We will leave the hand wringing and teeth gnashing to others. We expect there will be a lot of that in the days ahead. We have had our say on the misguided premises and tortured statutory interpretation underpinning the final risk retention rule as it applies to collateralized loan obligation transactions (“CLOs”). The result from the agencies is what it is. Namely, the portions of the final rule germane to the CLO market were enacted largely unchanged from the second notice of proposed rulemaking, although, importantly, the cash trap proposed in the second notice of proposed rulemaking, whereby a CLO could not make distributions to the sponsor holding an eligible horizontal residual interest, except proportionate to the pay down of the CLO liabilities, was dropped and the agencies added significant color in the adopting release for the final rule that the requirement that the sponsor “organize and initiate” a securitization transaction, namely that the sponsor must have “actively participated in the organization and initiation activities that would be expected to impact the quality of the securitized assets…typically through underwriting and/or asset selection”.1 Unfortunately, the final rule represents a big bag of nothing when it comes to the relief the industry was anticipating for CLOs. Thus, in this OnPoint our focus, after a brief explanation of where we stand from a U.S. risk retention perspective, will be on the road ahead and possible options that exist for sponsors (both managers and funds) under the final rule, cognizant that no one size will fit all.
Introduction: The Road Here
Section 941 (“Section 941”) of the Dodd-Frank Wall Street Reform and Consumer Protection Act added section 15G (“Section 15G”) of the Securities Exchange Act of 1934. Section 15G required the Federal Deposit Insurance Corporation (“FDIC”) along with the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, the Department of Housing and Urban Development, the Federal Housing Finance Agency and the Securities and Exchange Commission (together, the “Agencies”) to adopt regulations that require the “securitizer” of asset-backed securities (“ABS”) to retain at least 5% of the credit risk of the assets collateralizing the ABS.2
In response to Section 15G, the Agencies originally proposed risk retention requirements in April 2011 via a notice of proposed rulemaking (the “First NPR”)3 and followed with a second notice of proposed rulemaking (the “Second NPR”)4 on August 28, 2013. In both instances, the Agencies solicited comments from market participants.
On October 21, 2014, the FDIC passed final U.S. risk-retention requirements (the “Final Rule”) for ABS to implement Section 941.5 The portions of the Final Rule applicable to CLOs were adopted unchanged from the Second NPR in most material respects, with two notable exceptions: (i) the equity cash trap was dropped and (ii) additional commentary was provided around the “organization and initiation” criteria applicable to a sponsor of a CLO. Because the Final Rule permits the Retention Interest to be retained by a sponsor or an originator (or a majority-owned affiliate of either such person), CLO managers will have the opportunity to utilize new or existing (in the case of certain balance sheet CLOs) structures to meet the risk retention requirements. In the final section of this OnPoint, we highlight some of the options that may be available to CLO managers for complying with the new risk retention requirements. We note that the exact option for a particular manager or fund will be subject to a number of bespoke considerations.
Basic Risk Retention Requirement
The Final Rule provides that a sponsor or a majority-owned affiliate of the sponsor must retain an economic interest in the credit risk of the securitized assets (the “Retention Interest”) which may be held in the form of: (i) a single vertical security or an interest in each class of ABS interests issued in the securitization that constitutes the same proportion of each such class equal to 5% of the face value of each tranche issued by the CLO (“Eligible Vertical Interest”), (ii) an eligible horizontal residual interest (i.e., first loss tranche) equal to 5% of the fair value (determined using a fair value measurement framework under U.S. GAAP) of all ABS interests in the CLO (“EHRI”), (iii) a cash reserve account funded in an amount equal to the EHRI in lieu thereof or (iv) any combination of Eligible Vertical Interest and EHRI.6
The Final Rule continues to define a sponsor as “a person who organizes and initiates a securitization transaction by selling or transferring assets, either directly or indirectly, through an affiliate, to the issuing entity.”7 A securitization transaction is a transaction involving the offer and sale of ABS by an issuing entity.8
The adopting release includes significant new color on how the Agencies view the role of a sponsor and for the first time indicates types of activities that the Agencies do not consider “organization and initiation” of a securitization transaction.9 According to this new commentary, a sponsor must actively participate in the securitization transaction by aligning its incentives with those of the investors and engaging in underwriting and/or asset selection.10 Further, the Agencies state that “an entity that serves only as a pass through conduit for assets that are transferred into a securitization vehicle, or 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 be an impermissible third-party holder of risk retention and would not qualify as a sponsor for risk retention purposes “because such activities, in and of themselves, do not rise to the level of ‘organization and initiation.’ In addition, negotiating 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 or securitizer.”11
