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On October 22, 2014, the federal regulatory agencies responsible for implementing regulations under Dodd-Frank finalized the risk retention rules for ABS transactions, including CMBS transactions. The final rules come more than three years after risk retention rules were originally proposed,1 and more than a year after the rules were re-proposed.2 The final rules contain a few clarifications and revisions to the re-proposed rules, but for the most part the final rules are substantially the same as the re-proposed rules.
The following is a summary of the risk retention provisions as they relate to CMBS. A summary of the revisions made to the re-proposed rules appears at page 8 and a summary of industry requested changes to the re-proposed rules that were not adopted in the final rules appears at page 9.
For CMBS, the risk retention requirements will become applicable two years after the final rules are published in the Federal Register.
The final rules retain the original 5% risk retention obligation for a CMBS sponsor (or a majority‑owned affiliate of the sponsor3), but provide an exception for CMBS backed (in whole or in part) by “qualifying CRE loans,” as discussed below.
There are generally two structures for retaining risk:
The B-piece buyer option, described below, is a form of horizontal retention.4
For sponsors satisfying their risk retention obligation through horizontal risk retention (including by means of the B-piece buyer option), the use of fair value will result in a higher retention obligation (by face amount) than the vertical risk retention obligation, and likely will increase the required retention amount well above the size of the B-piece in a typical CMBS conduit transaction.
The rules also permit a sponsor to satisfy its risk retention obligation by a combination of horizontal and vertical retention. This provision would allow CMBS sponsors to supplement the B-piece option by retaining, themselves or through an affiliate (or by causing contributing loan originators to retain), an additional eligible vertical interest to “top up” the amount by which the securities retained by the B-piece buyer falls short of 5% of fair value. The “vertical interest” required to be retained by the sponsor in a hybrid retention would represent an interest in each class of CMBS, including an interest in the class or classes retained by the B-piece buyer.
The rules also allow a sponsor to offset its risk retention requirement by the amount of eligible horizontal or eligible vertical interests retained by one or more loan originators (or a majority-owned affiliate of the applicable originator). However, no originator may retain more than its pro rata share (based upon collateral contributed) of the sponsor’s risk retention obligation, nor may any originator retain less than 20% of the sponsor’s risk retention obligation. Therefore, originators that contribute less than 20% of the collateral for a CMBS transaction cannot hold any of the required risk retention.5
During the period when risk retention is required, the sponsor (or originator, B-piece buyer or applicable majority-owned affiliate) is prohibited from hedging its exposure to the retained interests by purchasing any security or other financial instrument if (i) the payments on such security or instrument are materially related to the credit risk of the retained interest and (ii) such instrument in any way reduces or limits the financial exposure to the credit risk of the retained interest or any of the underlying assets.
Exceptions to this rule include (i) hedging interest rate or currency risk; and (ii) hedging via an index, as long as (x) any single security that the sponsor is required to retain does not account for 10% or more of such index and (y) all classes of securities issued in connection with any securitization in which the sponsor is required to retain a risk interest, do not collectively account for 20% or more of such index.
In addition, 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.6
In general, a retaining sponsor, originator or B-piece buyer (or applicable majority-owned affiliate) may not sell or otherwise transfer any interest that it is required to retain to any person other than a majority-owned affiliate. However, the final rules allow the original B-piece buyer or the sponsor to sell its eligible horizontal residual interest to a qualifying B-piece buyer after five years, subject to the same restrictions and conditions that apply to an initial B-piece buyer. These conditions include the requirement that the subsequent B-piece buyer conduct an independent review of the credit risk of each securitized loan.
The final rules include the previously proposed sunset provision, which allows the transfer (or hedging) of a retained interest upon the latest of:
In addition, a B-piece buyer will not be restricted from hedging, transferring or financing its retained interest after all of loans in the pool have been defeased with cash or cash equivalents (which can include obligations backed by the full faith and credit of the United States).7
The final rules contain a CMBS-specific alternative to satisfy a sponsor’s risk retention obligation, permitting the acquisition of a subordinate horizontal interest (i.e., the B-piece) in the CMBS transaction by a third-party purchaser (or a majority-owned affiliate of the third-party purchaser) that agrees to hold the horizontal interest subject to conditions similar to the requirements that would be applicable to the sponsor’s retention of a horizontal interest.
