Since its initial release we have received numerous inquiries from market participants (clients and non-clients alike) concerning the meaning and ramifications of the final U.S. risk retention rule (the “Final Rule”) on collateralized loan obligation transactions (“CLOs”). Our first DechertOnPoint on the subject1 laid out some very early stage proposals for consideration by market participants. In this follow-up, we address some frequently-asked questions regarding compliance with the Final Rule.
What structuring options are available for asset managers currently managing CLOs who wish to or need to set up a new entity (or restructure an existing entity) to manage their future CLOs and raise the capital necessary to hold risk retention?
In the Final Rule, the rulemaking agencies (the “Agencies”)2 provided that the collateral manager in a CLO (the “CLO Manager”) is a sponsor by virtue of its selection and management of the loans in the CLO.3Since most asset management firms currently serving as CLO Managers are fee-for-service agents4 and are not capitalized in a manner that would permit such entities to purchase the credit risk retention interest5 required under the Final Rule (a “Retention Interest”), a number of the questions we have received revolve around the options available to such CLO Managers to be able to comply with the Final Rule. Although the effective date of the Final Rule is not until December 24, 2016 (the “Effective Date”), many CLO Managers are addressing this issue now since they believe it will be important to be able to explain to investors in new CLOs how they intend to comply with the Final Rule on and after the Effective Date and because, absent other guidance from the Agencies, the CLO Manager will need to hold an appropriate Retention Interest so it does not inadvertently run afoul of the Final Rule if a CLO after the Effective Date issues additional securities or undertakes a refinancing or repricing as described below.
CLO Managers typically earn fees for their related asset management services. Although many CLO Managers make an equity investment in the CLOs they manage, most will need to raise additional capital to be able to acquire the Retention Interests mandated by the Final Rule. We expect that one result of the Final Rule will be that third party investors who historically have invested directly in CLOs may now consider doing so directly and/or indirectly through a vehicle that owns the related Retention Interest.
There are a number of options CLO Managers may consider for raising additional capital, and one size will not fit all CLO Managers. Each solution will be unique to its platform and may be combined with other options. Having said that, there are two main options CLO Managers have been considering for raising capital—the highlights of which are discussed in more detail below.6
One option involves approaching investors and seeking their investment directly into the existing CLO Manager entity. This option may itself be accompanied by a significant restructuring of the existing CLO Manager to enable the new investors to participate alongside existing investors on economic terms agreeable to each investor base. While certain to be pursued by some CLO Managers, most have indicated a preference for a variant of this approach, which is being termed the capitalized manager vehicle (“CMV”) option. The CMV option involves the creation of a newly capitalized and self-managed CLO Manager that would be the CLO manager and hold risk retention interests on a going forward basis for a number of transactions. As with the creation of any new entity, raising the money, negotiating the terms and setting up a CMV necessarily entails significant time and expense—probably more so than any of the other options. However, one reason many are attracted to this approach is that, if properly structured, the CMV will very likely satisfy not only the letter but also the spirit of the Final Rule. In addition, a CMV could also be further structured in a manner to satisfy EU risk retention requirements thereby offsetting some of the cost and expense and serving as a more global solution for these managers.7
Another option is for the CLO Manager to form a majority owned affiliate (“MOA”) in which it will either own more than a majority of the voting and economic equity in the MOA or with respect to which it will control the significant economic decisions to be made by the MOA and own a controlling financial interest in the MOA as determined under U.S. generally accepted accounting principles (“GAAP”). This structure allows the CLO Manager to continue to be the collateral manager of a CLO and receive management fees there from while its MOA will hold the Retention Interest and receive the related payments with respect thereto.
Each of these structures would permit the Retention Interest vehicle to capitalize itself using both debt and equity capital.
