Although the final US risk retention rules were adopted in October 2014, the rules will not apply until December 24 2016 to asset-backed securities (ABS) issued on or after December 24 2016 with respect to all asset classes other than residential mortgage-backed securitisations (RMBS) (to which the rules have applied since December 24 2015).
This update examines the exclusion which applies to certain non-US securitisation transactions and describes the basic US risk retention requirements. It is not a comprehensive review of the US risk retention rules; rather, it is intended to highlight the key issues to consider when determining whether a proposed transaction falls within the 'foreign-related transaction' safe harbour and, if not, to assess on a preliminary basis how a transaction might be analysed under the US risk retention rules.
While the US risk retention rules do not provide a carve-out tied specifically to Regulation S offerings or allow for substitute compliance by a non-US person that complies with another country's risk retention rules, they do provide a 'safe harbour' exclusion for certain "foreign-related transactions".
The safe harbour should generally be available to most securitisations of non-US assets by non-US sponsors and issuers relying exclusively on Regulation S, but will be more difficult to apply to transactions which will also be distributed in the United States.
The safe harbour provides that the retention requirements do not apply to a securitisation transaction if each of the following conditions is met:
- The securitisation transaction is not required to be, and is not, a registered public offering under the Securities Act of 1933, as amended.
- No more than 10% of the dollar value (or equivalent amount in the currency in which ABS interests are issued, as applicable) of all classes of ABS interests in the securitisation transaction are sold or transferred to US persons or for the account or benefit of US persons.
- Neither the sponsor of the securitisation nor the issuing entity is:
- chartered, incorporated or organised under the laws of the US or any state;
- an unincorporated branch or office (wherever located) of an entity that is chartered, incorporated or organised under the laws of the US or any state; or
- an unincorporated branch or office located in the United States or any state of an entity that is chartered, incorporated or organised under the laws of a jurisdiction other than the United States or any state.
- If the sponsor or issuing entity is chartered, incorporated or organised under the laws of a jurisdiction other than the United States or any state, no more than 25% (based on unpaid principal balance) of the assets that collateralise the ABS interests sold were acquired by the sponsor or issuing entity, directly or indirectly, from:
- a majority-owned affiliate of the sponsor or issuing entity that is chartered, incorporated or organised under the laws of the US or any state; or
- an unincorporated branch or office of the sponsor or issuing entity that is located in the US or any state.
The definition of 'US persons' is substantially the same as the definition in Regulation S, including that it explicitly states that a 'US person' does not include any agency or branch of a US person located outside the United States, as long as the agency or branch:
- operates for valid business reasons; and
- is engaged in the business of insurance or banking and is subject to substantive insurance or banking regulation, respectively, in the jurisdiction where it is located.
The definition of 'US persons' does not generally 'look through' to the shareholders of a sponsor; but like Regulation S, the safe harbour does not apply to any transaction that is part of a plan or scheme to evade the risk retention rules.
In the adopting release, the agencies provided guidance that the calculation of the 10% limit is intended to include only ABS interests sold in the initial distribution of ABS interests. Secondary sales to US persons would not normally be included in the calculation, unless the circumstances indicate that such sales were contemplated at the time of the issuance (and not included in calculating compliance with the 10% limit). Accordingly, the 10% limit must be computed only on the date of initial distribution of an ABS interest and not an ongoing basis following the initial distribution. However, if different classes or portions of the same class of ABS interests are distributed by or on behalf of the issuing entity or a sponsor on different dates, the 10% limit must be calculated on each such distribution date. Commentators on the rules have indicated that the exclusion will be difficult to use in any transaction open to investors that are US persons, simply because it will not always be possible to identify prior to closing that the actual US purchasers will be less than the 10% limit.
In calculating the percentage of those ABS interests sold to US persons or for the account or benefit of US persons, interests retained by the sponsor may be included as part of the aggregate ABS interests in the securitisation transaction.
If the safe harbour cannot be used, then the application of the US risk retention rules to the specific securitisation transaction must be examined.
Base risk retention requirements
The US risk retention rules generally provide that a sponsor (or a majority-owned affiliate of the sponsor) of a securitisation transaction must retain an economic interest in the credit risk of the securitised assets equal to at least 5% of the aggregate ABS interests in a transaction.
A sponsor of a securitisation transaction can satisfy the risk retention requirements by retaining:
- an 'eligible vertical interest' (EVI), whereby the sponsor holds a portion of each class (or tranche) of ABS interests issued as part of a single securitisation transaction or a single eligible vertical security representing the same percentage of each class equal to at least 5% of the ABS interests;
- an 'eligible horizontal residual interest' (EHRI), whereby the sponsor retains the first loss position equal to at least 5% of the fair value of the ABS interests;
- an 'eligible horizontal cash reserve account' (EHCRA), whereby – in lieu of retaining all or any part of an eligible residual horizontal interest – the sponsor holds cash or cash equivalents in a specified type of reserve account (interest-only reserve accounts do not qualify); or
- any combination of the above.
