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NOVEMBER 25, 2014
Agencies Adopt Final Dodd-Frank Risk Retention Rules for
During the week of October 20, 2014, several federal agencies (the “Agencies”)1 adopted final rules (the “Final
Rules”)2 to implement the Dodd-Frank credit risk retention requirements for asset-backed securities.3 The
Agencies originally proposed risk retention rules in April 2011 (the “Originally Proposed Rules”). Following
comments received from representatives of the financial industry, trade groups and others, the Agencies reproposed
the rules in August 2013 (the “Re-Proposed Rules” and, together with the Originally Proposed Rules,
the “Prior Proposals”).4 The Re-Proposed Rules responded to many, but not all, of the deficiencies in the
Originally Proposed Rules cited by commenters. As a result, the Agencies received further comments on the ReProposed
Rules, seeking additional exemptions and modifications. Despite these comments, the Final Rules
leave unaddressed many of those remaining issues. Under the Final Rules, certain asset classes fare better than
others, and, in certain cases where industry comments were not fully addressed, the final risk retention
requirements may pose challenges for the asset classes in question. Some of the important points include:
• Critically, the Final Rules, unlike the Re-Proposed Rules, do not contain restrictions that limit the cash flow
that may be paid to a sponsor from a retained eligible horizontal residual interest.
• The Agencies allow flexible combinations of horizontal and vertical risk retention interests.
• Sunsets on the prohibitions on hedging and transfer of retained interests were retained largely as set forth in
the Re-Proposed Rules.
1 The Agencies are: the Securities and Exchange Commission (“SEC”); Office of the Comptroller of the Currency; Board of Governors of the
Federal Reserve System; Federal Deposit Insurance Corporation (“FDIC”); and, with respect to the rules relating to residential mortgages, the
Federal Housing Finance Agency (“FHFA”) and the Department of Housing and Urban Development.
2 The joint release of the Agencies is available at: http://www.sfindustry.org/images/uploads/pdfs/Risk_Retention_Final_Rule.pdf.
3 Section 15G of the Securities Exchange Act of 1934 (the “Exchange Act”) was added by Section 941 of the Dodd-Frank Wall Street Reform
and Consumer Protection Act (“Dodd-Frank”).
4 The Re-Proposed Rules were published in the Federal Register on September 20, 2013: http://www.gpo.gov/fdsys/pkg/FR-2013-09-
20/pdf/2013-21677.pdf. We summarized the Re-Proposed Rules in a Sidley Update dated October 22, 2013 (“Agencies Re-Propose Dodd-Frank Act
Risk Retention Rules for Asset-Backed Securities and Request Further Comment”), available at:
The Originally Proposed Rules and related proposing release are available at: http://www.gpo.gov/fdsys/pkg/FR-2011-04-29/pdf/2011-8364.pdf.
We summarized the Originally Proposed Rules in a Sidley Update dated April 13, 2011 (“Agencies Issue Proposed Dodd-Frank Act Risk Retention
Rule for Asset-Backed Securities”), available at: http://www.sidley.com/Agencies-Issue-Proposed-Dodd-Frank-Act-Risk-Retention-Rule-for-AssetBacked-Securities-04-13-2011/.SIDLEY
• The Final Rules generally do not recognize unfunded forms of risk retention, such as guarantees, liquidity
facilities and letters of credit.
• The Final Rules will become effective one year (in the case of residential mortgages) or two years (for all
other asset classes) after the date of their publication in the Federal Register (in either case, the “Effective
Date”). Offers and sales of asset-backed securities after the respective Effective Date will be subject to risk
retention requirements under the Final Rules.
Residential Mortgage-Backed Securities (RMBS)
• For purposes of the exemption from risk retention for private-label U.S. RMBS, the Final Rules align the
definition of “qualified residential mortgage” (or “QRM”) with the definition of “qualified mortgage” (or
“QM”) under rules of the Consumer Finance Protection Bureau (with minor adjustments). The definition of
qualified residential mortgage will be subject to periodic review, initially four years after the Effective Date,
and every five years thereafter, and at any time upon request of one of the Agencies.
• The Agencies did not adopt the more restrictive “QM-plus” construct outlined in the Re-Proposed Rules.
• Under the Final Rules, a limited reduction in risk retention is generally available to sponsors of blended
pools in which residential mortgages are mixed with certain community-focused residential mortgages, and
an exemption from risk retention is available to sponsors of blended pools of QRMs and three-to four-family
residential mortgages that meet the QM criteria other than that they be “covered transactions.”
Commercial Mortgage-Backed Securities (CMBS)
• The third-party purchaser alternative for CMBS risk retention allows up to two third-party purchasers, each
of which holds a pari passu portion of the eligible horizontal residual interest (known as the “B-piece”).
• As a condition to the third-party purchaser risk alternative, an operating advisor (representing the interests
of CMBS investors as a collective whole) must be appointed and, among other things, have the power to
recommend removal of the special servicer; and any such recommendation must be actionable by a majority
vote of all CMBS holders voting on the matter–with a maximum quorum requirement of 20% of the
outstanding balance (representing at least three unaffiliated ABS interest holders).
• A sponsor of a CMBS transaction that relies on the third-party purchaser alternative remains legally
responsible for ongoing compliance by the third-party purchaser. No third-party purchaser may be an
affiliate of the sponsor for a CMBS transaction, which will limit sponsors’ ability to monitor satisfaction by
third-party purchasers of ongoing conditions.
• The Final Rules did not provide relief for the (not insignificant) portion of the CMBS market that takes the
form of single-borrower or single-credit transactions, which often are tranched without a non-investment
grade layer and thus are unlikely to attract qualifying third-party purchasers (since there is no traditional Bpiece,
and purchasers of investment grade tranches would be unlikely to incur the cost of the significant
independent due diligence upon which relief is conditioned). The Agencies considered extensive arguments
from commenters on this subject, but declined to provide a separate exemption for transactions
characterized as “single-borrower or single-credit (SBSC) transactions.”SIDLEY UPDATE
• The qualifying asset exception for CMBS collateralized by qualifying commercial real estate loans specifies a
level payment of principal and interest (as opposed to straight-line amortization of principal and interest)
over loan terms of 25 years (or 30 years, for loans on multifamily properties). The qualifying asset exception
also excludes interest-only commercial real estate mortgages.
• Under the Re-Proposed Rules, vertical interest risk retention would have been measured by fair value, which
would have subjected some CMBS, which commonly are issued at a premium to par, to higher risk retention
levels relative to asset-backed securities of other asset classes more commonly issued nearer to par. This
measurement criterion for vertical interests was not reflected in the Final Rules.
Collateralized Loan Obligations (CLOs)
• Like the Prior Proposals, the Final Rules reflect the Agencies’ determination that the manager of a CLO
transaction is its “sponsor,” even though neither a manager nor any of its affiliates typically acts as a seller or
transferor of the securitized assets to the issuing entity. The Agencies rejected proposals made by
commenters (i) to recognize the fees of CLO managers (particularly subordinated or incentive management
fees) as aligning the interests of CLO managers and investors and (ii) to consider alternative CLO-specific
risk retention structures.
• The risk retention requirement is likely to make it more difficult for CLO managers without balance sheet
capacity to participate in the CLO market.
• The risk retention alternative for “open market CLOs” first proposed in the Re-Proposed Rules was carried
forward into the Final Rules. This alternative will allow risk retention to occur at the asset level instead of at
the securitization level by imposing risk retention on the lead arranger of a lending facility in which a CLO
invests (and not on the CLO manager). Although this theoretically provides relief to CLO managers, it does
so in a manner that is inconsistent with current market practice (for both lending facilities and CLOs). As a
result, it is not clear if this alternative approach will in fact provide meaningful relief for CLOs.
• As noted above, proposed restrictions on cash flows in respect of horizontal residual interests were not
included in the Final Rules. This is a critical and beneficial change in the Final Rules for CLO transactions,
which often permit subordinated CLO tranches to receive cash flows early in a transaction and in excess of
those that would have been permitted under the Re-Proposed Rules.
• The Final Rules apply to CLOs that offer and sell asset-backed securities following the Effective Date. This
will include not only new CLOs but also CLOs that have their initial closings before the Effective Date and
then offer and sell asset-backed securities after the Effective Date. In general, the exercise of a typical “refinancing”
option in a CLO is expected to constitute an issuance of securities that, if occurring after the
Effective Date, will require compliance with the Final Rules. It remains unclear whether the exercise of a “repricing”
option in a CLO will be treated similarly.
• Because of the relatively long tenor of CLO structures, the sunsets on transfer and hedging prohibitions
under the standard risk retention approach will likely provide little relief, because the sunsets are tied to
pool balance reductions.
• While the Final Rules impose risk retention requirements on CLO managers, they are silent on the
consequences of the resignation or removal and replacement of a collateral manager that holds a required SIDLEY UPDATE
risk retention interest. As a result, it is unclear whether the risk retention requirement ceases to apply
following such a resignation or removal, whether the retiring or removed CLO manager must continue to
hold the required risk retention interest (notwithstanding the fact that it no longer acts as CLO manager), or
whether the newly appointed CLO manager must acquire the required risk retention interest.
• Accordingly, risk retention will likely present challenges for the CLO market and, by extension, the loan
market that it supports.
Asset-Backed Commercial Paper (ABCP)
• The Final Rules maintain the basic framework contained in the Re-Proposed Rules for the sponsor of an
ABCP conduit that elects to satisfy the risk retention requirements by utilizing the “eligible ABCP conduit”
• Within that framework, greater flexibility has been introduced in a number of respects. The commercial
paper issued by an ABCP conduit is no longer limited to nine-month paper, but may now have a maturity of
up to 397 days. The assets acquired by the ABCP conduit are no longer limited to asset-backed securities but
may now include any “ABS interest.” There is now some recognition that permitted assets may include not
only those originated by an originator-seller but also those acquired by the originator-seller in a business
combination. Finally, limited transfers of assets between ABCP conduits are now permitted.
• However, it remains a requirement that an ABCP conduit acquire its assets in an initial issuance by an
“intermediate SPV.” The Agencies have allowed some expansion in the definition of intermediate SPV to
include certain orphan SPVs, but the Agencies rejected the suggestion to allow direct purchases by an ABCP
conduit from an originator-seller without an intermediate SPV.
• Finally, the Final Rules continue to require an unconditional 100% liquidity facility (i.e., one not conditioned
on the performance of underlying assets) for a sponsor to utilize the eligible ABCP conduit risk retention
option. The Agencies note that “the ABCP option is designed to accommodate conduits that expose the
liquidity provider to the full credit risk of the assets in the securitization.” This 100% requirement contrasts
with the statutory risk retention standard of 5%.
• The limitations of the eligible ABCP conduit risk retention option can be expected to lead sponsors to
consider the alternatives of the standard horizontal and vertical risk retention strategies.
Other Asset-Backed Securities (Other ABS)
• The Final Rules, like the Re-Proposed Rules, do not include a representative sample method for risk
retention, which could have been a commercially useful tool for sponsors of granular pools of securitized
assets (such as auto loans and credit card receivables).
• The absence of a representative sample option may present challenges for sponsors seeking off-balance sheet
treatment of securitized assets for accounting purposes and, for regulated financial institutions subject to the
U.S. capital adequacy rules, reduced risk-weighted capital charges.
• The Agencies provided little relief despite industry comments criticizing the underwriting and other criteria
making up the definition of “qualifying automobile loan” as inconsistent with standard market underwriting SIDLEY UPDATE
practices. In particular, those criteria that require individualized credit underwriting for automobile loans
contrast with current practices that rely on externally generated credit scores and credit reports.
• The Final Rules’ definition of “qualifying automobile loan” excludes asset-backed securities backed by
automobile leases, loans to finance fleet and other commercial automobiles, motorcycle loans and
recreational vehicle loans.
