In a complex securitization structure, determining the identity of the sponsor under the credit risk retention rules can be a daunting task.
Under the credit risk retention rules adopted pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act), a single “sponsor” of a securitization generally is responsible for retaining not less than 5% of the credit risk of any asset that, through the issuance of asset-backed securities (ABS), is transferred, sold, or conveyed to a third party. By requiring that sponsors retain a significant economic interest in their securitizations, the rules are intended to provide an incentive to monitor and ensure the quality of assets that are securitized and to better align the economic interests of sponsors with their investors.
Under the rules, a “sponsor” “organizes and initiates a securitization transaction by either selling or transferring assets, either directly or indirectly, including through an affiliate, to the issuing entity.” Obviously, determining the identity of the sponsor that must retain the required risk is critical. That party bears significant legal responsibilities for an extended period of time and must have the financial wherewithal to acquire and hold the required interest.
In a simple securitization structure, determining the identity of the sponsor may be fairly straightforward. For example, in an automobile retail contract securitization by a captive finance company of a manufacturer, the finance company is likely to have originated all the receivables, to service the receivables on an ongoing basis, to own the depositor, to select the receivables for the asset pool, to transfer the receivables through the depositor to the issuing entity, and to structure and control the securitization of those receivables through its employees. In these circumstances, it is clear that the finance company is the sponsor. That result is logical—the finance company is clearly the entity with the most significant ability to influence the quality of its securitization, and will likely have the financial capacity to fund the acquisition and long-term holding of the risk retention interest.
In a more complicated structure, where securitization roles are more dispersed, the identity of the sponsor (or sponsors) may be far less clear. For example, many investment funds are significant investors in and securitizers of private label residential mortgage loans and marketplace loans. Assume that a fund group has invested in these types of assets and wishes to securitize them. Assume further that the receivables that are to be securitized are held by several investment funds in the group, that each of those funds is managed by an external investment adviser, that the depositor is located elsewhere in the fund group structure, that the receivables are selected and the securitization is structured and managed by personnel housed at both the investment manager and at other entities within the fund group structure, and that the receivables were originated by and are serviced by unrelated third parties. Identifying the sponsor of a securitization in such a structure is much more difficult. Even if you can identify a single sponsor, requiring that entity to retain the required credit risk may not serve the policy goals behind the rules, and that entity may not be financially capable of acquiring or maintaining the required risk retention position. Perhaps more importantly, it may be desirable for the funds themselves to bear the economic benefit and burden of the required risk retention interest in proportion to their contribution of receivables to the securitization.
In this LawFlash, we examine in detail the factors that go into determining the identity of the sponsor of a securitization—beyond the text of the definition in the Dodd-Frank Act. We also discuss how a securitizer may use these factors to better identify a clear and logical sponsor for its securitizations, one that supports the policy goals behind the rules and that has the financial wherewithal to fund and maintain the required risk retention position. Finally, while sponsors generally are prohibited from transferring or hedging the retained interest, we explore several provisions of the rules that may allow other parties to hold or finance that interest.
This LawFlash represents our current views in an evolving area. We note that the Agencies have not specifically addressed these issues, and if they did, their conclusions could differ.
History of the Definition of “Sponsor”
The definition of “sponsor” in the risk retention rules is substantially identical to the longstanding definition of “sponsor” under Regulation AB, as “the person who organizes and initiates an asset-backed securities transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the issuing entity.” However, the determination of the sponsor’s identity under Regulation AB never engendered nearly the attention that has resulted from the adoption of the risk retention rules. Why is that?
Under Regulation AB, the only real implication of being the sponsor was the disclosure about the sponsor required in registered public offerings. The required disclosure regarding the sponsor is fairly limited; most of the more detailed disclosures about an entity that serves as a sponsor are required by its activity in other capacities, such as servicer or originator. Moreover, particularly in the period since the credit crisis, many of the securitizations of the types of assets that are commonly owned and securitized by investment funds (e.g., private label residential mortgage loans and marketplace loans) and other company groups with complex ownership structures have been accomplished privately in Rule 144A offerings to which the disclosure requirements of Regulation AB do not apply directly.