Capitalized Manager Vehicle (CMV) Option
In broad terms, we would expect each CMV to be structured along the following lines. The CMV would be the collateral manager of the CLO and the entity that holds the Retention Interest, either directly or through an MOA. The CMV could be capitalized in various ways, including by way of equity alone or debt and equity. As with any operating asset management entity, the capital would fund the expenses of the entity as well as any capital investment undertaken by the entity (including acquisition of the Retention Interest). The CMV would earn CLO management fees and returns on the Retention Interest and on any other assets that might be owned by the CMV. All earnings of the CMV would be distributed through a payment waterfall to the debt and/or equity holders of the CMV. The waterfall would be reflective of investor stipulations and include payments to service providers (including the Staff and Services Provider (as defined below), if applicable). To avoid the risk of the CMV being characterized as an impermissible use by a CLO Manager of third party equity to satisfy risk retention under the Final Rule,8 the CMV would be self managed, would not refer to or track specific Retention Interests and would not directly pass CLO management fees through to the entity or entities providing personnel and back office support needed to carry on the day to day operations of the management business (the “Staff and Services Provider”).
The CMV would be the CLO Manager for each CLO and ideally would be a registered investment advisor.9 The CMV’s CLO management business could be self-contained in whole or in part within the CMV with the CMV employing personnel itself, or personnel could be obtained via secondment under a staff and services agreement with the Staff and Services Provider.
Finally, since the sponsor of a CLO is an entity that “organizes and initiates”10 the transaction, the CMV, in our view, must be a self-managed entity with substantive decision-making power within the entity itself. In that regard, to the extent that another entity (including the Staff and Services Provider, if applicable) performs any of the collateral management functions (i.e., underwriting, asset selection or asset management) on its behalf, through delegation11 or otherwise, the CMV should have a board of directors, at least a majority of which are independent, similar to a board of a business development company, that exercises customary oversight of the CMV, its investment management activities and its conflicts of interest and which would have the power to terminate the Staff and Services Provider or any other entity that provides services on its behalf or to which the CMV has delegated any duties.
To the extent the CMV receives or is deemed to receive income from its management activities, this may raise tax implications for U.S. trade or business tax sensitive direct and indirect investors in the CMV. For those investors, tax counsel should be consulted as to how to address these concerns when the CMV is set up initially.
Majority Owned Affiliate (MOA) Option
The Final Rule permits a sponsor to satisfy its retention obligation by having its MOA hold the Retention Interest. Under this approach the CLO Manager acts as the collateral manager of the CLO and receives the related CLO management fees. The MOA of the CLO Manager holds the Retention Interest and receives returns thereon. MOA is defined as “an entity (other than the issuing entity) that, directly or indirectly, majority controls, is majority controlled by or is under common majority control with, such person. For purposes of this definition, majority control means ownership of more than 50% of the equity of an entity, or ownership of any other controlling financial interest in the entity, as determined under GAAP.”12 A CLO Manager seeking to effectuate this option will need to either itself, or via its owner who majority controls it (and who will continue to do so), (i) hold more than 50% of the voting interests and economic equity in the MOA or (ii) if the MOA is a variable interest entity under GAAP, possess the power to direct the activities that most significantly impact the MOA’s economic performance and hold a controlling financial interest as determined under GAAP. In the preamble to the Final Rule, the Agencies explained that they replaced the concept of a consolidated affiliate as a permitted holder of the Retention Interest with this formulation since it “ensures that any loss suffered by the holder of risk retention will be suffered by either the sponsor or an entity in which the sponsor has a substantial economic interest.”13
To satisfy clause (ii) of the MOA option, the CLO Manager will need to obtain an opinion or other comfort from its accountants that it has a controlling financial interest determined under GAAP. This term is typically used under GAAP to determine which person, if any, is required to consolidate a variable interest entity under GAAP. The CLO Manager (or its owner) will need to control the major economic decisions of the MOA in relation to the Retention Interest and any other assets owned by the MOA. It will also need to own enough of the economic equity in the MOA to be determined to have a “controlling financial interest” under GAAP. Later this year it is expected that GAAP will migrate to a “principal/agent” approach under which to make this determination and any such determination will entail a facts and circumstances analysis by the accountants. We currently expect that most accounting firms will want to see that the CLO Manager (or its owner) not only controls the major economic decisions of the MOA but also owns at least 10% to 20% of the economic equity in the MOA.