This Sidley Update summarizes a number of important elements of the Final Rules. The discussion below
includes two initial sections, one that provides background on Section 941 of Dodd-Frank and the Prior
Proposals, and a second that offers observations applicable generally to all asset-backed securities. Those
sections are then followed by sections related to particular asset classes (RMBS, CMBS, CLOs, ABCP Conduits
and Other ABS) and other exemptions and exceptions.
Under Section 15G of the Exchange Act, which was added by Section 941 of Dodd-Frank, the Agencies must
jointly adopt regulations requiring “securitizers” to retain, on an unhedged basis, not less than 5% of the credit
risk for any asset that the securitizer, through the issuance of an “asset-backed security,” transfers, sells or
conveys to a third party. The rules must specify certain exemptions and exceptions to the base risk retention
rules, including an exemption for asset-backed securities that are collateralized exclusively by residential
mortgages that qualify as QRMs and possible exceptions for other assets that meet underwriting standards that
entail low credit risk.5
The risk retention requirements apply to “securitizers” of asset-backed securities.6 Although the Final Rules
articulate a separate term for “securitizer,” they, like the Prior Proposals, require that the “sponsor” of an assetbacked
securities transaction be primarily responsible for retaining an economic interest equal to at least 5% of
the credit risk of the assets collateralizing the issuance of “asset-backed securities.” The Final Rules permit a
sponsor’s majority-owned affiliates7 (wholly-owned in the case of revolving pool securitizations) to satisfy the
standard risk retention requirement at the inception of the transaction; and without the necessity of transfer
from the sponsor, such affiliates may share in holding the retained interest with the sponsor. Consistent with the
Prior Proposals, a sponsor may share its risk retention requirement with one or more originators that meet
5 Generally, the risk retention requirements aim to remedy the general erosion of lending standards purportedly resulting from the “originate to
distribute” business model practiced in the lending market. As noted in the preambles of the Prior Proposals, the legislative history of Section 15G
states that “[w]hen securitizers retain a material amount of risk, they have ‘skin in the game,’ aligning their economic interest with those of investors
in asset-backed securities.” The Agencies reaffirm this position in the preamble to the Final Rules, stating that “[b]y requiring that a securitizer retain
a portion of the credit risk of the securitized assets, the requirements of section 15G provide securitizers an incentive to monitor and ensure the
quality of the securitized assets underlying a securitization transaction and, thus, help align the interests of the securitizer with the interests of
6 The term “securitizer” is defined under Section 15G of the Exchange Act to include both (i) the “issuer” of an asset-backed securities
transaction and (ii) the person that initiates or organizes the asset-backed securities transaction by selling or transferring assets, directly or indirectly,
including through an affiliate, to the issuer. The Agencies refer to any person covered by prong (ii) as the “sponsor.”
7 Under the Final Rules, “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, where majority control means ownership of more than 50
percent of the equity of an entity, or ownership of any other controlling financial interest in the entity, as determined under U.S. generally accepted
8 The subsection of the Final Rules providing for retention by “multiple sponsors” remains substantially the same as under the Prior Proposals.
For securitizations where two or more entities would each meet the definition of sponsor, the Final Rules require that one of the sponsors must SIDLEY UPDATE
As required under Section 15G of the Exchange Act, the Final Rules incorporate by reference the definition of
“asset-backed security” from Section 3(a)(79) of the Exchange Act (i.e., any fixed-income or other security
collateralized by any type of self-liquidating asset that allows the holder of the security to receive payments that
depend primarily on the cash flow from the asset) in determining whether a transaction is a “securitization
transaction” subject to the risk retention requirements. Accordingly, the Final Rules apply to instruments such
as collateralized debt obligations (CDOs) and CLOs that do not meet the more restrictive definition of “assetbacked
security” contained in the SEC’s Regulation AB, which governs the disclosure requirements for assetbacked
securities offerings that are registered under the Securities Act of 1933 (the “Securities Act”). The Final
Rules also apply to offers and sales of asset-backed securities regardless of whether such securities are publicly
offered, privately placed or are otherwise exempt from registration under the Securities Act. The Final Rules do
not apply to transactions not involving Exchange Act “asset-backed securities,” such as synthetic asset-backed
2. GENERAL CONSIDERATIONS UNDER THE FINAL RULES
Base Risk Retention Requirements Under the Re-Proposed Rules
Like the Prior Proposals, the Final Rules generally require the securitizer to hold at least 5% of the securitization
transaction, either through a vertical slice of each class of ABS interests or a horizontal slice of the most junior
ABS interest, or a combination of a vertical slice and a horizontal slice adding up to 5%. The Final Rules do not
require a premium capture cash reserve account (which would have had a negative economic impact on
sponsors) or impose a cash flow restriction on any horizontal residual interest (which would have been difficult
to administer and would also have had a negative impact).
Flexible Standard Risk Retention Requirement
Under the Final Rules, the Agencies retain the general approach set out in the Re-Proposed Rules, which
provided for a base set of risk retention requirements with exemptions and exceptions to those requirements.
However, the Final Rules do modify, in various degrees, some of the base set of risk retention requirements and
certain of the exemptions and exceptions.
Standard Risk Retention Approach. The Final Rules allow a sponsor to satisfy its risk retention
requirement in respect of its securitization transaction (before giving effect to any exemption or exception) by
retaining an eligible vertical interest, an eligible horizontal residual interest or any combination thereof, as long
as the percentage amount of the vertical interest and the percentage amount of the horizontal vertical interest
combined is no less than 5%. The percentage amount of an eligible vertical interest is the percentage of each
class of “ABS interests” that is issued in the securitization and held by the sponsor. The percentage amount of
eligible horizontal residual interest equals the “fair value” (discussed below) of the eligible horizontal residual
interest expressed as a percentage of the fair value of all of the ABS interests issued in the securitization. The
Agencies maintain the re-proposed definition of “ABS interest,” but with an exclusion for non-economic REMIC
comply with the rule (although the Final Rules do not prohibit multiple sponsors from retaining credit risk as long as one of those sponsors complies
with the requirement).SIDLEY UPDATE
residual interests and certain REMIC regular interests used in multiple-tier REMIC structures.9 Under the Final
Rules, an eligible horizontal residual interest need not be represented by a single class of ABS interests, but may
consist of multiple adjacent classes. In addition, a sponsor will be able to hold an eligible vertical interest as a
“single vertical security” evidencing interests in each class of ABS interests that result in the security
representing the same percentage of each class of ABS interests as if held as multiple vertical interests. A
majority-owned affiliate of the sponsor is permitted to hold all or a portion of a required risk retention interest,
except such affiliate must be wholly-owned in the case of risk retention interests retained in respect of a
revolving pool securitization. Thus, the Agencies provide sponsors with a reasonably flexible basic set of risk
retention options that are intended to accommodate an array of securitization transactions across asset classes.
Par Value and Fair Value Measurements. The Originally Proposed Rules measured risk retention with
reference to the par value of securitization tranches. The Re-Proposed Rules changed the method for measuring
retention for both vertical and horizontal residual interests to one based on the fair value of the ABS interests
retained. The Final Rules keep the fair value approach for horizontal residual interests, but revert to the par
value method for vertical interests, as the Agencies agreed with commenters that there is no need for a fair value
method in the latter context (and thus no requirement to disclose fair value calculations in respect of
securitization transactions if risk retention is achieved solely through retained vertical interests).
The Agencies provide little guidance regarding the meaning of fair value other than that it should be determined
in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”).10 The Agencies state that
accountants already address the concept of fair value in various contexts and should not face unusual difficulties
in applying it to horizontal residual interests. The time for determining fair value for purposes of satisfying the
risk retention requirement is now the date of the initial issuance of the related ABS interests, rather than the
date of pricing the ABS interests.
The Final Rules impose detailed disclosure obligations11 and require sponsor certifications with respect to fair
value determinations of eligible horizontal residual interests and certain other material items.
As noted above, the Final Rules eliminate restrictions on projected cash flow to the horizontal residual interest
out of concern that their operation might produce unintended consequences or might have an unduly restrictive
impact on certain asset classes. The Agencies state in the preamble that if they observe in the future that the way
fair value is being calculated in practice undermines the effectiveness of the retention of a horizontal residual
interest to align the interests of sponsors and investors, the Agencies will consider modifications to the Final
9 The Final Rules define an “ABS interest” as any type of interest or obligation issued by an issuing entity, whether or not in certificated form,
including a security, obligation, beneficial interest or residual interest (other than (i) non-economic residual interests in a REMIC and (ii) an
uncertificated REMIC regular interest that is held in another REMIC where both REMICs are part of the same structure and a single REMIC in that
structure issues ABS interests to investors (these exclusions are new in the Final Rules and clause (ii) relates to the typical multiple-tier REMIC
structure)), payments of which are primarily dependent on the cash flows of the collateral owned or held by the issuing entity. As further defined,
“ABS interest” excludes common or preferred stock, limited liability interests, partnership interests, trust certificates or similar interests that are
issued primarily to evidence ownership of the issuing entity and the payments, if any, of which are not primarily dependent on the cash flows on the
collateral held by the issuing entity, and does not include the right to receive payments for services provided by the holder of such right, including
servicing, trustee services and custodial services.
10 The preamble to the Final Rules cites Accounting Standard Codification (ASC) Topic 820, published by the Financial Accounting Standards
11 For details regarding these disclosures, please see Appendix A.SIDLEY UPDATE
The Final Rules keep the concept, introduced in the Re-Proposed Rules, that in lieu of holding all or part of the
risk retention in the form of a horizontal residual interest, such retention may be satisfied by the maintenance of
a funded horizontal cash reserve account in an amount equal to the amount of the horizontal residual interest
that is replaced by the horizontal cash reserve account. Investments in such an account are restricted to cash and
cash equivalents (e.g., high-quality, highly liquid short-term investments), and the account must be held by the
trustee for the benefit of the issuing entity. Amounts in the account must be available to absorb losses on the
ABS interests to the same extent as a horizontal residual interest would absorb such losses. Under certain
circumstances, funds in the account may be used to pay critical expenses of the issuing entity when the issuing
entity otherwise has insufficient funds.
Effects of Elimination of Representative Sample Option. The Final Rules do not provide the
representative sample option included as part of the menu of options under the Originally Proposed Rules.
Under that approach, a sponsor would have been able to satisfy risk retention by retaining ownership of a
representative sample of the pool of assets that are designated for securitization in the transaction.
The representative sample approach has been one of two risk retention options (the other being vertical risk
retention) available under the FDIC Safe Harbor Rule (defined below), which is applicable to U.S. insured
depository institutions. Sponsors of automobile loan-backed deals that satisfy the risk retention requirements
under the FDIC Safe Harbor Rule have taken advantage of this option. However, the option will no longer be
available under the FDIC Safe Harbor Rule because, as discussed further below, risk retention under that rule
will automatically conform to the final Dodd-Frank risk retention rules.12
The accounting treatment and (for regulated financial institutions) risk-based capital requirements may vary
depending on the form in which the sponsor holds a retained interest.13 The elimination of the representative
sample option limits a sponsor’s standard risk retention options to horizontal and/or vertical risk retention,
which may not be practicable (particularly for horizontal risk retention) if as a result the sponsor must treat the
securitization transaction as an “on-balance sheet” transaction for accounting purposes. The absence of the
representative sample approach thus may affect sponsors that are concerned about consolidation of the issuing
entity for accounting purposes.
“Servicing Assets.” The Final Rules keep the concept of “servicing assets” to address the fact that issuing
entities often hold assets other than loans or other types of core assets.14 The preamble describes various types
of servicing assets, which include proceeds of the core assets, as well as “cash and cash equivalents, contract
rights, derivative agreements of the issuing entity used to hedge interest rate and foreign currency risks, or the
collateral underlying the securitized assets.”
12 A representative sample alternative remains available under the European Union’s capital requirements regime. That regime is briefly discussed
in Section 9 below.
13 Under Statement of Financial Accounting Standards (SFAS) Nos. 166 and 167, retention of a material risk can result in all assets in the
securitization transaction (and not just the retained risk) being required to be accounted for on balance sheet. The form and amount of risk retention
can also affect the amount of risk-based capital a regulated financial institution is required to maintain with respect to the securitization.