Other rules previously adopted under the Dodd-Frank Act have placed more substantive obligations on the sponsor. For example, Rule 15Ga-1 requires the securitizer (for this purpose, the sponsor or the depositor) to file quarterly or annual Forms ABS-15G to disclose repurchase demand activity regarding the asset pool. However, the identity of the sponsor under these rules still does not pose anything close to the level of importance implied by the risk retention rules.
For these reasons, prior determinations of sponsor status generally have not been scrutinized nearly as closely as they have since the adoption of the credit risk retention rules. The fact that an entity was designated as the “sponsor” of a securitization program prior to its required compliance with the risk retention rules should not be dispositive.
Factors to Be Considered in Identifying a Sponsor
The Agencies provided significant additional guidance on how to identify the sponsor of a securitization in the commentary accompanying the adoption of the rules:
The agencies believe that the organization and initiation criteria . . . are critical to determining whether a person is a . . . sponsor. The agencies are of the view that, in order to qualify as a party that organizes and initiates a securitization transaction and, thus, as a . . . sponsor, the party must have actively participated in the organization and initiation activities that would be expected to impact the quality of the securitized assets underlying the asset-backed securitization transaction, typically through underwriting and/or asset selection.
The underwriting or selection of the pool assets for the securitization is of such importance that, in the context of a collateral manager of a collateralized loan obligation (CLO) vehicle, the Agencies concluded that it is not necessary for the collateral manager ever to have legally owned or possessed the pool assets to be deemed to have “transferred” them to the issuing entity, because it selects the pool assets and directs the issuing entity to purchase them.
Further to the guidance above:
[A]n entity that serves only as a pass-through conduit for assets that are transferred into a securitization vehicle, or that only purchases assets at the direction of an independent asset or investment manager, only pre-approves the purchase of assets before selection, or only approves the purchase of assets after such purchase has been made would not qualify as a ‘‘sponsor’’. If such a person retained risk, it would be an impermissible third-party holder of risk retention for purposes of the rule, because such activities, in and of themselves, do not rise to the level of ‘‘organization and initiation’’. In addition, negotiation of underwriting criteria or asset selection criteria or merely acting as a ‘‘rubber stamp’’ for decisions made by other transaction parties does not sufficiently distinguish passive investment from the level of active participation expected of a sponsor . . . .
Thus, the commentary in the Adopting Release adds two crucial factors for the determination of sponsorship status:
- Active selection of the assets to be securitized (the most important factor); and
- Undertaking active selection of the assets and other organizational and initiation activities through its own employees, rather than at the direction of a third party or acting solely as a “rubber stamp.”
These factors add to (and are more important than) the sole specific factor identified in the definition of “sponsor” itself:
- Transfer, directly or indirectly, of the receivables to the issuing entity.
As noted by the Agencies, the crucial asset selection and “no rubber stamp” factors derive from the requirement that the sponsor “organize and initiate” the securitization. In the view of our firm and based on our experience in the securitization markets, other typical functions of a sponsor that support the conclusion that it organizes and initiates a securitization include the following:
- Ownership of the equity of the depositor;
- Formation of the issuing entity;
- Selection of the underwriter, initial purchaser or placement agent for the securitization and negotiation of the related contractual arrangements;
- Structuring of the securitization, in cooperation with underwriter, initial purchaser or placement agent;
- Engagement of issuer’s counsel and accountants;
- Selection and contracting with any third-party due diligence service providers (other than those engaged by the underwriter, initial purchaser or placement agent);
- Performance of all due diligence not performed by the underwriter, initial purchaser or placement agent and hired third-party providers;
- Drafting, together with issuer’s counsel, the transaction documents and the disclosure documents;
- Servicing the assets to the extent that they are not serviced by third-party servicers, and overseeing any servicing undertaken by third-party servicers; and
- Selection and negotiation of the terms of engagement of the transaction parties on behalf of the issuer, including the trustees, custodians, servicers and rating agencies.