The Final Rule confirms the Second NPR’s clarification that a sponsor or a “majority-owned affiliate” of the sponsor may hold the Retention Interest. A majority-owned affiliate is defined as “an entity (other than the issuing entity) that, directly or indirectly, controls12 a majority of, is majority controlled by or is under common majority control with, the sponsor. 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.”13
The Final Rule also retained the provision from the Second NPR that if there is more than one sponsor of a securitization transaction, it is the responsibility of each sponsor to ensure that at least one sponsor (or at least one of their majority-owned affiliates) retains the Retention Interest.14
Another concept retained from the Second NPR is the ability to have an “originator” hold the Retention Interest.15 An originator is a “person who, through an extension of credit or otherwise, creates an asset that collateralizes an ABS and sells the asset directly or indirectly to a securitizer or an issuing entity.”16The Final Rule permits a sponsor to offset the amount of its risk retention requirements by the amount of eligible interests acquired by an originator. Generally, the originator must acquire the eligible interests from the sponsor at the closing in the same manner and proportion (as between horizontal and vertical interests) as those acquired by the sponsor in proportion to the amount of assets sold or transferred by the originator to the securitizer or issuing entity subject to a minimum of 20% of the retention requirement. By requiring that the originator must have originated at least 20% of the securitized assets, the Agencies sought to “ensure that the originator retains risk in an amount significant enough to function as an actual incentive for the originator to monitor the quality of all the securitized assets (and to which it would retain some credit risk exposure).”17
In a concession to the concerns raised in numerous comment letters, the Final Rule eliminated what industry participants termed the “cash trap” proposed in the Second NPR in instances where sponsors held their Retention Interest in the form of an EHRI. This mechanic required that the projected payments of any distributions to the first loss tranche could not exceed the projected rate at which the other ABS holders would receive principal payments. The CLO industry viewed this as a non-starter for CLOs which have significant reinvestment periods and customarily allow excess interest proceeds to flow out to the first loss tranche at the bottom of the priority of payments waterfall during the reinvestment period while more senior ABS holders have not yet begun to receive principal payments. Ultimately, the Agencies determined that the fair value disclosures described below, that are required in connection with an EHRI, would protect investors against structures designed to repay equity too soon.
The Final Rule retained the requirement that a sponsor provide comprehensive disclosures of the manner in which the “fair value” of EHRI will be calculated. Sponsors that hold a Retention Interest in the form of EHRI must disclose to potential investors under the caption, “Credit Risk Retention”:
- a reasonable period of time prior to sale of the ABS, (a) the fair value (expressed as a percentage of the fair value of all of the ABS interests issued in the transaction) and the dollar amount the sponsor plans to retain through EHRI or, if specific prices, sizes or interest rates of each tranche are not yet available, a range of fair values based on bona fide estimates or specified models with disclosure of the method used by the sponsor to determine any range of prices, tranche sizes or interest rates; (b) a description of the material terms of the EHRI expected to be retained; (c) a description of the valuation methodology used to calculate the fair value or range of fair values of all classes of ABS interests, including the EHRI expected to be retained; (d) a list or a comprehensive description of key inputs or assumptions used to calculate the fair value or range of fair values of all classes of ABS interests, including the EHRI expected to be retained; and (e) certain other rates, including but not limited to discount rates, default and recovery rates and prepayment rates used in the valuation methodology with an overarching requirement that the disclosure include, “at a minimum descriptions of all inputs and assumptions that either could have a material impact on the fair value calculation or would be material to a prospective investor’s ability to evaluate the sponsor’s fair value calculations”18 and a summary description of the reference data set or other historical information used to develop the key inputs and assumptions; and
- a reasonable time after the closing of the securitization, (a) the fair value of the EHRI retained by the sponsor based on actual pricing, tranche sizes and interest rates; (b) the fair value of the EHRI that the sponsor is required to retain to satisfy its Retention Interest requirement; and (c) any material differences between the methodologies actually used to calculate fair value at closing and those disclosed as described in #1 above.19
Confirmation of Prior Relief
Despite calls from CLO and leveraged loan market participants for additional exemptions from the retention requirements in the Final Rule for CLOs, no such exemptions were adopted. The adopting release indicates that the Agencies were not inclined to provide further exemptions to the CLO market due in large part to their ongoing concerns regarding the underwriting standards of banks within the leveraged loan market.20 However, in addition to the framework described above, the Final Rule continued to include two exemptions to the requirement that a sponsor hold the Retention Interest.
