The new EU capital rules for banks and investment firms set out in the fourth Capital Requirements Directive 2013/36/EU (CRD IV) and the Capital Requirements Regulation (Regulation (EU) No 575/2013) (the CRR), collectively known as the CRD IV package, came into effect on January 1, 2014.
The re-cast securitization risk retention and due diligence requirements are incorporated in Part 5 (Articles 404-410) of the CRR and replace the rules that had become commonly known as “Article 122a” in the EU Banking Consolidation Directive.1 The CRR requires that the European Banking Authority (EBA) draft certain technical standards that will specify further measures with respect to the obligations under Part 5 of the CRR. The EBA published its final draft regulatory technical standards (the Draft RTS) and implementing technical standards (the Draft ITS and together with the Draft RTS, the EBA Standards) on December 17, 2013.2
While the EBA Standards will apply directly to entities regulated under the CRR, they will also be relevant when interpreting the equivalent risk retention rules that apply to: (i) alternative investment fund managers authorized under the EU Alternative Investment Fund Managers Directive3; and (ii) EU insurance companies under the Solvency II Directive.4 This update examines some of the changes that have been proposed under the EBA Standards, and focuses in particular on issues which may arise within the context of cross-border transactions.
Article 410 of the CRR mandates the EBA to prepare draft: (i) regulatory technical standards in relation to the risk retention and investor due diligence requirements; and (ii) implementing technical standards in relation to additional risk weights to be applied where the risk retention and related obligations have not been complied with (the Technical Standards). The Technical Standards will replace the guidance on Article 122a contained in the guidelines published by the Committee of European Banking Supervisors (the CEBS Guidelines) on December 31, 2010 and the Q&A document subsequently published by the EBA (the Q&A) on September 29, 2011.
The EBA published a consultation paper on the draft EBA Standards on May 22, 2013 (theConsultation Paper),5 which proposed technical standards that were significantly different from the CEBS Guidelines and did not carry over certain key provisions from both the CEBS Guidelines and Q&A. There has since been much discussion on the impact of the proposals, particularly within the context of the CLO market. However, the concerns were not restricted to CLOs; they extended to the broad array of financing transactions drawn under the CRR definition of a “securitisation”. There are relatively few changes between the initial proposals in the Consultation Paper and the final EBA Standards. The majority of the issues identified during the consultation process remain outstanding and will, to some extent, affect market participants worldwide, not just in the EU.
Key Issues Arising Under the EBA Standards
Removal of Aligned Entity Concept
Under Article 122a no credit institution (in effect, bank) was allowed to be “exposed” to a securitization position unless the originator, sponsor or original lender6 retained a “material net economic interest” of at least 5% in the securitization. Likewise, Article 405(1) of the CRR mandates the same requirement, but imposes the requirement also on EU investment firms regulated under the Markets in Financial Instruments Directive7 (MiFID).
In circumstances where there is no originator, sponsor or original lender, the CEBS Guidelines acknowledged that an entity whose interests were most optimally aligned with those of investors (the Aligned Entity) might be the risk retaining entity and specifically noted a non-credit institution collateral manager and a subordinated investor as examples of Aligned Entities. This flexibility in identifying the retaining entity had been helpful not only in addressing certain technical issues in respect of the definitions of “originator” and “sponsor”, but also in structuring transactions in circumstances where no other party was willing, or due to capital constraints was able, to hold the retained risk.
However, in a move which has caused some concern in the market, the EBA has replaced the concept of an Aligned Entity with an extended definition of “sponsor” (which under Article 122a was limited to credit institutions) to include certain categories of MiFID regulated investment firms. Although the revised definition will mean some CLO managers will now be permitted to be the risk retaining entity, many will still fall outside the scope of the definition, including such MiFID asset managers currently undergoing a re-authorization process under the Alternative Investment Fund Managers Directive. Importantly within the context of cross-border transactions, this means that managers outside of the EU will: (i) not be able to meet the definition of “sponsor” for purposes of the risk retention requirements; and (ii) no longer be able to rely on the Aligned Entity approach, thereby, curtailing their activities in the European securitization market.
Consolidated Risk Retention
Article 405(2) of the CRR allows (as did Article 122a) the retention requirement to be satisfied on the basis of holdings of a consolidated group if certain conditions are met. However, whilst the text of Article 122a(2) only referred to consolidated retention within the context of a group headed by an EU credit institution or financial holding company whose regulatory capital requirements are supervised on a consolidated basis, the CEBS Guidelines and Q&A allowed for consolidated retention by non-banking groups where the group reported on a consolidated basis for accounting purposes.
With this flexibility, groups headquartered outside the EU had been able to satisfy the risk retention requirements through an originator’s parent company or other consolidated group affiliates that did not necessarily qualify as an original lender, originator or sponsor. However, the Draft RTS do not carry over the corresponding provisions of the CEBS Guidelines or Q&A, and thus limit consolidated retention to EU entities under regulatory capital supervision. This will mean that groups headquartered outside of the EU, as well as unregulated EU financial groups will be confined to risk retention on a solo basis by an entity that meets the strict criteria of an original lender, originator or sponsor.