Compared to the CMV option, the MOA option is likely a less time consuming and legally intensive vehicle to set up. However, as an initial matter, this approach has appeared less appealing to some since a MOA may not be structured nor be sufficiently capitalized to serve as an “originator” for those who want to satisfy both U.S. and EU risk retention requirements. That being said, we are also considering a variant on the MOA structure that might satisfy EU risk retention requirements with a separate EU originator vehicle providing third party equity to the MOA.
If a CLO which closed prior to the effective date of the Final Rule engages in a refinancing or issues new securities, does this trigger a risk retention requirement?
The risk retention requirements of the Final Rule apply to any “securitization transaction” which takes place after the Effective Date. Since a “securitization transaction” involves any “offer and sale of asset-backed securities”, certain actions taken by a CLO which closed prior to the Effective Date could bring the CLO into the purview of the Final Rule after the Effective Date. Under the Securities Act understanding of what constitutes a new offering, a refinancing in which existing securities are redeemed and new securities are issued14 would be considered a new “offer and sale”, as would an additional issuance of new securities.
We do not believe the Agencies intended to subject existing CLOs which undertake a refinancing to the new risk retention requirements for a number of reasons. Notably, such transactions lack a statutory prerequisite in that they contain no “securitizer” since there is no new credit risk being transferred to investors as a result of the refinancing. In addition, requiring the sponsor to acquire a Retention Interest in connection with a refinancing raises practical concerns as the CLO Manager would not have any unilateral right to acquire the securities necessary to satisfy the Final Rule in such grandfathered CLO. It also does not comport with the policy behind the two year phase-in of the Final Rule. We expect and hope for further clarification on this point from the Agencies; however, absent any such guidance, market participants will resolve the uncertainty by taking the position that a refinancing or an additional issuance after the Effective Date brings the CLO within the scope of the Final Rule.
What about re-pricings?
Since re-pricings generally involve only a change in interest rate to the CLO, whether or not a new “offer and sale” have taken place is less clear. As a general securities law matter, if the transaction presents the investor with a decision that could be construed as a new investment decision with respect to the security, this would be viewed as a new “offer.” Further, as noted below, in contexts separate from the U.S. Risk Retention Rules, the SEC and various courts have indicated that certain amendments to transaction documents, including amendments which affect the fundamental economic terms of the relevant securities, may rise to the level of an “offer to sell” of new securities. In the re-pricing provisions of most CLOs, the re-pricing mechanic does not occur automatically (but at the request of the equity or the CLO Manager or both), and noteholders are given an opportunity to keep their notes at the revised interest rate or, if they do not consent to the re-pricing, to sell at a pre-determined redemption price (typically par plus accrued interest). Given that standard CLO re-pricing mechanics require consent of all affected noteholders (with the mandate to buy out those that do not consent), and that reducing the interest rate is generally regarded as a change in the fundamental economic terms of the securities (discussed further below), a re-pricing would likely be considered a new offering of a security for Securities Act purposes, thus making it likely that the CLO would be caught up in the Final Rule as a new “securitization transaction” involving the “offer and sale” of asset-backed securities after the Effective Date. However, like refinancing, to require a grandfathered CLO to comply with the Final Rule simply because it has undertaken a repricing raises similar practical concerns as a refinancing (it may not be possible for the CLO Manager to acquire the securities necessary), and also, like a refinancing, does not implicate the overarching policy goal of the Final Rule (namely, the improvement in the credit quality of assets going into a securitization) since no new assets are transferred in connection with a re-pricing. Thus, we similarly expect and hope for some explicit relief on this point from the SEC.