14 The Final Rules define “servicing assets” as rights or other assets designed to assure the servicing or 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
Hedging, Transfer and Financing Restrictions and Sunsets
Hedging, Transfer and Financing Restrictions. The Final Rules contain restrictions on hedging, transfer
and financing that are substantially the same as those in the Re-Proposed Rules. Consequently, the Final Rules
prohibit a retaining sponsor from selling or otherwise transferring any interest or assets that it is required to
retain other than to majority-owned (or wholly-owned, as applicable) affiliates of the sponsor. A retaining
sponsor and its affiliates also may not hedge their required risk retention positions or pledge those positions as
collateral for any obligation (including a loan, repurchase agreement or other financing transaction), unless the
obligation is with full recourse to the pledgor.
Certain activities are not considered prohibited hedging activities. Sponsors and their affiliates will be permitted
• hedge interest rate or foreign exchange risk; or
• hedge based on an index of instruments that includes asset-backed securities, subject to limitations based on
the portion of the index represented by the specific securitization transaction and by all securitization
transactions in which the sponsor is required to retain an interest.
If an originator retains all or a portion of the risk otherwise required to be retained by a sponsor, the originator
is generally subject to the limits on transfers, hedging and financings that apply to sponsors.
Sunsets. Section 15G of the Exchange Act requires that the risk retention regulations specify the minimum
duration of the risk retention required. In a change from the Originally Proposed Rules, the Final Rules (like the
Re-Proposed Rules) contain sunsets on the prohibitions on transfer and hedging of retained risk positions,
reflecting the view that the effectiveness of risk retention in ensuring sound underwriting diminishes after a
period of time has lapsed and peak delinquencies have occurred.
The Agencies have adopted separate sunsets for sponsors of RMBS and non-RMBS transactions to account for
longer durations of residential mortgages. For sponsors of RMBS transactions collateralized entirely by
residential mortgages, the restriction on transfer and hedging expires on the later of:
• five years after the date of the closing of the securitization transaction; and
• the date on which the total unpaid principal balance of the residential mortgages has been reduced to 25% of
their total unpaid principal balance at closing;
provided that the restrictions expire in any case not later than seven years after closing.
For sponsors of other securitization transactions, the prohibition on transfer and hedging sunsets on the latest
• the date on which the total unpaid principal balance of the securitized assets has been reduced to 33% of the
total unpaid principal balance of the securitized assets at closing;
• the date on which the total unpaid principal obligation under the related ABS interests has been reduced to
33% of the total unpaid principal obligation of the ABS interests at closing; and
• two years after closing.
However, there is no sunset provision for risk retention interests in revolving pool securitizations.SIDLEY UPDATE
In addition, as noted below, an initial third-party purchaser of an eligible horizontal residual interest of CMBS
may transfer its interest commencing five years after closing, so long as the transferee satisfies certain of the
conditions applicable to the initial third-party purchaser, including the requirements that the subsequent thirdparty
purchaser acquire its interest in cash and conduct an independent review of the securitized assets prior to
Option to Allocate the Risk Retention to an Originator
As permitted by Section 15G of the Exchange Act, the sponsor may allocate its risk retention requirement to the
“originator” of the securitized assets under the standard risk retention options, subject to the agreement of the
originator and to certain other conditions. For this purpose, “originator” is defined in the same manner as in
Section 15G (i.e., as a person who, through the extension of credit or otherwise, creates a financial asset that
collateralizes an asset-backed security and sells the asset directly or indirectly to the securitizer). As a
consequence, only the original creditor under an asset–and not a subsequent purchaser or transferee of the
asset–qualifies as an “originator.”15 Any amount allocated to an originator would reduce the sponsor’s risk
retention requirement.16 There are only minor changes between the Re-Proposed Rules and the Final Rules in
respect of originator risk retention.
The originator’s allocation is limited under the Final Rules such that the ratio of the percentage risk position
acquired and retained by the originator to the total percentage risk position otherwise required to be retained by
the sponsor does not exceed the ratio of the unpaid principal balance of all the securitized assets originated by
the originator to the unpaid balance of all the securitized assets in the securitization transaction.
The originator must acquire and retain at least 20% of the aggregate risk retention amount otherwise required to
be held by the sponsor, and must comply with the hedging, transfer and other restrictions with respect to such
interest as if the originator were a sponsor that acquired the retained interest. The sponsor would remain
primarily responsible for compliance and would be required to notify investors of any noncompliance by the
Alignment of “Qualified Residential Mortgage” with “Qualified Mortgage”; Periodic Review
Among the more discussed aspects of Section 15G was the definition of “qualified residential mortgage” (“QRM”)
for purposes of the exemption from standard risk retention for private-label RMBS. Dodd-Frank requires that
QRM be “no broader” than “qualified mortgage” (“QM”) under section 129C of the Truth in Lending Act (as
amended by Dodd-Frank) and the regulations implemented thereunder. Under the Originally Proposed Rules,
the Agencies defined QRM with reference to QM, as well as a number of loan criteria characteristic of higher
credit quality loans, including maximum loan-to-value and debt-to-income requirements and minimum down
payment and FICO score requirements. As the Agencies acknowledged, the overwhelming majority of
15 It remains unclear how the Agencies would interpret this definition in the context of correspondent lending arrangements where the original
creditor is in effect originating for another entity in accordance with that entity’s underwriting standards.
16 We note that the Final Rules include an analogous mechanism in the provisions applicable to open market CLOs. In that context, lead arrangers
of syndicated loans that retain risk positions in the loans themselves can satisfy the risk retention requirement, provided a number of conditions are
met. This is discussed in Section 5 below.SIDLEY UPDATE
commenters objected to various aspects of the originally proposed approach, including banks, industry groups,
some consumer advocates and other securitization market participants, as well as members of Congress who
advised that the 20% minimum down payment requirement under the Originally Proposed Rules was contrary
to legislative intent. Under the Re-Proposed Rules, the Agencies eliminated the underwriting and performance
criteria specified in the Originally Proposed Rules and proposed to align QRM with QM. Most commenters
viewed the reproposal favorably. Those objecting cited the different purposes of the risk retention and ability-torepay
rules and expressed a desire for specific underwriting criteria, among other things.
The Agencies have opted to align QRM with QM, with limited modification to the Re-Proposed Rules. The
Agencies conclude that the alignment of QRM with QM meets the statutory goals and directive of limiting credit
risk, preserving access to affordable credit and reducing the compliance burden in the origination of mortgage
loans. In addition, the Agencies cite various new and proposed rules and regulations, including the loan-level
disclosure requirements for registered transactions recently adopted as part of Regulation AB II, as mitigating
the need for any broad-based risk retention requirements for private-label RMBS. Improved industry standards
for due diligence and representations and warranties, among other things, also apparently helped to persuade
the Agencies. The Agencies acknowledge that bifurcation of QM and non-QM in the mortgage market may lead
to a securitization market dominated solely by QMs, yet take the position that alternatives would have presented
greater risks, possibly resulting in greater segmentation in the securitization market and increased costs of credit
A mortgage loan will be a QRM if the lender satisfies any of the applicable QM definitions under the ability-torepay
rules of the Consumer Finance Protection Bureau (“CFPB”). Sponsors may take advantage of either the
legal safe harbor for compliance or the rebuttable presumption of compliance for higher-priced QMs.
Accordingly, certain mortgage loans that are prohibited from being QMs, such as negative amortization loans,
certain balloon and reverse mortgage loans or home equity lines of credit, will not qualify as QRMs. QMs also
must have a term to maturity of 30 years or less. Total fees and points generally must not exceed 3% of the total
loan amount. The maximum debt-to-income ratio for a borrower under the QM rules is 43%. Mortgages that are
exempt from the ability-to-repay rules are not QRMs; however, certain community-focused residential
mortgages will benefit from a separate exemption from risk retention under the Final Rules.
Consistent with the Prior Proposals, reliance on the QRM risk retention exemption is also conditioned on all of
the QRMs being currently performing (i.e., the borrower is not 30 days or more past due, in whole or in part, on
the mortgage). In an apparent technical glitch, the preamble to the Final Rules states that delinquency is to be
measured as of the cut-off date, whereas the text of the Final Rules requires that delinquency be measured as of
the closing date (as was proposed). To satisfy the exemption, the depositor with respect to the securitization
transaction (which may not be the sponsor) must deliver a certification to the effect that it has evaluated the
effectiveness of its internal supervisory controls with respect to the process for ensuring that all assets that
collateralize the asset-backed securities are QRMs (or servicing assets) and has concluded that the controls are
effective. The depositor must evaluate the effectiveness of its internal supervisory controls as of a date no more
than 60 days preceding the cut-off date of the securitization transaction. The certification must be made
available by the sponsor to investors and, upon request, to the Agencies.
A sponsor of an exempt QRM-backed securitization transaction will not immediately lose the exemption if it
subsequently determines that one or more of the mortgage loans collateralizing the asset-backed securities does
not meet all of the criteria to be a QRM. Following such determination, the QRM exemption will be lost unless SIDLEY UPDATE
the sponsor repurchases the loan from the issuing entity at a price at least equal to the remaining aggregate
unpaid principal balance and accrued interest on the loan no later than 90 days after the determination that the
loan does not satisfy the QRM requirements, and provides holders of the asset-backed securities notice of any
such loans required to be repurchased and the cause for such repurchase. The Agencies declined to allow
substitution of mortgage loans in lieu of repurchase.
Importantly, as the Agencies acknowledge, the QRM definition will evolve as the CFPB amends, modifies or
clarifies the applicable definitions of QM under the ability-to-repay rules. Absent any future action by the
Agencies, the primary credit risk retention exemption for RMBS will indirectly fall within the purview of the
federal government’s chief consumer protection regulator. The Final Rules require that the Agencies periodically
review the definition of QRM to determine whether market or regulatory conditions warrant modification. The
initial review will occur four years after the Effective Date, and every five years thereafter. This timeline is
intended to coincide with the CFPB’s schedule of periodic reviews of QM standards, to assist in determining
whether any modifications would be appropriate. Any Agency may request a review at any time, including
following amendment to the definition of QM or due to changes in the residential mortgage market. The
commencement of a review will be subject to prior notice in the Federal Register and a solicitation of public
comment. The Agencies’ final determination of their review will be published no later than six months after
notice of the commencement of the review, unless extended. Any amendment to the definition of QRM must be
completed within 12 months of publication of the notice disclosing the final determination, subject to extension
by the Agencies.
Exclusion of Non-Economic REMIC Residual Interests from ABS Interests
Under the Final Rules, the Agencies reverse the preliminary position taken under the Re-Proposed Rules by
excluding from the definition of “ABS interests” (i) non-economic residual interests issued by a REMIC and
(ii) uncertificated regular interests in a REMIC held by another REMIC that is part of the same structure,
provided a single REMIC in that structure issues ABS interests to investors. Sponsors of RMBS (or CMBS)
issuing entities structured as real estate mortgage investment conduits, or REMICs, that rely on standard risk
retention need not take into account non-economic residual tranches in allocating risk retention among
horizontal and vertical interests.
Limited Exemption for Mortgages on Three-to Four-Family Residential Properties and
Community-Focused Residential Mortgages
Mortgage loans on three-to four-family residential properties that meet all of the QM criteria (other than that
they be covered transactions) and certain other criteria have the benefit of a new exemption under the Final
Rules.17 As a technical matter, such mortgage loans are excluded from the definition of QM (and, in turn, QRM)
because they are not extensions of consumer credit and therefore not covered transactions under the QM rules.
The Agencies recognize that such residential mortgages demonstrate credit risk comparable to that of two-unit
residential mortgages that are covered transactions under the CFPB’s Regulation Z. If a three-to four-unit
residential mortgage loan fails to satisfy the applicable criteria, preservation of the exemption will require
repurchase on the same basis as QRMs, as described above.