Grandfathering of Article 122a Transactions
The EBA’s Consultation Paper was silent on whether transactions with issue dates prior to January 1, 2014 that had been structured to be compliant with the CEBS Guidelines, but which may not be compliant with the CRR, would be grandfathered. The EBA Standards do not provide full grandfathering, but do provide that a competent authority “may” consider whether Article 122a and “the associated guidance was and is continuously met” in assessing whether additional risk weights should be applied in circumstances where there is a material failure to comply with the CRR by reason of negligence or omission in relation to transactions issued between January 1, 2011 and December 31, 2014.8
This provides some comfort for existing investors in securitization positions that have been structured in good faith on the basis of the CEBS Guidelines and Q&A, but do not comply with the CRR. This would include amongst others, CLOs and securitizations structured on the basis of the Aligned Entity concept and securitizations with consolidated group retention featuring non-EU entities. However, the proposed position does not go far enough in facilitating an investor’s ability to on-sell Article 122a legacy positions as the proposed grandfathering provision in the Draft ITS is limited to investors that actually held Article 122a compliant securitization positions prior to January 1, 2014.9
Other Points of Interest
The CRR risk retention rules apply to any consolidated affiliate of an EU credit institution or investment firm10 that takes credit exposures for the regulatory balance sheet of the consolidated group. This includes both regulated and unregulated consolidated affiliates (such as banks, securities firms, asset management firms, financial holding companies and even unregulated SPVs, in the financial group) regardless of where they are situated.
This can not only raise significant operational difficulties if subsidiaries are located in a non-EU jurisdiction where there are different or conflicting risk retention requirements, but also put these subsidiaries at a competitive disadvantage to other entities which are not subject to the EU risk retention requirements (because they are not subject to consolidation with an EU credit institution or investment firm). In this regard, the CEBS Guidelines had provided for some flexibility in the application of the due diligence requirements of Article 122a(4) and (5) with respect to investments or exposures to securitizations in a consolidated entity’s trading book. The CEBS Guidelines also contemplated EU banking groups using a “limited market-making function for non- or partially compliant securitizations (e.g. in their non-EU authorised entities, which do not themselves otherwise fall directly within the scope of the provisions of Article 122a).”11
The Draft RTS go further than the CEBS Guidelines in this regard, and expressly provide that non-compliant securitization positions held in the trading book on a consolidated basis for purposes of market-making activities by third country group entities would not be considered a breach of Article 405 of the CRR, provided that the securitization positions are not material with respect to the overall risk profile of the trading book of the group and do not form a disproportionate share of the trading activities of the group.12
Unfunded Forms of Risk Retention
The CEBS Guidelines provided flexibility with respect to the form of the retained interest, including retention on a synthetic or contingent basis (e.g., through the use of derivatives, guarantees and letters of credit). The Draft RTS limit unfunded forms of risk retention to circumstances where the risk retaining entity is a credit institution (i.e., a bank).
In this particular context, the definition of “credit institution” is not limited to EU banks. However, it means that any non-bank original lenders, originators and sponsors wanting to meet the retention requirement on a synthetic or contingent basis will have to fund the retention upfront by posting cash collateral in a segregated client account in support of their retention obligation.13
Harmonization of International Risk Retention Rules
As countries outside of the EU (notably, the United States) also move towards implementing rules on risk retention, there is a growing concern as to compliance with conflicting requirements of different regimes. During the EBA’s consultation process there were calls for an ability to amend the form of adopted risk retention in the event that a transaction subsequently needed to comply with third country (i.e., non-EU) requirements. In its response the EBA recognized the need for an internationally harmonized approach to risk retention, but it did not consider the Technical Standards to be the appropriate platform for such an objective. Nonetheless, the EBA did signal that Article 11(4) of the Draft RTS may be an avenue for changing the risk retention option if required in such circumstances.14 Article 11(4) generally restricts changes to the retention option during the life of a securitization,“unless such change is required due to exceptional circumstances and is not used as a means to reduce the amount of the retained interest.”
While the recognition of conflicting requirements is helpful and Article 11(4) may provide some relief when dealing with different forms of retention methods, that Article may be of limited assistance when seeking to address unsolvable conflicts such as differences in persons that may qualify as risk retaining entities. Taking the re-proposed US risk retention rules under the Dodd-Frank Act as an example, for a CLO transaction that does not take advantage of the “open market CLO” exemption, the preamble to the re-proposed rules (like the originally proposed rules) states that the related CLO manager is the “securitiser” required to hold the retained interest in satisfaction of the base risk retention requirements.15 In contrast, under the CRR, a CLO manager would only qualify as a sponsor insofar as it is a credit institution or investment firm regulated under MiFID.
The EBA Standards are currently before the European Commission and it has until mid-March 2014 (three months from when the EBA presented the EBA Standards) to decide whether to adopt the EBA Standards, which it could do either in full or in part with amendments. The European Parliament and Council will then have between one and three months to review and object to the EBA Standards. Therefore, the earliest that the Technical Standards could come into force will be April 2014.
Status of CEBS Guidelines and the Q&A
Despite the fact that the EBA Standards are still subject to the approval of the European Commission, the CEBS Guidelines and Q&A ceased to apply as of January 1, 2014. This leaves an interim gap in the criteria that should be applied to structuring transactions that do not fit squarely within the ambit of the CRR risk retention requirements. Interestingly, however, the EBA does make reference to certain examples in the CEBS Guidelines remaining available,16 including the guidance in the CEBS Guidelines on the grandfathering of pre-January 1, 2011 securitizations until December 31, 2014. This may suggest that those parts of the CEBS Guidelines that do not conflict with the CRR or Technical Standards may still be informative in determining the CRR’s practical meaning in the varied circumstances to which it applies.
It seems unlikely that there will be any significant changes to the EBA Standards resulting from the remainder of the EU legislative review process. This will leave a number of uncertainties as to the application of the CRR in unusual structures. There is some remit to address open issues with further guidance from the EBA through the Q&A facility on its website.17 However, this process is unlikely to be immediate, but rather will develop over time. In the meantime, market participants will need to work with their advisors to develop a suitable approach on complex risk retention structures.