In addition, market participants may be able to revise standard CLO re-pricing mechanics to make the interest rate re-setting procedures more akin to what takes place with auction rate securities. These auction rate securities typically provide that an auction occur automatically at certain pre-determined intervals at which the dividend rate or interest rate is reset by means of an auction, with a failed auction resulting in an automatic re-set of rates at a pre-determined level. Since issuers of auction rate securities (such as auction rate preferred stock) have received some comfort from the SEC that, in those contexts, the re-setting of interest rates based on an auction does not necessarily rise to the level of a new “offer” with each auction, we expect CLO securitizations to revise existing re-pricing mechanisms to more closely align with what is done in these types of auctions (and likely seek similar no-action relief from the SEC with respect to such mechanics) with the aim to prevent a triggering of risk retention requirements.
Aside from Re-Pricing, what other types of amendments to a grandfathered CLO could cause it to lose its grandfathered status?
Any amendment to a security which substantially affects the legal rights and obligations of the holders of the outstanding securities could constitute a new offering of a new investment.15 Thus, absent any guidance on this point from the Agencies or otherwise, an amendment to a CLO indenture that would rise to an “offer and sale” made after the Final Rule becomes effective could subject an otherwise grandfathered CLO to compliance with the Final Rule.
The SEC and courts have provided some guidance as to what types of amendments so substantially alter the rights associated with the outstanding securities as to give rise to an offer and sale of a new security. In certain SEC no-action letters, certain fundamental economic terms of fixed-income securities have been identified as being so essential that an amendment of such terms would rise to the level of a new security, including items such as “payment of principal and interest, interest rate, interest payment date, maturity date, redeemability or sinking fund provisions.”16 Particularly, it has been established that an extension of the maturity date of a security is significant enough to rise to this level.17 On the other hand, the SEC has given no-action relief to a number of situations involving amendments which do not affect the fundamental rights of the holders or rise to a new investment decision; although this is a highly fact-specific analysis which can only be conducted on a case-by-case basis, certain types of CLO amendments, particularly those which do not require each affected noteholder to consent or even certain amendments which only require a majority to consent, would likely not rise to the level of a new offering of a new security and thus would not jeopardize the grandfathered status of the relevant CLO. Thus, parties wishing to amend the indenture of a grandfathered CLO should consult with counsel to determine whether the proposed amendment may bring the CLO within the purview of the Final Rule, and CLO Managers would be advised to ensure that CLO indentures provide that their consent is required for any such change.
To what extent would a CLO structured with one or more tranches documented as “loans” rather than “securities” fall under the risk retention requirements?
In the context of CLOs, many have asked whether a CLO structured with one or more loan tranches could exclude such tranches from the risk retention requirements. For instance, consider a CLO in which the most senior position in the capital stack is structured as a loan (e.g., the Class A Loan), while the remaining positions are structured as securities (e.g., Class B Note, Class C Note, etc.). While the line of demarcation between what is a loan and what is a security is far from clear, if that CLO has issued some securities, the entire CLO securitization would be subject to the risk retention requirements of the Final Rule, including any tranches structured as “loans.” This is due to the fact that the retention obligation is calculated on the value of all ABS interests issued in a transaction and not solely on the value of the asset-backed securities issued in such transaction. A loan, while not an asset-backed security, would fit within the definition of ABS interests as it would be considered an “obligation.” “ABS interests” are defined in pertinent part as “[a]ny 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” (emphasis added).18 As such, even assuming that loan tranches would not be considered asset-backed securities, should a CLO issue any asset-backed securities, the CLO sponsor would nonetheless be required to hold 5% of all tranches in such CLO.
To what extent would a loan to an SPV which is a wholly-owned subsidiary of a parent company fall under the risk retention requirements?
A properly arranged loan extended to a special purpose entity which is a wholly-owned subsidiary of a parent company would most likely not be subject to the Final Rule, because in most scenarios no asset-backed security would be issued. This is due to the fact that a properly structured loan should not be classified as a security. Further, the equity interests of the SPV in this context would arguably fall within the financing subsidiary carve-out of the definition of “asset-backed security” since the equity interests are only issued to the parent and, in any case, could potentially be structured so as not to depend for purposes of their payment primarily on the cash flow of the assets in the subsidiary.