First, the Final Rule provides that for “open-market CLOs” the retention requirements will be satisfied if, for each loan owned by the CLO, the loan arranger holds at least 20% of the aggregate principal balance of the funded portion of the syndicated credit facility at origination and thereafter retains unhedged at least 5% of the face amount of the CLO-eligible loan tranche until the earliest of repayment, maturity, acceleration, payment or bankruptcy default. An “open market CLO” may consist only of senior secured syndicated loans acquired in the open market and servicing assets and less than 50% of its assets may be syndicated by lead arrangers (or may be originated by originators) that are affiliates of the CLO or the CLO manager. While admittedly inconsistent with current market practice, the Agencies concluded that this option could provide a “sound method”21 for CLO risk retention in the future.22
Second, the Final Rule provides an exemption from the retention requirements for static pool securitizations of loans that meet certain conservative underwriting guidelines. These loans, defined as “qualifying commercial loans,” are subject to limitations with respect to debt coverage, leverage, amortization periods and other loan terms.23 Market commentary following the Second NPR indicated that most loans acquired by CLOs would not satisfy such conservative underwriting standards.24
We do not expect that either of these two exemptions will be of significant benefit for future CLOs subject to the Final Rule.
Effective Date, Application to Grandfathered CLOs and Retention Period
As described above, the Final Rule becomes effective on the date two years after it is published in the Federal Register. CLOs issued prior to such date are exempt from compliance with the Final Rule. A notable challenge that CLO managers will face will be the application of the risk retention requirements to CLOs existing prior to the effective date of the Final Rule. While such CLOs will be “grandfathered” from complying with the Final Rule under normal circumstances, there are instances in which such CLOs can subsequently become, in whole or in part, subject to the Final Rule. This will occur if, after the effective date of the Final Rule, such CLOs undertake a refinancing, certain re-pricings or an additional issuance of CLO notes. Because these transactions involve the issuance of CLO notes (ABS), they would qualify as “securitization transactions” that would not be “grandfathered” under the Final Rule.
Confirming the approach in the Second NPR, the Final Rule provides that the retention requirements will be satisfied if the sponsor retains the retention interest until the latest of “(1) the date on which the total unpaid principal balance of the securitized assets that collateralize the securitization is reduced to 33 percent of the original unpaid principal balance (if applicable) as of the date of the cut-off date of the securitization, (2) the date on which the total unpaid principal obligations under the ABS interests issued in the securitization is reduced to 33 percent of the original unpaid principal obligations at the closing of the securitization transaction, or (3) two years after the date of the closing of the securitization transaction.”25
Restrictions on Transfer, Hedging and Financing of the Retention Interest
The Final Rule generally retained the Second NPR’s approach to transfer, hedging and financing of the Retention Interest. Sponsors and their majority-owned affiliates may transfer the Retention Interest only to each other and a majority-owned affiliate may hold the Retention Interest only so long as it remains a majority-owned affiliate of the sponsor.26 The hedging rules generally prohibit hedging that is materially related to the credit risk of the Retention Interest or of the particular assets collateralizing the transaction.27With respect to financing, neither the retaining sponsor nor any of its affiliates may pledge the Retention Interests as security in connection with a financing unless “such obligation is with full recourse to the sponsor or affiliate, respectively.”28
Certain Open Issues
There are a number of open issues imbedded in the Final Rule that we expect will be the subject of further discussion and analysis by CLO market participants. For example, one open question is whether a lender foreclosing on a permitted pledge of a Retention Interest causes the sponsor to no longer be in compliance with the Final Rule. A second is whether the removal and replacement of a CLO manager that holds the Retention Interest as a sponsor or through a majority-owned affiliate thereof under the Final Rule causes the sponsor to no longer be in compliance with the Final Rule. Third, it is not entirely clear that a fund or permanent capital vehicle that originates or selects loans through its investment adviser acting as its agent is within the meaning of “sponsor” contemplated by the Final Rule where the investment adviser of the fund or permanent capital vehicle is also the manager of the CLO. As with other regulatory developments affecting CLOs, we would expect a market consensus to emerge (albeit perhaps slowly) on these and other open issues.
Other Regulatory Considerations
In addition, any manager of a CLO will need to comply with the anti-fraud provisions of the Investment Advisers Act of 1940, as amended (the “Advisers Act”). For example, to the extent the CLO issuer acquires loans from other clients of the CLO manager, any such cross trade must be on terms that are fair to both such other client and the CLO issuer. If the CLO manager or certain of its affiliates sell a loan to or buy a loan from the CLO issuer, any such principal transaction and the price of the trade must be consented to in advance by someone independent from the CLO manager on behalf of the CLO issuer such as its independent board of directors or an independent review party retained by the CLO issuer. In addition, a CLO manager that meets the definition of an “investment adviser” under the Advisers Act must comply with relevant provisions of the Advisers Act and is subject to fiduciary duties which include duties with respect to seeking best execution, allocating opportunities, etc. Advisers that are registered, or required to be registered, under the Advisers Act may be subject to other relevant requirements under the Advisers Act and related rules.