The requirements of the B-piece buyer are as follows:
A CMBS transaction in which the sponsor is relying on the B-piece buyer option must feature an operating advisor that (i) is not affiliated with any other parties to the transaction, (ii) has no financial interest in the transaction (aside from fees), and (iii) has the following rights and responsibilities:
Reliance on the B-piece buyer option does not relieve a sponsor of its primary risk retention obligation and, therefore, the final rules require sponsors to “maintain and adhere to” policies and procedures to monitor B-piece buyers’ compliance with the requirements of the rule (although the rules do not specify what such policies and procedures should be). In the event that the sponsor detects a failure a B-piece buyer to adhere to the requirements of the rule, it must promptly notify all holders of the CMBS.
The final rules provide that “qualifying CRE loans” attract a zero risk retention requirement. Despite the request of many industry participants, the standards for qualification as a QCRE loan are still extremely tight.
The final rules provide a benefit for including QCRE loans in a pool, even if they do not comprise 100% of the pool, by permitting the required risk retention percentage to be reduced proportionately (but not by more than 50%) by the percentage of QCRE loans in the pool. For example, if a CMBS pool contains 20% QCRE loans, the risk retention requirement would be reduced to 4%, instead of 5%.
The final rules contain numerous requirements for a loan to qualify as a QCRE loan, including the following:
If a sponsor is relying on inclusion of QCRE loans in a securitization to reduce its risk retention obligations, then it must certify that it has internal supervisory controls to determine that such QCRE loans meet all the QCRE requirements. In the event that it is determined, after securitization, that any such loan did not meet the requirements for a QCRE loan, then, if such failure is material, the sponsor must either cure such deficiency or repurchase the loan at a price equal to par plus accrued interest.
The final rules require that the sponsor provide potential investors and, upon request, the SEC and appropriate Federal banking agencies (if any) with written disclosures regarding the retained interests that includes the following:
Horizontal interest. With respect to any retained horizontal residual interest, a sponsor must disclose:
B-Piece Buyer. With respect to any horizontal risk that is retained by a third-party B-piece buyer, a sponsor must disclose within a reasonable period of time prior to the sale of CMBS, the name of the B-piece buyer, its experience in investing in CMBS, the fair value of the interest to be retained, the purchase price paid by the B-piece buyer, the material terms of the retained interest and the material terms of the transaction documents with respect to the operating advisor.
Vertical interest. With respect to any retained vertical interest, the sponsor must disclose:
Record Retention. Sponsors are required to retain all required disclosures for three years after all CMBS interests in the related securitization transaction are no longer outstanding.
 A majority-owned affiliate is 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 GAAP.
 In lieu of the sponsor retaining an eligible horizontal interest or utilizing the B-piece buyer option, the sponsor may instead establish with the CMBS trustee a “horizontal cash reserve account” in the amount of the fair value of the eligible horizontal interest sold, which would be held in cash or cash equivalents and available to offset losses and other shortfalls on the transaction.
 Although the rules and the accompanying release 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 rules or the accompanying release 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.
 Although this restriction does not appear to expressly sunset, as is the case for transfer and hedging restrictions as discussed below, the restriction on nonrecourse financing applies to CMBS interests “required” to be retained. This suggests that if the CMBS interest can be transferred, it should be able to be financed with nonrecourse financing.
 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.
 Although not expressly stated in the final rules or the accompanying release, if a sponsor is retaining a vertical interest in a CMBS transaction (and as a result is retaining a portion of the most subordinate CMBS class or classes), the sponsor’s retention should not prevent two separate B-piece buyers from holding the remaining portion of the horizontal risk retention.