While loans extended to special purpose entities may not need to comply with the Final Rule, the same may not be true for loans extended to SPVs to facilitate the short-term warehousing of loans prior to CLO closing, particularly if such warehouses have equity owners other than the parent (as is often the case).19While such loans are similar in many respects to long term loans extended to special purpose entities, the Agencies have indicated that a CLO is organized and initiated when the CLO sponsor “partners with a structuring bank that assists in financing asset purchases that occur before the legal formation of the CLO.”20 As such, it is possible that sponsors may be asked to comply with the Final Rule beginning as early as the closing of such a warehouse facility. In this context the sponsor may be required to hold equity equal to 5% of the value of the warehouse loans and the equity contributions.21
How does the ability to hold risk retention through a MOA reconcile with the anti-hedging provisions of the Final Rule?
As described above, the Final Rule permits a MOA to hold the Retention Interest.22 The Final Rule also includes a prohibition on hedging applicable to a sponsor and any of its affiliates.23
At the risk of lending this view more credence than it deserves, we note that some CLO market participants have suggested the breadth of the anti-hedging provisions could be problematic for certain types of MOAs established by a sponsor. Specifically, it has been suggested that the sale of an equity interest to a third party investor of the MOA would be the sale of a security that reduced the exposure of the sponsor. This line of thinking further posits that unless the MOA itself was significantly overcapitalized and/or engaged in other lines of business, the value, cash flow and losses of the security would correlate to the Retention Interest.
We, along with (as it appears) most of the market, reject this view. The formation and capitalization of a MOA to hold the Retention Interest, even if such MOA had no other assets or operations, comports with the Final Rule since it is expressly permitted and since the sale of the equity interests in a MOA to third party investors is not a hedge, either under the commonly-understood meaning of such term or under the Final Rule’s own terminology. As an initial matter, causing the MOA to purchase the Retention Interest is explicitly permitted by the Final Rule.24 Once issued, the equity interests in the MOA do not themselves “reduce or eliminate the exposure of the sponsor” as they do not entitle the sponsor (or any other party) to payments in the event of losses from the Retention Interest. Rather, the third party investor invests with the sponsor in the MOA, and both would share in the profits and losses of the Retention Interest held by the MOA as they mutually agree in the organizational documents of the MOA. Simply because a third party investor may provide a portion of the funds necessary for purchasing the Retention Interest and share in the economic upside or downside of the Retention Interest does not in any way “reduce or eliminate the exposure” of the MOA or the sponsor to the Retention Interest itself. Said another way, the mere establishment of a MOA in full compliance with the Final Rule does not in turn violate the Final Rule because it does not reduce or eliminate (i) the capital required to be infused into such MOA by the sponsor or (ii) the Retention Interest required to be held by a MOA.
Finally, we do not believe that our reading is an over-technical one designed to evade the Agencies’ intent. We note that the Agencies’ inclusion of the option for a “majority-owned” affiliate to hold the Retention Interest was not some inadvertent loophole, but appears to be a carefully considered and intentional decision. Further, the Agencies considered varying benchmarks on the ownership scale and landed on “majority-owned” affiliate after deeming “any consolidated affiliate” too broad in that it would include entities which the sponsor does not have sufficient economic exposure to25 and even posed the question of whether or not “wholly-owned” affiliate would be more appropriate.26 In the end, they deemed a “majority” ownership, as defined by them, sufficient economic exposure to satisfy the intent of the statute. We consider the Agencies’ statements regarding what constitutes sufficient economic exposure by a sponsor to credit risk of the securitization transaction and the discussion surrounding the various alternatives a strong indication that the possibility that a third party could partially capitalize the MOA was certainly an intentional one. The notion that the Agencies in one breath permit a sponsor to cause a MOA to hold the Retention Interest and then deny such route in another breath is not one which we espouse.