17 The Agencies correspondingly define “residential mortgage” under the Final Rules to include mortgage loans secured by a residential structure
that contains one to four units. Under the Prior Proposals, a “residential mortgage” was defined only in reference to covered transactions (or
transactions exempt from the definition of covered transactions) under Regulation Z.SIDLEY UPDATE
In addition, certain “community-focused residential mortgages” that do not expressly satisfy the QM rules but
are exempt from the ability-to-repay rules will have the benefit of a new limited exemption under the Final
Rules. Such residential mortgages, defined as those exempt from the definition of covered transaction under
section 1026.43(a)(3)(iv)-(v) of Regulation Z, generally are made under government-sponsored programs or
non-profit programs that serve the public interest by facilitating access to credit for low- and moderate-income
borrowers. Community-focused residential mortgages under the Final Rules will be subject to periodic review by
the Agencies under the terms described above for QRMs. Other mortgage products exempt from the ability-torepay
rules, such as home equity lines of credit, reverse mortgages and timeshares, will not fit within the new
Limited Partial Exemption for Blended Residential Mortgage Pools
The Agencies generally declined to permit commenters’ requests to blend QRMs with non-QRMs and
correspondingly reduce the amount of risk retention by the proportion that QRMs bear to the mortgage pool;
however, sponsors of securitization transactions that include a combination of non-exempt residential
mortgages and community-focused residential mortgages will be able to reduce the percentage of risk retention
required to be held (by the ratio of the unpaid principal balance of the community-focused residential mortgages
to the total unpaid principal balance of residential mortgages, up to the maximum upper limit of 50%). In
addition, under the Final Rules, blended pools of QRMs and qualifying residential mortgages on three-to fourfamily
residential properties described above will be permissible and have the benefit of a full exemption from
risk retention. Except in these limited circumstances, sponsors of RMBS backed by pools containing non-QRMs
will not be able to take advantage of the QRM exemption in whole or in part (including any reduction in risk
retention for a “blended pool,” as permitted for other “qualifying” asset classes) and must satisfy the standard
risk retention requirements.
The Agencies determined not to adopt a narrower definition of QRM introduced in the Re-Proposed Rules that
would have required satisfaction of additional underwriting and loan performance criteria believed to further
reduce risk of default in addition to meeting the QM standard, referred to as “QM-plus.” Commenters objecting
to the QM-plus approach commented that it would limit affordable credit and delay the return of a robust
private mortgage market. In declining to implement this option, the Agencies cite the negative impact on the
affordability of credit, particularly for low- and middle-income, minority and first-time home purchasers.
Like the Prior Proposals, the Final Rules provide that the 100% guaranty of Fannie Mae or Freddie Mac will be
deemed to satisfy the risk retention requirement under the Final Rules so long as Fannie Mae or Freddie Mac, as
applicable, is operating under the conservatorship or receivership of the FHFA with capital support from the
United States. In addition, the 100% guaranty of any limited-life regulated entity succeeding to the charter of
Fannie Mae or Freddie Mac will be treated similarly, provided the entity operates with capital support from the
United States. The Final Rules also provide that the hedging prohibitions will not apply to Fannie Mae or
Freddie Mac or to any such limited-life regulated entity (under the circumstances described) or to any of their
respective affiliates or to the issuing entity for a given securitization transaction.SIDLEY UPDATE
Increased Flexibility for Sponsors of Commercial Mortgage-Backed Securities
The Final Rules expand the range of risk retention options for sponsors of CMBS and modify other aspects of the
Prior Proposals relating to CMBS. The options available to CMBS sponsors under the Final Rules include the
• retention either by one or by two third-party purchasers (holding on a pari passu basis) of an eligible
horizontal residual interest;
• retention by the sponsor alone under any combination of the standard forms of risk retention described
• retention by the sponsor and one or more originators that satisfy the applicable conditions to hold any
combination of the standard forms of risk retention described above;
• retention by a combination of the sponsor and one or two third-party purchasers (holding on a pari passu
basis), with the third-party purchaser(s) holding an eligible horizontal residual interest and the sponsor
holding a vertical interest; or
• exemption from retention requirements where CMBS is collateralized by a pool consisting entirely of
qualifying commercial real estate loans (and partial exemption where the pool is mixed).
Third-Party Purchaser Retention. Section 15G of the Exchange Act contemplates an exemption from risk
retention for a sponsor if a third-party purchaser specifically negotiates for and holds the first-loss position in
the transaction, performs due diligence on the assets in the pool prior to closing and satisfies other conditions.
Under the Final Rules, retention by a third-party purchaser in a CMBS transaction will be available where the
third-party purchaser and the securitization transaction meet the following conditions:
• 100% of the securitized assets consist of commercial real estate loans and servicing assets;
• if there are two third-party purchasers of the eligible horizontal residual interest, their residual interests are
• each third-party purchaser holds for its own account the eligible horizontal residual interest in the
securitization in the same form, amount and manner as would be held by the sponsor;
• each third-party purchaser pays for the eligible horizontal residual interest in cash at the closing without
financing being provided, directly or indirectly, from any person that is a party to, or an affiliate of a party to,
the securitization transaction other than a person that is a party to the transaction by reason of being an
• each third-party purchaser performs an independent review of the credit risk of each asset in the pool prior
to the sale of the CMBS that includes, at a minimum, a review of the underwriting standards, collateral and
expected cash flows of each loan in the pool;
• each third-party purchaser is prohibited from being affiliated with any other party to the securitization
transaction other than investors, the special servicer or originators that collectively contribute less than 10%
of the unpaid balance of the securitized assets; andSIDLEY UPDATE
• the underlying securitization transaction documents provide for an operating advisor that meets certain
qualifications set forth in the Final Rules, including its being unaffiliated with other parties to the
securitization transaction; its lack of any financial interest therein (other than its fee), and its acting in the
best interest of all investors as a collective whole.
The operating advisor’s role under the Final Rules largely reflects current industry practice and includes
consulting with the special servicer on material servicing decisions after the eligible horizontal residual interest
has a principal balance of 25% or less of its initial principal balance (taking into account appraisal reductions)
and reviewing the actions and reports of the special servicer and issuing periodic reports to investors.
In addition, the operating advisor may recommend in its periodic report to investors that a special servicer be
replaced if the operating advisor determines, in its sole discretion exercised in good faith, that (1) the special
servicer has failed to comply with a standard required under the applicable transaction documents, and (2) a
replacement would be in the best interest of the investors as a collective whole. Upon such recommendation, the
special servicer would be subject to replacement upon the affirmative vote of a majority of the outstanding
principal balance of ABS interests voting. A quorum for any such vote must be set forth in the transaction
documents and may not specify a quorum of more than the holders of 20% of the outstanding principal balance
of all ABS interests, with such quorum including at least three investors.
Notwithstanding comments requesting that the sponsor not be primarily responsible for a third party
maintaining compliance with the risk retention rules, the sponsor will retain the responsibility for compliance by
any third-party purchaser with the risk retention requirements. The sponsor will be required to notify investors
if it discovers that a third-party purchaser is not in compliance. The sponsor’s obligation will apply with respect
to both initial third-party purchasers and subsequent transferees that acquire the eligible horizontal residual
interest after the five-year sunset on transfers and hedging.
The Final Rules did not provide relief for “single-borrower or single-credit” transactions, which are not an
insignificant portion of the CMBS market. Most single-borrower or single-credit transactions are tranched
without a non-investment grade layer. Purchasers of investment grade tranches are unlikely to be willing to
incur the expense required to conduct the due diligence upon which the third-party purchaser alternative is
conditioned. Thus, for transactions that are normally structured without a traditional B-piece, this alternative
will likely be irrelevant, leaving the standard risk retention approach as the only option.
Sunset on Third-Party Purchaser Option. A third-party purchaser of an eligible horizontal residual
interest of CMBS may transfer its interest commencing five years after closing so long as the transferee satisfies
certain of the conditions applicable to the initial third-party purchaser.
Disclosure Requirements Relating to the Third-Party Purchaser Option. A reasonable time prior to
the sale of the CMBS, the sponsor will be required to disclose to potential investors (and, upon request, the SEC
and the appropriate federal banking agency) the name and form of organization of each initial third-party
purchaser, a description of such initial third-party purchaser’s experience in investing in CMBS and any other
information regarding such initial third-party purchaser or its retention of the first-loss position that is material
to investors in light of the circumstances of the particular securitization transaction. In addition, the sponsor will
be required to disclose the purchase price paid by each initial third-party purchaser for the first-loss position,
the material terms of such position and the fair value of the position the sponsor would have retained if the
sponsor had relied on retaining an eligible horizontal residual interest. The sponsor will also have to cause to be SIDLEY UPDATE
provided to potential investors the representations and warranties concerning the securitized assets, the
schedule of any securitized assets that are determined not to comply with such representations and warranties,
and the factors that were used to make the determination that securitized assets should be included in the pool
notwithstanding that they did not comply with such representations and warranties, such as compensating
factors or a determination that the exceptions were not material.18 The Final Rules add disclosure requirements
with respect to the operating advisor and material terms of the applicable transaction documents, including the
name and form of organization of the operating advisor, any material conflict of interest between the operating
advisor and any other transaction party, its compensation and a description of the operating advisor’s
experience, expertise and financial strength to fulfill its obligations.
Qualifying Commercial Real Estate Loans
As further discussed below in Section 7 describing full and partial exceptions from risk retention for assetbacked
securities backed by qualifying assets, CMBS sponsors may take advantage of a full or partial exception
from risk retention for a securitization transaction backed in whole or in part by a pool of commercial real estate
loans that satisfy certain underwriting and product standards. Currently, very few commercial real estate loans
satisfy these requirements.
In connection with both of the Prior Proposals, the Agencies took the position that the manager of a CLO
transaction is the securitizer (and sponsor) for purposes of risk retention. There was criticism from market
participants that neither CLO managers nor their affiliates typically act as sellers or transferors to the issuing
entities and that many CLO managers, particularly those that organize CLOs for loans traded in the secondary
market, may not have the balance sheet capacity to hold risk retention. Despite the criticism, the Agencies made
no change to this position, and under the Final Rules the CLO manager is the sponsor for purposes of risk
retention. Moreover, the Agencies rejected industry arguments that the fees of CLO managers, in particular
subordinated fees, align the interests of CLO managers and investors, and thus the Final Rules do not permit
such fees to satisfy CLO risk retention obligations.
Open Market CLOs
The Agencies retained an alternative manner of risk retention, originally proposed in the Re-Proposed Rules, for
CLOs that satisfy the requirements of a so-called “open market CLO.” Under this alternative, CLO managers do
not need to satisfy the standard risk retention requirement for a CLO transaction if the transaction meets certain
conditions, most notably a requirement that arrangers of underlying syndicated loans retain risk interests in the
loans as a condition to such loans being included in the CLO. As discussed below, however, the proposed open
market CLO approach is inconsistent with current market practice and is expected to be of limited utility.
As conceived by the Agencies, the open market CLO exemption will impose, among other conditions, the
18 This requirement is similar to the items of Regulation AB requiring disclosure regarding pool assets that deviate from the disclosed underwriting
criteria or other benchmarks or criteria used in the issuer’s asset review for registered transactions.SIDLEY UPDATE
• The open market CLO does not acquire or hold any assets other than senior, secured syndicated loans that
are “CLO-eligible loan tranches” (described below) and servicing assets.
• The open market CLO does not invest in ABS interests or in credit derivatives (other than hedging
transactions that are servicing assets to hedge risks of the open market CLO).
• All purchases of CLO-eligible loan tranches by the open market CLO issuing entity (including loan tranches
acquired in a warehouse period) are made in open market transactions on an arm’s-length basis.
• The manager of the open market CLO is not entitled to receive any management fee or gain on sale at the
time the open market CLO issues its ABS interests.19
Under the Final Rules, to qualify as a “CLO-eligible loan tranche” a loan must have the following features:
• The loan is a term loan of a syndicated credit facility to a commercial borrower.
• The loan is a senior secured loan, which will exclude second lien loans, unsecured loans and bonds, which
have historically been eligible for purchase (subject to limited baskets) in CLO structures.