In the investment fund example described above, the key asset selection and “no rubber stamp” factors, taken on their own, may point to the investment manager of the fund as being the sponsor of the securitization. This result is not necessarily consistent with the policy underlying the rules and is unlikely to lead to an economically desirable result. Given the dispersal of other responsibilities in the example, the other factors do not make identifying an appropriate sponsor in the existing structure significantly easier. However, they can provide a roadmap for restructuring the organizational chart to point towards the desired entity, which may be an existing entity in the structure or may be newly formed.
In general, to be the sponsor, an entity should select the assets to be securitized and perform as many of the other identified securitization functions as possible, acting through its own employees. “Dual-hatting” those employees with other entities in the structure may be acceptable, so long as their securitization-related functions are clearly undertaken in their capacities as employees of the sponsor.
It also is advisable that the receivables pass through the sponsor on their way to the issuing entity. This may not necessarily be strictly required, in light of the CLO language from the Adopting Release quoted above. However, we believe it is helpful to the analysis, because this factor is part of the definition of “sponsor.” In our view, taking an economic risk in acquiring the pool assets is a positive factor in coming to a sponsorship conclusion.
If we slightly modify our investment fund example to contemplate a fund structure with only a single fund, it may be simplest to ensure that the fund itself performs most organization and initiation activities through its own personnel, who may be dual-hatted with the investment adviser and others. In this example, the fund would be the sponsor of its own securitization and could directly hold the required risk retention interest. There is no need for the receivables to pass through any other entity on their way to the issuing entity because the receivables start their journey in the portfolio of the fund. One potential drawback of this approach is that a fund with a limited life may expire before the risk retention rules permit disposition of the risk retention interests, which could violate the risk retention rules. There also may be tax issues to this approach if the fund is a foreign entity. Otherwise, this may be a clean solution in appropriate circumstances.
If (as we originally assumed) there are multiple funds providing the receivables for the asset pool, then management of the securitization process may be restructured so that a different entity performs most securitization organization and initiation activities using its own personnel. That sponsor entity may be an existing entity that already houses some of these functions, or may be newly formed. As noted, the argument that this entity is the sponsor will be strengthened if the receivables pass through the identified entity on their way to the issuing entity. An advance purchase—in which the sponsor entity takes some or all of the risk that the receivables may not all be able to be successfully securitized—may further strengthen the conclusion.
If, for practical reasons, enough of the group’s securitization functions have been transferred to the identified sponsor entity and its personnel to reach the conclusion that it is the sole sponsor, but sufficient such functions remain with other entities and their personnel to raise concerns that one or more of those other entities might also be sponsors, a co-sponsorship arrangement is a possible solution. As noted above, where there are multiple sponsors of a securitization, the rules permit (and in fact require) only one of them to hold the required risk retention interest, and the other sponsors are legally responsible for its compliance with the rules. We generally would expect to see this arrangement between co-sponsors memorialized in a contract.
Ownership of Sponsor and Majority-Owned Affiliates
In general, a sponsor is prohibited from transferring the retained interest, hedging the retained credit risk, or pledging the retained interest on other than a full recourse basis. However, the rules do contemplate certain exceptions.
Where the risk retention rules require or permit the sponsor or any other party to retain credit risk, then except as otherwise specifically provided, the risk may be retained by majority-owned affiliates (MOAs) of that party. A “majority-owned affiliate” of a party is an entity other than the issuer that directly or indirectly majority controls, is majority controlled by, or is under common majority control with, that party. For these purposes, “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 generally accepted accounting principles (GAAP).
In our experience, to reach a determination that an entity has a “controlling financial interest” in another, major accounting firms typically have required that the controlling entity hold at least 20% of the equity interests in the controlled entity, and virtually all of the voting rights in and other control features over the controlled entity (save, potentially, a veto right over merger, dissolution, and other fundamental corporate transactions). Therefore, in appropriate circumstances, it may be acceptable for a subsidiary of a sponsor to be an MOA of the sponsor and to hold the required risk retention, even if a significant portion of the economic equity in the subsidiary is held by other entities (including, in a multiple fund structure, the funds contributing pool assets to a securitization).