Making Lemonade from Regulatory Lemons: Some Options for Sponsors
While as noted above, the Final Rule retained a majority of the provisions in the Second NPR relating to CLOs as proposed and failed to provide sought after relief for the CLO market, the Final Rule also presents a number of options for CLO managers and funds or permanent capital vehicles acting as sponsors of CLOs. Such potential sponsoring entities can and will need to position themselves competitively in the market by creating structures that permit the applicable sponsor and investors to realize economic benefits while complying with the letter and the spirit of the Final Rule. Set forth below are some of the approaches we anticipate sponsors to be focused on:
- Manager as Sponsor. One approach that CLO managers will be considering is having the management entity itself act as sponsor and allowing investors to participate directly in the ownership of the CLO manager. Because the Agencies view the CLO manager as the “sponsor”, the CLO manager would be eligible to hold the Retention Interest. Investors could then participate in the capital structure of the management company. CLO managers could structure capitalization plans that permit investors to acquire equity or debt interests of the management company. Well tailored capitalization plans could be negotiated to correspond either to the performance of the management company as a whole or in a manner such that returns more closely mirror the performance of one or more CLO transactions. A variant of this option would be for a fund or permanent capital vehicle to act as manager of the CLO and hold the Retention Interest.
- Majority-owned Affiliate of Manager as Sponsor. Another option CLO managers will be considering is satisfying the retention requirements through the use of one or more newly formed subsidiaries (typically limited liability companies) that the CLO manager controls and in which the CLO manager owns a majority of the equity or a controlling financial interest as determined under GAAP. The question of what constitutes a controlling financial interest under GAAP and how much equity the CLO manager must hold in the vehicle to meet that requirement under GAAP will need to be determined by the CLO manager with its auditors. The majority-owned affiliate would be capitalized with equity provided by the CLO manager and by third party equity and/or debt financing and utilize capitalization structures that could tie equity returns to performance across individual or multiple CLO transactions. With the Agencies’ emphasis on the CLO manager having sufficient “skin in the game” to have an incentive to monitor underwriting and credit selection of the assets, it will be important that the CLO manager have funds at risk in the equity of any majority-owned affiliate. We think that the Agencies’ view that in order for an entity to qualify as an “originator” it must originate 20% of the underlying loans and hold at least 20% of the Retention Interest may serve as a useful data point for how much equity a CLO manager might consider retaining in a majority-owned affiliate provided its auditors agree that amount is sufficient so that the CLO manager holds a controlling financial interest determined under GAAP.
- Fund or Permanent Capital Vehicle as Sponsor. With the Agencies’ view that a vehicle capitalized with third party equity (other than to the extent permitted in connection with a majority-owned affiliate of the sponsor or of the originator) is not an acceptable holder of risk retention unless it actively participates in the credit decision making with respect to the loans that go into a CLO, another focus for CLO managers will be the possibility of forming a well-capitalized fund or permanent capital vehicle to act as sponsors of CLOs and acquire and hold the Retention Interests in CLOs and possibly other CLO notes. Experienced CLO managers could provide the vehicle with personnel capable of doing the initial underwriting of the loans and of managing the loans under staffing arrangements provided that credit decisions with respect to the loans are made by an independent investment committee or board of the vehicle. Under this approach the vehicle in the first instance would make an independent decision whether to acquire loans and offer them for sale to the CLO and the CLO manager would make the decision whether or not to acquire the loans for the CLO. Both the vehicle and the CLO manager would be “sponsors” of the CLO and the vehicle would agree to retain the Retention Interest.
- Originator as Holder of Retention Interest. Further, as described above, a CLO manager could enlist the participation of an originator in its CLO transactions to hold risk retention so long as the originator originates at least 20% of the underlying loans and holds at least 20% of the Retention Interest. While not applicable to CLOs of broadly syndicated loans, many in the middle market space currently utilize a platform that would not require significant modification to take advantage of this option. In addition, those originators could use their majority-owned affiliates to own that portion of the Retention Interest allocated to the originator.
- Financing of the Retention Interest. The Final Rule, like the Second NPR, permits a sponsor (or a majority-owned affiliate of the sponsor) to finance the acquisition of a Retention Interest on a full-recourse basis. Because most financing facilities secured by assets such as Retention Interests contain “mark-to-market” collateral valuation mechanics, CLO managers must consider their ability to meet any mark-to-market calls under such facilities.
- Marriage of U.S. and EU Risk Retention. A final focus will be on establishing a vehicle structured to comply with both U.S. and European risk retention requirements. There are several iterations on this we are currently reviewing with CLO market participants including an appropriately structured CLO manager or fund that acts as sponsor for the Final Rule and as originator pursuant to the European risk retention rules, is well capitalized and has personnel capable of underwriting and managing the loans, and is the party that transfers the loans into the CLO.