• At least 5% of the face amount of the CLO-eligible loan tranche is retained by the “lead arranger” of the
credit facility until the earliest of the repayment, maturity, involuntary and unscheduled acceleration,
payment default or bankruptcy default of such CLO-eligible loan tranche. In addition, the lead arranger must
comply with limitations on hedging, transferring and pledging the interest retained by the lead arranger.
• Lender voting rights give holders of the CLO-eligible loan tranche consent rights with respect to, at
minimum, any material waivers and amendments of the credit agreement, any intercreditor agreement and
other applicable documents governing such CLO-eligible loan tranche.
• The pro rata provisions, voting provisions and similar provisions applicable to the security associated with
the CLO-eligible loan tranches are not materially less advantageous to the holders of such CLO-eligible loan
tranche than the terms of other tranches of comparable seniority in the broader syndicated credit facility.
The Final Rules include certain minimum collateralization requirements for a CLO-eligible loan tranche (the
adequacy of which is to be determined in the commercially reasonable judgment of the CLO manager).20 These
provisions require the CLO manager to certify, on or prior to each date that it acquires a loan constituting part of
a new CLO-eligible loan tranche, that it has policies and procedures to evaluate the likelihood of repayment of
19 The definition of “CLO manager,” for the purposes of the open market CLO exemption, requires that the CLO manager be a registered
investment adviser under the Investment Advisers Act, or be an affiliate of a registered investment adviser which is itself managed by such registered
investment adviser. Because of this definition, affiliates of the CLO manager that are managed by the CLO manager also may not benefit from any
management fees or gains on sale at the time the CLO ABS interests are issued.
20 To qualify, a loan must meet the following conditions:
i. the loan is not subordinate in right of payment to any other obligation for borrowed money of the commercial borrower;
ii. the loan 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
iii. 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 loan 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.SIDLEY UPDATE
loans acquired by the CLO and it has followed such policies and procedures in evaluating each CLO-eligible loan
To qualify as a “lead arranger,” with respect to a CLO-eligible loan tranche, an institution must:
• be active in the origination, structuring and syndication of commercial loan transactions and have played a
primary role in the structuring, underwriting and distribution on the primary market of the CLO-eligible
• have taken an allocation of the funded portion of the syndicated credit that is at least 20% of the aggregate
principal balance at origination and that equals or exceeds the allocation to any other member of the
syndication group that funded at origination; and
• be identified in the applicable agreement governing the CLO-eligible loan tranche; represent therein to the
holders of the CLO-eligible loan tranche and any participation interest that the lead arranger satisfies the
first item above and, at the time of the initial funding of the CLO-eligible loan tranche, will satisfy the second
item above; further represents that in its reasonable judgment, the terms of the CLO-eligible loan tranche
are consistent with the requirements of the certain provisions of the Final Rules; and covenant to the holders
that it will fulfill the requirements of the first item above.
The open market CLO exemption also requires disclosure, both before closing and on at least an annual basis
thereafter, of every asset held by the CLO, including the name, standard industrial category code (SIC Code) and
legal entity identifier of the obligor, the full name of the CLO-eligible loan tranche, the face amount of the CLOeligible
loan tranche and the face amount of the portion thereof held by the CLO, the price at which the loan
tranche was acquired by the CLO, the name of the lead arranger for each CLO-eligible loan tranche, and the
name and form of organization of the CLO manager.
Given the substantial restrictions and requirements of the open market CLO exemption, it is highly unlikely that
it presents a practical alternative to the standard risk retention requirements. For example, revolving loans and
participations in letters of credit do not qualify as CLO-eligible loan tranches under the Final Rules. Moreover,
lead arrangers do not have risk retention requirements imposed on them in the current loan market, and
imposing a new requirement to maintain minimum unhedged positions in loans may be inconsistent with the
business, operations and risk management policies of lead arrangers. It would require a substantial change to
terms currently found in the syndicated loan market to create a volume of CLO-eligible loan tranches sufficient
to provide meaningful investment opportunities for open market CLOs. At this time, such a change seems
CLO Market Challenges
Given the likelihood that the open market CLO exemption will not be available for most CLOs, new CLOs will be
generally required to comply with the standard risk retention requirement. As noted above, only CLO managers
that are able and willing, directly or through majority-owned affiliates, to purchase and hold a standard 5% risk
retention interest (vertical, horizontal or combined) will be able to participate; this may exclude CLO managers
that do not have significant balance sheet capacity, a group that historically has played an important role in the
CLO market. Moreover, the sunsets on transfer and hedging prohibitions under the standard risk retention
requirements are likely to be of little value in the case of CLOs. CLO assets have relatively long tenors and, as
noted above, these sunsets are tied to pool balance reductions and thus will likely provide little relief.SIDLEY UPDATE
Moreover, a number of issues remain unresolved with respect to the application of the Final Rules to CLOs.21
The Final Rules apply to issuing entities that offer and sell asset-backed securities following the Effective Date.
While this will not include a CLO that has offered and sold all of its securities prior to the Effective Date, it would
include any CLO, even one that initially closed prior to the Effective Date, if the CLO offers and sells any
additional securities after the Effective Date. This will affect any CLO that permits additional issuances of
securities. In addition, many CLOs include provisions permitting the issuance of securities or the incurrence of
indebtedness after the initial closing to refinance one or more of the tranches of securities previously issued by
the CLO. Under the terms typically included in CLO documents, it is expected that the exercise of such a “refinancing”
option would likely constitute an offer and sale of securities that, if occurring after the Effective Date,
would require compliance with the Final Rules. In addition, some CLOs include provisions permitting the repricing
of one or more of its tranches of securities. While such a re-pricing does not typically involve the actual
issuance of new securities, the SEC has determined, in other contexts, that a material change in the terms of a
security can constitute a deemed new issuance. As a result, it remains unclear whether the exercise of such a “repricing”
option in a CLO after the Effective Date would require compliance with the Final Rules.
Unlike many securitization transactions that include an originator that transferred a pool of securitized assets, a
CLO involves a manager that is only a service provider to the issuing entity. As a result, a CLO manager may,
subject to the terms of its management agreement, resign or be removed and replaced as the manager of a CLO.
The Final Rules do not address whether, in the event of the replacement of a CLO manager, the risk retention
ceases to apply, must remain satisfied by the original CLO manager, or must thereafter be satisfied by the
replacement CLO manager. As a result, the consequences of the resignation or removal and replacement of a
CLO manager following the Effective Date are unclear.
Given the expected limited utility of the open market CLO alternative and of the limited relief otherwise
provided by the Final Rules, the risk retention requirements are expected to have an adverse effect on the CLO
market and on the loan market that it serves. Although market participants have over two years to prepare for
the Effective Date, participants are currently working to identify alternatives that satisfy the risk retention
requirements of the Final Rules in a manner that would permit many current CLO managers to continue to
participate in the CLO market and would also permit certain new CLO managers to enter the market. Such
alternatives may include, for example, structures involving the establishment by CLO managers of majorityowned
affiliates to acquire and hold the required interests in CLOs. In those structures, the CLO manager would
be required to provide sufficient capital in order to qualify the holder of the retained interests as a majorityowned
affiliate, but third parties could provide additional investment capital, and further capacity may be
provided through leverage (though, as noted above, any pledge of the retained interests must collateralize fullrecourse
obligations). Such approaches would come at a cost, which would need to be considered by market
participants. Other alternatives may be identified as discussions continue.
6. ABCP CONDUITS
The Agencies considered a wide variety of comments with respect to the treatment of ABCP conduits under the
Re-Proposed Rules, but elected to retain largely intact the Re-Proposed Rules’ framework for ABCP conduits.
The Agencies affirmed their view that an arranger or manager of an ABCP conduit is a sponsor or “securitizer”
21 The Loan Syndications and Trading Association, Inc. (the “LSTA”) has filed in federal court a challenge focusing on the CLO portion of the
Final Rules and brought under the Administrative Procedure Act of 1946. Sidley is representing the LSTA in the proceeding.SIDLEY UPDATE
for purposes of the statutory mandate and thus subject to the risk retention rules. They also affirmed the view
that, while a specific ABCP conduit option is made available under the Final Rules, an ABCP conduit sponsor is
not limited to using the ABCP conduit option to satisfy the risk retention requirements. A sponsor may elect to
utilize other available means of satisfying the risk retention requirements.
The basic structure of the ABCP conduit risk retention option under the Final Rules is modeled on a classic
ABCP conduit two-step transaction with limited flexibility for ABCP programs that feature variations on this
traditional model and with no flexibility for programs that do not have an unconditional 100% liquidity facility.
In order to avail itself of the “eligible ABCP conduit” option (in lieu of satisfying the standard risk retention
requirements), an ABCP conduit must satisfy the following conditions:
• Commercial Paper Issued. All asset-backed commercial paper issued by the ABCP conduit must have a
maturity at the time of issuance not exceeding 397 days (exclusive of days of grace, or any renewal thereof,
the maturity of which is likewise limited). This represents a change from the Re-Proposed Rules, which set
the maximum tenor for commercial paper at nine months. The Agencies took note of the fact that the
maximum maturity for securities that are eligible for purchase by money market mutual funds pursuant to
Rule 2a-7 under the Investment Company Act is 397 days. They were persuaded that the longer tenor under
the Final Rules was merited in light of the perceived likelihood that many conduits will need to issue ABCP
with a longer maturity in the future in order to accommodate the needs of regulated institutions that are
subject to the new Basel liquidity requirements.
• Qualification as an “eligible ABCP conduit.” In addition to being a bankruptcy-remote entity, in
order to qualify as an “eligible ABCP conduit,” the ABCP conduit must have the following features:
o Assets. Assets held by the ABCP conduit are limited to “ABS interests” acquired by the ABCP conduit in
an “initial issuance” from an “intermediate SPV.” Each of these components is discussed below.
ABS Interest. Under the Re-Proposed Rules, an ABCP conduit was permitted to acquire only assetbacked
securities. This has been changed under the Final Rules to permit the ABCP conduit to
acquire any “ABS interest,” which is defined to be “any type of interest or obligation issued by an
issuing entity, whether or not in certificated form, including a security, obligation, beneficial interest
or residual interest . . . payments on which are primarily dependent on the cash flows of the collateral
owned or held by the issuing entity.” Thus, for example, the claim arising from a loan made by an
ABCP conduit that would not constitute an asset-backed security is now an asset permitted to be held
by the ABCP conduit.
ABS interests permitted to be acquired by an eligible ABCP conduit are limited to (i) those
collateralized solely by assets originated by an originator-seller (or acquired by an originator-seller in
a business combination that qualifies for business combination accounting under U.S. GAAP) and by
servicing assets, (ii) special units of beneficial interest (or similar ABS interests) in trusts or special
purpose vehicles that retain legal title to leased property underlying leases originated by originatorsellers,
or (iii) ABS interests in a revolving pool securitization.
Each transaction to which the ABCP conduit is party must entail a two-step structure, one in which
an “originator-seller” originates assets and sells or transfers those assets, directly or through a SIDLEY UPDATE
majority-owned affiliate, to an “intermediate SPV,” and the intermediate SPV then enters into a
transaction with the ABCP conduit.
Originator-Seller. The Agencies expressly declined to permit an ABCP conduit under this option
to lend to or purchase assets directly from an originator-seller. The economic value of assets
originated by an originator-seller may be conveyed to an ABCP conduit only through the
intermediation of an intermediate SPV.
Intermediate SPV. An intermediate SPV is a bankruptcy-remote special purpose vehicle that is a
direct or indirect wholly-owned affiliate of the originator-seller. Under the Final Rules, an
intermediate SPV may also be an unaffiliated orphan SPV, an entity that has nominal equity owned
by a trust or corporate service provider that specializes in providing independent ownership of
special purpose vehicles. The assets that an intermediate SPV holds must have been acquired directly
from an affiliated originator-seller or an affiliated intermediate SPV, and the ABS Interests it issues
in turn must be collateralized solely by those assets.
