or a hotel, inn, or similar property):
1. that is occupied by one or more qualified tenants pursuant to a lease agreement with a term of no less than one month; and
2. where no more than 20% of the aggregate gross revenue of the property is payable from one or more tenants who;
a. are subject to a lease that will terminate within six months following the date of origination; or
b. are not qualified tenants.
“Qualified tenant” means:
1, A tenant with a lease who has satisfied all obligations with respect to the property in a timely manner; or
2. A tenant who originally had a lease that subsequently expired and currently is leasing the property on a month-to month basis, has occupied the property for at least three years prior to the date of origination, and has satisfied all obligations with respect to the property in a timely manner.
56 “Qualifying multi-family loan” means a CRE loan secured by any residential property (other than a hotel, motel, inn, hospital, nursing home, or other similar facility where dwellings are not leased to residents):
1. that consists of five or more dwelling units (including apartment buildings, condominiums, cooperatives and other similar structures) primarily for residential use; and
2. where at least 75% of the NOI is derived from residential rents and tenant amenities (including income from parking garages, health or swim clubs, and dry cleaning), and not from other commercial uses.
57 The notice of proposed rulemaking for the Original Proposal, stated that such measures may include a reduction in the loan amount sufficient to reflect potential losses; however, where the assessment reveals significant environmental hazards, originators are encouraged to reconsider the primary loan decision.
58 An automobile loan does not include any (a) loan to finance fleet sales; (b) personal cash loan secured by a previously purchased automobile; (c) loan to finance the purchase of a commercial vehicle or farm equipment that is not used for personal, family, or household purposes; (d) lease financing; or (e) loan to finance the purchase of a vehicle intended to be used for scrap or parts.
59 “State” is defined as any State of the United States, the District of Columbia, Puerto Rico, the Virgin Islands, or any other possession of the United States.
60 A “first pay class” is defined as a class of ABS interests for which all interests in the class are entitled to the same priority of payment and that, at the time of closing of the transaction, is entitled to repayments of principal and payments of interest prior to or pro-rata with all other classes of securities collateralized by the same pool of first-lien residential mortgages, until such class has no principal or notional balance remaining.
61 A “seasoned loan” is (i) with respect to ABS backed by residential mortgages, a loan that has been outstanding and performing for the longer of (A) a period of five years; or (B) until the outstanding principal balance of the loan has been reduced to 25% of the original principal balance; but in any event any residential mortgage loan that has been outstanding and performing for a period of at least seven years and (ii) with respect to all other classes of asset-backed securities, a loan that has been outstanding and performing for the longer of (A) a period of at least two years; or (B) until the outstanding principal balance of the loan has been reduced to 33% of the original principal balance. The definition of seasoned loans is structured similarly to the sunset provisions on transfer and hedging restrictions, although the hedging sunset is not qualified by loan performance.
62 “Specified costs” are any cost identified by a State legislature as appropriate for recovery through securitization pursuant to legislation enacted by a State that (i) authorizes the investor-owned utility company to apply for, and authorizes the public utility commission or other appropriate State agency to issue, a financing order determining the amount of specified costs the utility will be allowed to recover; (ii) provides that pursuant to a financing order, the utility acquires an intangible property right to charge, collect, and receive amounts necessary to provide for the full recovery of the specified costs determined to be recoverable, and assures that the charges are non-bypassable and will be paid by customers within the utility’s historic service territory who receive utility goods or services through the utility’s transmission and distribution system, even if those customers elect to purchase these goods or services from a third party; and (iii) guarantees that neither the State nor any of its agencies has the authority to rescind or amend the financing order, to revise the amount of specified costs, or in any way to reduce or impair the value of the intangible property right, except as may be contemplated by periodic adjustments authorized by the specified cost recovery legislation.