Nothing in the rules specifically addresses who may own the sponsor, so ownership of the sponsor may be another way to ensure that the economic benefits and burdens of risk retention go back to the appropriate parties. Multiple affiliated investment funds that intend to contribute assets to a securitization could form a new entity in which they own 100% of the equity. This new entity could then be allocated personnel and the lion’s share of the responsibility for the fund group’s securitization organization and initiation activities, and thus become the sponsor of the securitization. In appropriate circumstances, it may be permissible for the funds in this structure to share the economic benefits and burdens of the risk retention interest through their ownership of the sponsor.
Financing the Risk Retention Interest
The rules specifically contemplate that the sponsor (or its MOA) may finance its risk retention interest in certain circumstances. As noted, neither a sponsor nor any affiliate may pledge an interest it is required to retain as collateral for any financing (including a transaction structured as a repurchase agreement) unless the financing is full recourse to the borrower.
Neither the text of the rules nor the Adopting Release specifies what is meant by “full recourse.” Any financing of the risk retention piece clearly should be full recourse by its terms to the financing sponsor or MOA, placing no restrictions on the ability of the lenders to enforce the terms of the financing against the sponsor (or MOA) and all of its assets. We note, however, that if a sponsor or MOA has “pledged the interest . . . to support recourse financing and subsequently allowed (whether by consent, pursuant to the exercise of remedies by the counterparty or otherwise) the interest . . . to be taken by the counterparty to the financing transaction, the sponsor will have violated the prohibition on transfer.”
The requirement that the facility be “full recourse” may not prohibit closely affiliated entities from also being responsible for repayment of the facility (whether as a co-borrower or guarantor), particularly if the more creditworthy of those additional obligors are one or more of the affiliated funds that are the source of the asset pool.
Limits on Transferring or Hedging the Required Risk
As we have noted, a sponsor (or its MOA) generally is prohibited from transferring the required risk retention interest or hedging the retained credit risk. The rules specifically contemplate that the required risk retention interest may be held by an MOA of the sponsor and may be financed by the sponsor or its MOA on a full-recourse basis.
Nothing in the rules or the Adopting Release prohibits an MOA from issuing to others the portion of its economic equity that is not required to be retained by the sponsor, or prohibits a sponsor’s equity from being owned by any entity in any amount, and the rules specifically contemplate full recourse financing of the risk retention interest. One might wonder whether the prohibition on transfer and hedging may be violated by such arrangements, on the theory that the use of techniques that are otherwise permitted by the rules may move the benefits and burdens of ownership of the risk retention interest so far away from the securitization that the retention no longer serves as an effective incentive for a high-quality securitization. However, in the examples we have been discussing, equity interests in the sponsor or an MOA are allocated to the affiliated funds that are the source of the receivables in the asset pool, and any financing is on a full recourse basis as contemplated by the rules. While all factual situations are different, using these techniques in this limited manner seems unlikely to contravene the rules’ restriction on transfer or hedging.
When adopting the credit risk retention rules, the Agencies likely were considering only simpler securitization structures where the identity of the sponsor is relatively clear. The definition of “sponsor” may not on its own provide enough guidance to identify the sponsor of a securitization in a more complex structure, such as a fund group securitizing its portfolio of private label residential mortgage loans or marketplace loans.
Guidance given by the Agencies in the Adopting Release leads us to a list of specific securitization organization and initiation factors that we believe should be considered in determining the identity of the sponsor, but even these factors may not provide enough guidance for fund and other corporate groups with widely dispersed securitization roles to identify an existing sponsor with a high degree of certainty. These groups may use the sponsorship determination factors to restructure their operations, so it is clear that the desired entity (whether existing or newly formed) is the sponsor.
The formation of an MOA and the allocation of the equity interests in the MOA, as well as the allocation of the equity interests in the sponsor itself, are additional tools that may be used to ensure that the economic benefits and burdens of holding the risk retention interest ultimately rest with the appropriate parties. Full recourse financing of the required risk retention interest is specifically contemplated by the rules. The responsible use of these techniques should not run afoul of the rules’ prohibition on transfer and hedging.