Acquisition by ABCP Conduit. An eligible ABCP conduit must acquire ABS interests by one of
two means. The primary means is to acquire an ABS interest in an initial issuance by or on behalf of
an intermediate SPV. Under the Final Rules, an ABCP conduit may also acquire ABS interests from
another ABCP conduit in cases where (i) the transferring ABCP conduit acquired the ABS interest in
an initial issuance from an intermediate SPV, and (ii) the same liquidity provider supports both
o Liquidity. A “regulated liquidity provider” must have entered into a commitment to provide 100%
liquidity coverage to all ABCP issued by the ABCP conduit. Liquidity facilities of the type that are
commonly referred to as “partially supported liquidity” will not satisfy this requirement if they
contemplate any adjustment to the available loan or purchase price in the event of a deterioration in the
underlying assets. The Final Rules state that “liquidity support that only funds performing loans or
receivables or performing ABS interests does not meet the requirement.” The Agencies expressly
rejected the use of partially supported liquidity facilities in their response to commentators, citing a
[such facilities] could serve to insulate the liquidity provider from the credit risk of non-performing
assets in the securitization transaction. The ABCP option is designed to accommodate conduits that
expose the liquidity provider to the full credit risk of the assets in the securitization, with the
expectation that exposure to the credit risk of such assets will provide the liquidity providers with
incentive to undertake robust credit underwriting and monitoring.
As under the Re-Proposed Rules, a liquidity facility cannot be syndicated; it must be provided by a single
liquidity provider. However, unlike other risk retention options, a liquidity provider may hedge its
liquidity obligation or procure credit support by selling participations or implementing other backstop
arrangements so long as it remains directly responsible to the ABCP conduit for funding its obligations
under the liquidity facility.
• The Originator-Seller: Risk Retention. It remains a fundamental part of the eligible ABCP conduit
option that each originator-seller holds an economic interest in the credit risk of the assets collateralizing the SIDLEY UPDATE
related ABS interest held by the ABCP conduit. This economic interest must be in the amount and manner
(horizontal, vertical or as otherwise permitted) required under the Final Rules. Thus, investors in the
commercial paper issued by an eligible ABCP conduit will have the benefit of both the 5% risk retention
generally required for any sponsor of a securitization transaction, in this case provided by the originatorseller
(at the intermediate SPV level), and, in addition, the 100% unconditional liquidity facility required to
be provided by a regulated liquidity provider (at the ABCP conduit level).
• Additional Duties for ABCP Conduit Sponsor; Disclosure. The additional duties for the ABCP
conduit sponsor have not changed materially under the Final Rules. The sponsor continues to be required to
approve and monitor each originator-seller and intermediate SPV in respect of which the ABCP conduit
holds any ABS interests. The sponsor is also required to provide each purchaser of commercial paper, before
or contemporaneously with the first sale of commercial paper to such purchaser and at least monthly
thereafter, specific information with respect to the liquidity provider, the asset class and standard industrial
category code (SIC Code) for each originator-seller, and a description of the risk retention being provided by
each originator-seller. Furthermore, the sponsor must be prepared to provide such information and the
names and supplemental information for the originator-sellers to the Agencies, if requested. Finally, in the
event a sponsor determines that an originator-seller is not in compliance with its risk retention
requirements, the sponsor must notify the holders of the ABCP conduit’s commercial paper of the name of
such originator-seller and the nature of the related ABS interest held by the ABCP conduit, and must “take
other appropriate steps . . . which may include, as appropriate, curing any breach . . . or removing from the
eligible ABCP conduit any ABS interest that does not comply with [the risk retention requirements].” This
suggests that a liquidity facility is envisioned to be used, among things, for the disposition of nonconforming
assets held by an ABCP conduit.
The eligible ABCP conduit option is expected to be of somewhat limited utility. The generally inflexible structural
features at the transaction level and the requirement for 100% unconditional liquidity can be expected to lead
sponsors to more actively consider the alternatives of the standard horizontal and vertical risk retention
strategies. Any analysis of the alternatives will need to balance the requirement under the standard strategies
that the risk retention be in a form that is fully funded (standby letters of credit, guarantees, repurchase
agreements, asset purchase agreements and other unfunded forms of credit enhancement cannot be used to
satisfy the standard risk retention requirement), against the need to observe the structural requirements of the
eligible ABCP option.
7. OTHER ABS
Reduced Risk Retention Requirements for Certain Non-RMBS Securities
Dodd-Frank authorizes the Agencies to adopt regulations imposing a risk retention requirement of less than 5%
for assets other than QRMs if the originator of the assets meets certain prescribed underwriting standards. The
Final Rules make just limited changes to the exception qualifications set out in the Re-Proposed Rules for assetbacked
securities that are collateralized by (1) commercial real estate loans, (2) commercial loans, or
(3) automobile loans, in each case that meet certain underwriting standards.
Common to each qualifying asset class exception are the following principal conditions:SIDLEY UPDATE
• Single Asset Class Per Pool. The underlying assets for a given securitization must be of the same asset
class (e.g., no mixing of qualifying commercial real estate loans and qualifying commercial loans).
• Reinvestment Prohibition. The securitization transaction may not permit a reinvestment period.
• Cure or Buy-Back Requirements. The exception for a given securitization transaction is not lost if, after
closing, it is determined that an underlying asset failed to meet the relevant conditions, provided that either
(i) the failure is not material, or (ii) the sponsor, within 90 days, effectuates a cure or repurchases the asset
(and relevant disclosures are made).
• Certification. The sponsor must certify, prior to each issuance of asset-backed securities, that it evaluated
the effectiveness of its internal supervisory controls for ensuring that the loans meet the underwriting
requirements for the applicable exception and has concluded that those controls are effective. The sponsor
must provide the certification to investors prior to sale.
• Blended Pool Option. Although, as noted above, the assets of a given securitization must be of the same
asset class, they may consist of a blend of qualifying and non-qualifying assets in that class. Sponsors may
take advantage of a pro rata reduction in the 5% risk retention requirement (subject to a minimum of 2.5%
retention) in respect of the share of the pool constituted by the qualifying assets.22
• Securitization of Qualifying Assets Only. The risk retention requirements do not apply at all to a
securitization collateralized solely by servicing assets and either qualifying commercial real estate loans,
qualifying commercial loans or qualifying automobile loans.
Qualifying Commercial Real Estate Loans. A qualifying commercial real estate loan must satisfy certain
specific underwriting criteria. Among the more significant are the following:
• The originator must have determined that (i) based on the previous two years’ actual performance, the
borrower had, and (ii) based on two years of projections, which include the new debt obligation, following
the origination date of the loan, the borrower will have:
o a debt service coverage ratio of 1.5 or greater, if the loan is a qualifying leased real estate loan, net of any
income derived from a tenant(s) who is not a qualified tenant(s);
o a debt service coverage ratio of 1.25 or greater, if the loan is a qualifying multifamily property loan; or
o a debt service coverage ratio of 1.7 or greater, if the loan is any other type of commercial real estate loan.
• At origination, the applicable loan-to-value ratios (LTV) for the loan are:
o LTV of less than or equal to 65% and combined LTV of less than or equal to 70%; or
o LTV of less than or equal to 60% and combined LTV of less than or equal to 65%, if the capitalization
rate used in the required appraisal is less than or equal to the 10-year swap rate plus 300 basis points.
• All loan payments required to be made under the loan agreement are:
22 The share of the pool constituted by the qualifying assets is measured by the ratio of the total unpaid principal balance of the qualifying assets to
the total unpaid principal balance of all securitized assets in the pool.SIDLEY UPDATE
o based on level payments of principal and interest (as opposed to straight-line amortization) over a term
that does not exceed 25 years, or 30 years for a qualifying multifamily loan (e.g., no interest-only loans);
o to be made no less frequently than monthly over a term of at least 10 years.
• Under the terms of the loan agreement, any maturity of the mortgage note occurs no earlier than 10 years
following the date of origination.
As noted above, very few current commercial real estate loans currently satisfy these requirements. As a result,
we do not believe this is likely to prove a viable alternative to standard risk retention requirements.
Qualifying Automobile Loans. A qualifying automobile loan similarly must satisfy certain specific
underwriting criteria. The Agencies specify a number of express exclusions from the types of automobile
financings that qualify, the most relevant being:
• lease financings;
• loans to finance fleet sales;
• personal cash loans secured by a previously purchased automobile; and
• loans to finance the purchase of a commercial vehicle or farm equipment that is not used for personal, family
or household purposes.
Among the more notable affirmative conditions are the following:
• The originator of the loan must have determined and documented that:
o the borrower has at least 24 months of credit history;
o the borrower’s debt-to-income ratio is less than or equal to 36%; and
o within the previous 36 months, certain specified adverse credit events in respect of the borrower have
• The borrower must make a down payment from the borrower’s personal funds and trade-in allowance, if
any, that is at least equal to 10% (reduced from 20% in the Originally Proposed Rules) of the vehicle
purchase price plus various fees and tax.
• The terms of the loan agreement provide a maturity date for the loan that does not exceed the lesser of:
o six years from the date of origination (extended from five years in the Originally Proposed Rules); or
o 10 years minus the difference between the current model year and the vehicle’s model year.
• The terms of the loan agreement provide for, among other things, a fixed rate of interest and a level monthly
payment that fully amortizes the loan over its term.
As noted above, the definition of “qualifying automobile loan” is inconsistent with standard market underwriting
practices. In particular, the criteria that require individualized credit underwriting for automobile loans contrast
with current practices that rely on externally generated credit scores and credit reports. As a result, we do not
believe this is likely to prove a viable alternative to standard risk retention requirements.SIDLEY UPDATE
Qualifying Commercial Loans. For reduced risk retention requirements to apply to a commercial loan, the
loan must satisfy certain specific underwriting criteria. Among the more significant are the following:
• Prior to the origination of the loan, the originator of the loan must have determined that (i) based on the
previous two years’ actual performance, the borrower had, and (ii) based on two years of projections, which
include the new debt obligation, following the closing date of the loan, the borrower will have:
o a total liabilities ratio of 50% or less;
o a leverage ratio of 3.0 or less; and
o a debt service coverage ratio of 1.5 or greater.
• The loan must satisfy certain requirements as to collateralization, and include covenants relating to the
delivery of financial statements, the incurrence of liens on, or the transfer of, collateral securing the loan,
and the maintenance of insurance and the payment of taxes relating to such collateral.
• Loan payments required under the loan agreement must be:
o based on level monthly payments of principal and interest (at the fully indexed rate) that fully amortize
the debt over a term that does not exceed five years from the date of origination; and
o made no less frequently than quarterly over a term that does not exceed five years.
We note that few if any commercial loans in the current market have payment terms that would satisfy the
requirements for a qualifying commercial loan. As a result, we do not believe this is likely to prove a viable
alternative to standard risk retention requirements.
Master Trusts: Revolving Pool Securitizations
For revolving pool securitizations (referred to as revolving master trusts in the Prior Proposals), the sponsor may
satisfy the standard risk retention requirement under the Final Rules by maintaining a pari passu “seller’s
interest” (or an interest that is fully or partially subordinated to one or more series in identical or varying
amounts) of not less than 5% of the unpaid principal balance of all outstanding investor ABS interests issued by
the issuing entity, which percentage is subject to offset as described below. Most of the changes in respect of
revolving pool securitizations in the Re-Proposed Rules and Final Rules are designed to accommodate market
• The 5% seller’s interest required retention may be reduced by a corresponding percentage of the fair value of
ABS interest in each series in the form of any combination of (i) a residual ABS interest in excess interest and
fees that would otherwise be available to the seller but are subordinated to ABS interests (to the extent
provided in the Final Rules), and (ii) a horizontal residual interest with respect to such series. The amount of
the residual ABS interest in excess interest and fees and the amount of the horizontal residual interest are
calculated on the basis of their fair values.
• The following ABS interests are excluded from the calculation of the seller’s interest: (i) servicing assets
allocated to a specific series, and (ii) assets (often referred to in transactions as “ineligible assets”) that are
not eligible to be included in the calculation of the amount of assets required to support the investor ABS
• Funds in a principal accumulation account satisfying certain conditions may reduce the amount of investor
ABS interests for purposes of calculating the required seller’s interest.
• The 5% minimum seller’s interest requirement must be satisfied on the closing date and then measured and
satisfied at least monthly thereafter, with a one month cure period if it is not satisfied. The fair value of any
excess interest and fees offset must be calculated at the same intervals, but is subject to special calculation
methods. The fair value of any horizontal residual interest offset need only be calculated at closing, and
certain amounts must be excluded in the calculation.
• The Final Rules provide that a seller’s interest maintained at the legacy trust level may, subject to certain
limitations, be set off against the risk retention requirement at the issuing trust level.
• The sponsor will not fall out of compliance with risk retention requirements as a result of the reduction of
the seller’s interest below the required level during early amortization, subject to certain conditions.
• Funds in a pool-level excess funding account that satisfy certain conditions may also be applied to reduce the
seller’s interest retention requirement.
• As noted above, the sunset provisions elsewhere in the Final Rules do not apply to revolving securitization
pools since new assets are continually being added.
• As noted above, only the sponsor and its wholly-owned subsidiaries may hold the required risk retention
Tender Option Bonds
In the Final Rules, the Agencies refused to provide an exemption from the risk retention requirement for
securitizations or repackagings of municipal debt obligations (commonly known as “tender option bonds” or
“TOBs”); however, acknowledging the unique features of TOB programs, the Agencies did provide some relief for
TOBs issued by a “qualified tender option bond entity” (“QTOB”).23
Recognizing the unique nature of the securities issued by QTOB issuers, the Agencies expressly acknowledged
that residuals would qualify as a qualified horizontal residual interest before a tender option termination event
(“TOTE”)24 and as an eligible vertical interest after a TOTE. In addition to the residuals, the Agencies also permit
a sponsor's direct ownership of the same municipal securities held as collateral by a TOB issuer to count towards
23 A QTOB is defined as an issuing entity in which: (i) the entity is collateralized solely by servicing assets and by municipal securities that have the
same municipal issuer and the same underlying obligor or source of payment (determined without regard to any third-party credit enhancement) and
such municipal securities are not subject to substitution; (ii) such entity issues no securities other than: (x) a single class of TOBs with a preferred
variable return payable out of capital, and (y) one or more residual equity interests, that in the aggregate are entitled to all remaining income of the
issuing entity (commonly known as the “residuals”), provided that any such securities described in clause (x) or (y) constitute asset-backed securities;
(iii) the municipal securities held as assets by the entity are structured in compliance with Section 103 of the Internal Revenue Code of 1986 (the
“Code”), such that the interest payments on such securities are excludable from the gross income of the owners; (iv) the terms of all securities issued
by the issuer are structured so that all holders of such securities who are eligible to exclude interest received on such securities will be able to exclude
that interest from gross income pursuant to Section 103 of the Code or as exempt interest dividends pursuant to Section 852(b)(5) of the Code; (v)
such entity has a legally binding commitment from a regulated liquidity provider to provide a 100% guarantee or liquidity coverage with respect to all
of the outstanding TOBs; and (vi) such issuing entity qualifies for monthly closing elections pursuant to IRS Revenue Procedures 2003-84. The
Agencies limited their QTOB relief to TOBs that can be tendered for purchase to the issuer of such securities at any time, upon no more than 397
days, notice, for a purchase price equal to amortized cost of the security, plus accrued interest, at the time of tender.
24 Tender Option Termination Events are defined in the Final Rule by reference to the definition used in Section 4.01(5) of IRS Revenue
Procedure 2003-84, which includes: (1) bankruptcy of the municipal security issuer; (2) a downgrade of the municipal security below investment
grade; (3) a payment default on the municipal security; (4) the municipal security loses its tax exempt status; (5) the QTOB is downgraded below
investment grade; or (6) bankruptcy of the QTOB issuer.SIDLEY UPDATE
the 5% risk retention requirement (subject to the Final Rules’ transfer and hedging prohibitions).25 Similar to
the risk retention requirement for other ABS structures, the 5% risk retention requirement may be satisfied by
the sponsor26 or its majority-owned affiliates. The Agencies have also permitted the municipal securities
required to be held as collateral for QTOBs to include certain pass-through and pro rata interests in municipal
securities,27 and also provided relief from some of the disclosure requirements for sponsors that retain
municipal securities outside of the QTOB structure. For QTOBs, the disclosure requirements are limited to:
• the name and form of organization of the QTOB entity;
• a description of the form and subordination features of the retained residuals;
• to the extent any portion of the retained interest is a horizontal residual interest, the fair value of that
interest (expressed as a percentage of the fair value of all the ABS interests issued by the QTOB);
• to the extent any portion of the retained interest is a vertical residual interest, the percentage of ABS
interests issued represented by such vertical interests; and
• to the extent any portion of the retained interest involves directly holding the municipal security outside of
the QTOB entity, the name and form of organization of the QTOB entity, the identity of the issuer of the
municipal securities, the face value of the municipal securities deposited into the QTOB entity and the face
value of the municipal securities retained by the sponsor or its majority-owned affiliates.28
Finally, consistent with the operation of historical TOB programs, the Agencies expressly recognized that the
100% guarantee or liquidity coverage from a regulated liquidity provider29 for QTOBs is not required to apply
upon the occurrence of a TOTE.30
8. OTHER EXEMPTIONS AND REQUIREMENTS
Exemption for Certain Resecuritization Transactions
In the Final Rules, the Agencies adopt as proposed the two exemptions from risk retention for resecuritization
transactions specified in the Re-Proposed Rules, with some minor technical revisions. One exemption applies to
25 The Agencies have expressly permitted the 5% risk retention to be satisfied through any combination of ownership of the residuals or the direct
ownership of the municipal securities that are collateral for the QTOB.
26 The Agencies acknowledged that in TOB structures (as in other securitization transactions) there may be more than one “sponsor.” In such a
situation, it is the responsibility of the transaction parties to designate which party is the sponsor and is subject to the requirements of the Final Rules.
27 The Agencies expressly prohibited a QTOB from holding interests in another TOB issuer or from holding preferred stock in a closed-end
investment company that invests in municipal securities.
28 See discussion above under “Hedging, Transfer and Financing Restrictions” regarding prohibition on transfer and hedging with respect to 5%
risk retention requirement.
29 A regulated liquidity provider for a QTOB is limited to an entity that is a depository institution, a bank holding company (or a subsidiary
thereof), a savings and loan holding company (provided all or substantially all of the holding company's activities are permissible for a financial
holding company under 12 USC 1843(k) (or a subsidiary thereof)), or a foreign bank (or a subsidiary thereof) whose home country supervisor has
adopted capital standards consistent with the Capital Accord of the Basel Committee on Banking Supervision, provided the foreign bank is subject to
30 The preamble states: “In response to commenters’ requests for certain clarifications with respect to the required liquidity coverage, the agencies
recognize that the liquidity coverage may not be enforceable against the regulated liquidity provider upon the occurrence of a tender option
termination event. Liquidity coverage subject to this condition would nevertheless satisfy the liquidity coverage requirement in the final rule.”SIDLEY UPDATE
certain single-class pass-through resecuritizations, and the second is available to sponsors of resecuritizations of
“first-pay-class” RMBS backed by first-lien residential mortgages. The Agencies declined to make changes in
response to commenters who advocated for a resecuritization exemption for structures that re-tranche the credit
risk on the underlying asset-backed securities.
The Final Rules exempt a pass-through resecuritization transaction from the credit risk requirements if:
• the collateral consists solely of servicing assets and existing asset-backed securities for which credit risk was
retained or an exemption from retention under the Final Rules was utilized; and
• the transaction involves the issuance of only a single class of ABS interests and provides for the pass-through
of all principal and interest payments received on the underlying asset-backed securities (net of expenses of
the issuing entity) to holders of such class.
The Agencies also provide for an exemption for resecuritizations collateralized solely by servicing assets and socalled
“first-pay classes” of asset-backed securities for which credit risk was retained or an exemption from risk
retention under the Final Rules was utilized. The Final Rules generally define first-pay classes as classes 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, are entitled to principal and interest prior to or pro rata with all other classes of
securities collateralized by the same pool of first-lien residential mortgages. The resecuritization transaction
must not provide for reallocation of credit risk (except as a consequence of reallocation of prepayment risk),
which would appear to permit limited time-tranching, but not credit tranching. No class of ABS interests may
absorb realized principal losses on the first-pay classes constituting the collateral in priority to any other class.
In addition, the exemption will not permit any class of ABS interests to bear interest at an inverse floating rate
and will prohibit any other “similarly structured ABS interest.”
Each exemption requires that the underlying asset-backed securities in the resecuritization either satisfy risk
retention or be subject to an exemption, which will limit the pool of asset-backed securities eligible for a sponsor
of a resecuritization that relies on one of the exemptions described above following the Effective Date. Legacy
asset-backed securities would not be grandfathered for purposes of either exemption even though the alignment
of incentives with originators would have been realized years prior to the resecuritization. In addition, the
Agencies were not persuaded that a resecuritization exemption could facilitate customary REMIC or other
resecuritizations that provide valuable liquidity to the asset-backed securities markets without also easing
requirements for collateralized debt obligation transactions and other perceived high-risk structures. The
Agencies intend for the exemptions to allow for transaction structures that reallocate prepayment risk in the
manner seen in resecuritizations of senior RMBS tranches without providing for tranching of credit risk more
characteristic of collateralized debt obligation transactions.
Exemptions for Certain Other Securitization Classes
Government-Related Exemptions. Consistent with the Prior Proposals, the Final Rules would exempt the
• any securitization transaction that is collateralized solely by residential, multifamily or health care facility
mortgage loan assets that are insured or guaranteed by the United States or an agency of the United States,
and servicing assets;SIDLEY UPDATE
• any securitization transaction that involves the issuance of asset-backed securities that are insured or
guaranteed by the United States or an agency of the United States; and are collateralized solely by
residential, multifamily or health care facility mortgage loan assets or interests in such assets, and servicing
• any securitization transaction that is collateralized solely by loans or other assets made, insured, guaranteed
or purchased by any institution that is subject to the supervision of the Farm Credit Administration,
including the Federal Agricultural Mortgage Corporation, and servicing assets;
• any asset-backed security that is a security issued or guaranteed by any State, or by any political subdivision
of a State, or by any public instrumentality of a State that is exempt from the registration requirements of the
Securities Act by reason of Section 3(a)(2) of that Act;
• any asset-backed security that meets the definition of a qualified scholarship funding bond under the
Internal Revenue Code;
• any securitization transaction, if the asset-backed securities issued in the transaction are collateralized solely
by obligations issued by the United States or an agency of the United States and servicing assets,
collateralized solely by assets that are fully insured or guaranteed by the United States or an agency of the
United States (other than those referred to in the first bullet point above) and servicing assets, or fully
guaranteed as to the timely payment of principal and interest by the United States or any agency of the
• any securitization transaction where the asset-backed securities issued in the transaction are secured by the
intangible property right to collect charges for the recovery of specified costs and such other assets, if any, of
an issuing entity that is wholly owned, directly or indirectly, by an investor owned utility company that is
subject to the regulatory authority of a State public utility commission or other appropriate State agency
(commonly referred to as “stranded-cost” securitizations); and
• any securitization transaction that is sponsored by the FDIC acting as conservator or receiver under any
provision of the Federal Deposit Insurance Act or of Title II of Dodd-Frank.
Certain Student Loan Securitizations. The Agencies declined to implement a complete exemption for
securitization transactions collateralized solely by student loans made under the Federal Family Education Loan
Program (“FFELP loans”), and instead adopted substantially as re-proposed the reduced risk retention
requirements for securitization transactions of FFELP loans and servicing assets. For securitization transactions
for which the collateral consists only of servicing assets and (1) FFELP loans guaranteed as to at least 98% (but
less than 100%) of defaulted principal and accrued interest, and (2) FFELP loans guaranteed as to 100% of
defaulted principal and accrued interest, the risk retention requirements are 2% and zero, respectively. For other
FFELP-loan backed securitizations, the sponsor must hold at least 3% risk retention.
Seasoned Loans. The Agencies adopted as re-proposed the exemption from risk retention for securitization
transactions collateralized by highly seasoned loans (both residential mortgages and other kinds of loans). To
satisfy the conditions for being a seasoned loan under the Final Rules, a loan must not have been modified since
origination or been delinquent for 30 days or more, and must satisfy a minimum seasoning requirement. For
RMBS transactions, the loan must be outstanding and performing for the shorter of (1) the longer of five years
and such time that its outstanding principal balance has been reduced to 25% of its original principal balance SIDLEY UPDATE
and (2) seven years. For all other asset classes, the loan must be outstanding and performing for the longer of
two years and such time that its outstanding principal balance has been reduced to 33% of its original principal
balance. The Agencies decided against a seasoned loan exemption that would allow for loans subject to prior
delinquency, regardless of any subsequent record of performance.
Additional Exemptions. The Agencies generally reserve authority to jointly adopt or issue additional
exemptions, exceptions and adjustments to the credit risk retention requirements, including exemptions,
exceptions and adjustments for classes of institutions or assets.
Safe Harbor for Certain Foreign-Based Transactions. The Agencies adopted substantially as reproposed
the safe harbor from risk retention for certain predominantly foreign-related transactions. The Final
Rules’ risk retention requirements will not apply to a foreign-based securitization transaction if, among other
• the securitization transaction is not, and is not required to be, registered under the Securities Act;
• no more than 10% of the dollar value (or the equivalent amount in a foreign currency) of all classes of ABS
interests are sold or transferred to U.S. persons or for the account or benefit of U.S. persons (which the
Agencies clarify in the preamble should be applied only to ABS interests sold in the initial distribution);
• neither the sponsor of the securitization transaction nor the issuing entity is chartered, incorporated or
organized under the laws of the United States or any State or is the unincorporated U.S. branch or office of
an entity not chartered, incorporated or organized under the laws of the United States or a State (collectively,
a “U.S.-located entity”); and
• no more than 25% of the assets collateralizing the asset-backed securities sold in the securitization
transaction were acquired by the sponsor, directly or indirectly, from a consolidated affiliate of the sponsor
or issuing entity that is a U.S.-located entity.
The Final Rules also contain an anti-evasion provision that limits the applicability of the safe harbor by
restricting transactions that, while in technical compliance with the safe harbor, are part of a plan or scheme to
evade the requirements of Section 15G and the Final Rules.
Given the limited nature of the safe harbor, it remains the case that many foreign-related securitizations could
be subject to Dodd-Frank risk retention, notwithstanding that substantially all of the assets underlying the
related asset-backed securities may have foreign obligors, have been originated and underwritten by non-U.S.
entities subject to foreign rules and regulations and collateralize asset-backed securities primarily targeted to
9. RELATIONSHIP TO OTHER RISK RETENTION RULES AND PROPOSALS
No Mutual Recognition with Other Risk Retention Rules
The Agencies determined not to recognize satisfaction of risk retention under other regimes as sufficient to
satisfy Dodd-Frank risk retention, observing in the preamble to the Final Rules that non-U.S. jurisdictions do
not recognize U.S. risk retention and that accommodating different interests across regimes would be
impracticable. In addition, the Agencies state that unfunded forms of risk retention, which may be permissible SIDLEY UPDATE
under other regimes, do not provide for sufficient alignment of incentives.31 As a result, unfunded forms of risk
retention such as guarantees, liquidity facilities, letters of credit and synthetic exposures, which are acceptable in
certain circumstances under European Union (“EU”) risk retention requirements (discussed below), would not
be available under Dodd-Frank risk retention requirements except as described above in Section 3 under
FDIC Securitization Safe Harbor Rule
The Final Rules’ risk retention requirements apply to sponsors without regard to whether the securitizer is a
financial institution or other regulated entity. In September 2010, the FDIC adopted a safe harbor rule (the
“FDIC Safe Harbor Rule”) regarding treatment by the FDIC, as conservator or receiver of an insured depository
institution, of securitizations issued after September 30, 2010, that conditions its applicability on compliance
with certain securitization best practice requirements, including a credit risk retention requirement.32 In
anticipation of the Final Rules, the FDIC Safe Harbor Rule provides that its risk retention requirements (but not
its other requirements) will automatically conform to the final Section 15G risk retention rule upon the “effective
date” of such final rule. It is not entirely clear from the FDIC Safe Harbor Rule whether the term “effective date”
refers to the date on which the Final Rules are published in the Federal Register or the actual Effective Date of
the requirements (which, as noted above, will be one year or two years after such publication date, depending on
the type of asset-backed security); however, it appears that the latter is the more reasonable conclusion.33
The FDIC Safe Harbor Rule’s current risk retention requirement differs materially from that under Section 15G
and the Final Rules, including by limiting the forms of risk retention to two options: vertical slice and
representative sample risk retention. By operation of the “auto-conform” provision of the FDIC Safe Harbor
Rule, risk retention will be governed by the Final Rules, which will result in the elimination of the representative
sample risk retention option. This alternative has been popular among FDIC-regulated sponsors of automobile
European Union Risk Retention Regime
Securitization risk retention, due diligence and ongoing monitoring requirements apply to EU credit institutions
(generally, banks) and EU investment firms under Articles 404-410 of the EU Capital Requirements Regulation
(Regulation (EU) No 575/2013) (“CRR”). The current CRR risk retention regime generally restricts a European
credit institution or investment firm (together with its consolidated group affiliates) from investing in a
securitization (as defined by the CRR) unless the originator, sponsor or original lender (within the meaning of
CRR) in respect of that securitization has explicitly disclosed that it will retain, on an ongoing basis, a material
net economic interest of not less than 5% in that securitization in the manner contemplated by Article 405 of the
CRR. Similar, but not identical, requirements to those set out in Articles 404 to 410 of the CRR also apply to
31 The Agencies appear to believe that a contractual promise to absorb losses, rather than actual investment at risk, is not sufficient to satisfy its
notion of “skin in the game.” The Agencies acknowledge the (sometimes stark) bifurcation of approaches proposed–sponsors either may take
advantage of an exemption or full or partial exception, or must satisfy the more onerous standard risk retention option–yet appear to have ignored
the role unfunded risk retention options could play.
32 We summarized the FDIC Safe Harbor Rule, including its risk retention requirement, in a Sidley Update dated October 4, 2010, available at:
33 The FDIC may have intended the former, but there has been no formal statement in this regard.SIDLEY UPDATE
regulated alternative investment fund managers under the European Union’s Alternative Investment Fund
Managers Directive (Directive 2011/61/EU).34
There are some fundamental differences in approach between the EU risk retention requirements and Section
15G of the Exchange Act and the Final Rules, including, among others, the absence of sunset provisions and
asset-based exemptions under the EU regime, the absence of a representative sample option as a form of risk
retention under the Final Rules (which continues to be available under the EU provisions), and the differing
requirements as to persons that may hold the retained interest within the context of CLO transactions.
Accordingly, the interplay between the Final Rules and the EU regime will require close consideration when
structuring asset-backed securities offered globally. This may present challenges in certain cases, particularly
because no mutual recognition exists between the United States and European Economic Area regulators with
regard to risk retention.
The following Sidley lawyers or your regular contacts at the firm would be pleased to provide more information.
Thomas P. Brown
Mark I. Greenberg
To receive Sidley Updates, please sign up at www.sidley.com/subscribe.
34 We address the EU risk retention regime in the following Sidley Updates: (i) Sidley Update dated January 30, 2014 (“EU Securitization Risk
Retention Proposals: Issues for Consideration in Cross-Border Transactions”), available at: http://www.sidley.com/European-Banking-AuthorityProposals-on-EU-Risk-Retention-Rules-Issues-for-Consideration-on-Cross-Border-Transactions-01-30-2014/;
and (ii) Sidley Update dated May 22,
2013 (“AIFM Directive 2013 Sidley Update: Securitisation Risk Retention Requirement”), available at: http://www.sidley.com/AIFM-Directive-
Fair Value Disclosures and Recordkeeping Requirements
The Final Rules impose disclosure obligations with respect to the sponsor’s fair value determination of a
horizontal residual interest and certain other material items. The Final Rules require disclosure at two points in
time: (i) first, to potential investors under the caption “Credit Risk Retention” (presumably, this will be in the
preliminary offering document) a reasonable period of time prior to the sale of the asset-backed securities and
(ii) second, to investors a reasonable period of time after the closing of the securitization transaction.
Prior to sale:
• the fair value (expressed as a percentage of the fair value of all of the ABS interests issued in the
securitization transaction and dollar amount) of the horizontal residual interest that the sponsor expects to
retain at the closing of the securitization; if specific prices, sizes or rates of interest of each tranche of the
securitization are not available, the sponsor must disclose a range of such fair values based upon a range of
bona fide estimates of such prices, sizes and rates of interest; the sponsor disclosing such ranges must also
disclose the method by which it determined such ranges;
• a description of the material terms of the horizontal residual interest;
• a description of the valuation methodology used to calculate the fair value (or range of fair values) of all
classes of ABS interests;
• the key inputs and assumptions (or a comprehensive description thereof) used in measuring the estimated
total fair value (or ranges thereof) of all classes of ABS interests; to the extent applicable, such disclosure of
inputs and assumptions must include (1) discount rates, (2) loss given default (recovery ), (3) prepayment
rates, (4) default rates, (5) lag time between default and recovery, and (6) the basis for forward interest rates
• a summary description of the reference data set or other historical information used to develop these key
inputs and assumptions;
• descriptions of all inputs and assumptions that could have a material impact on the fair value calculation or
would be material to an investor’s ability to evaluate the calculation. If the description includes a description
of curves, it must include the methodology used to derive each curve and a description of any aspects of each
curve that could materially affect the fair value calculation or an investor’s ability to evaluate the calculation;
• if the sponsor uses information about the securitized assets in its fair value calculation, that information
must be as of a date not more than 60 days prior to the date of first use by investors (or 135 days in the case
of a securitization that pays quarterly or less frequently).
• the fair value calculation for the actual retained horizontal residual interest at closing time, based on actual
sales prices and tranche size;SIDLEY UPDATE
• the fair value (expressed as a percentage of the fair value of all ABA interests) of the actual retained
horizontal residual interest and such fair value percentage for the required retained horizontal residual
• if the valuation methodology or key inputs or assumptions used prior to sale materially differ from those
used at the closing, a description of those material differences.
If the sponsor uses a horizontal cash reserve account, the sponsor must disclose comparable information. If the
sponsor retains a vertical interest, it must disclose, a reasonable time both before the sale and after the closing,
various information, including the amount and form of the vertical interest and the material terms thereof.
The special calculation and disclosure rules for revolving pool securitizations are discussed in Section 7.
The Final Rules add records maintenance requirements with respect to the disclosures described above.
Sponsors would be required to maintain written records and provide disclosures to the SEC and, if applicable, its
federal banking agencies, until three years after all ABS interests are no longer outstanding.35
BEIJING ∙ BOSTON ∙ BRUSSELS ∙ CHICAGO ∙ DALLAS ∙ GENEVA ∙ HONG KONG ∙ HOUSTON ∙ LONDON ∙ LOS ANGELES NEW YORK ∙
PALO ALTO ∙ SAN FRANCISCO ∙ SHANGHAI ∙ SINGAPORE ∙ SYDNEY ∙ TOKYO ∙ WASHINGTON, D.C.
Sidley Austin refers to Sidley Austin LLP and affiliated partnerships as explained at www.sidley.com/disclaimer. www.sidley.com
35 Perhaps because of an oversight, the express language setting forth the three-year recordkeeping requirement does not appear to limit the
disclosure requirement to a single series of asset-backed securities or securitization transaction, but instead applies to “all ABS interests.”