The key distinction among the base risk retention requirements is that a sponsor holding retention solely in the form of an EVI need not calculate 'fair value', while a sponsor holding any part of the retention in the form of an EHRI or EHCRA must calculate the required amount of retention using 'fair value'. 'Fair value' of the retained interests is to be determined in accordance with Generally Accepted Accounting Principles. The complexity of determining fair value is significant and has influenced sponsors to use EVI in the preponderance of transactions that have been reported so far.
All sponsors must make certain disclosures regarding the retention within a reasonable period prior to the sale of the ABS, including a description of the material terms of the retained interest and:
- for an EHRI or EHCRA, the fair value of the interest; and
- for an EVI, the percentage that the sponsor is required (and the amount the sponsor is expected) to retain as a vertical interest.
Sponsors holding retention in the form of an EHRI or EHCRA must disclose specified information related to the fair value calculation of such retention interest, including a description of the methodology and assumptions used to make the fair value calculation.
Within a reasonable time after closing, the sponsor must also disclose:
- for an EHRI or EHCRA:
- the actual fair value of the retained EHRI or EHCRA at closing;
- the amount that the sponsor was required to retain at closing; and
- any material differences between the actual methodology and assumptions and those used prior to sale; and
- for an EVI, the amount of the vertical interest retained at closing if that amount is materially different from the amount disclosed prior to sale.
Among other exemptions, the US risk retention rules also establish exemptions for certain transactions collateralised solely by a single class of qualifying assets and by servicing assets including qualified residential mortgages, qualified commercial loans, qualified commercial real estate loans and qualified automobile loans, in each case meeting prescribed underwriting criteria. The rules also provide for special risk retention regimes for open market collateralised loan obligations, commercial mortgage-backed securities and eligible asset-backed commercial paper conduits.
These special rules are:
- unlikely to be applicable to most US securitisations (in part because the rules were not meaningfully adapted to any asset class other than residential mortgages); and
- even less likely to be applicable to non-US transactions (in part because the rules are very US-centric).
Who can retain?
The US risk retention rules require a sponsor (or majority owned affiliate of the sponsor) of a securitisation to hold and retain the relevant economic interest.
'Sponsor' is defined in the US rules as a person that organises and initiates a securitisation transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the issuing entity.
If there is more than one sponsor, each must ensure that at least one of the sponsors (or a majority owned or, in the case of a revolving pool securitisation, wholly owned affiliate of any sponsor) retains the required economic interest. A sponsor is allowed to transfer its retained ABS interest to a majority-owned affiliate or, in the case of a revolving pool securitisation, a wholly owned affiliate.
A sponsor is also allowed to reduce its risk retention requirement by the portion of any risk retention assumed by an originator of the securitised assets, as long as such originator contributes more than 20% of the underlying asset pool. However, the sponsor is not allowed to allocate to an originator any portion of the required risk retention amount exceeding the percentage of securitised assets contributed by such originator. The purpose of the 20% threshold is to cause an originator to retain a sufficient amount of risk to create an incentive for such originator to monitor the quality of the assets in the pool. The adopting release states that the 'originator' must create the underlying financial asset rather than acquire the assets from other originators.
Hedging and transfer of and reduction to risk retention
The US risk retention rules contain a general prohibition on hedging and transfer of any required retention.
However, the rules allow the sponsor to take hedge positions that are not materially related to the credit risk of the particular securitisation transaction, such as positions relating to overall market interest rate movements and currency exchange rates. Hedge positions tied to securities that are backed by similar assets originated and securitised by other persons are also allowed. The retainer is not allowed to pledge any retained ABS interest as collateral unless the obligation is with full recourse to the sponsor or affiliate. Any originator, originator-seller or third-party purchaser that retains credit risk pursuant to the rules must comply with the hedging and transfer restrictions as if it were the sponsor.
The rules also contain certain hedging and transfer restriction time limits that terminate a sponsor's prohibition on hedging and transfer of the required risk retention. For a non-RMBS securitisation, the restrictions end on the latest of:
- the date on which the total unpaid principal balance of the securitised assets that collateralise the securitisation is reduced to 33% of the original unpaid principal balance as of the closing date of the securitisation transaction;
- the date on which the total unpaid principal obligations under the ABS issued in the securitisation is reduced to 33% of the original unpaid principal obligations at the closing date of the securitisation transaction; or
- two years after the closing date of the securitisation transaction.
If the outstanding principal balance of the ABS interests is reduced, the required risk retention can be reduced if it is the form of an EHRI or EVI. The rules require the sponsor to measure the EHRI as of the closing date and there is no restriction on paying down an EHRI in accordance with the terms of the securitisation transaction. However, funds on deposit in an EHCRA cannot be released until the other ABS interests have been paid in full. Such restriction would require the balance of the ABS interests to be paid down to zero before any funds in the EHCRA could be released.
Revolving pool securitisations
A sponsor of a 'revolving pool securitisation', such as a credit card ABS, can satisfy the risk retention requirements by retaining a 'transaction-level' seller's interest of at least 5% of the unpaid principal balance of all outstanding investor ABS interests in the issuing entity.
The revolving pool securitisation risk retention option is available only to transactions where the ABS interests are collateralised by a common pool of securitised assets that will (or may) change in composition over time. The retention option is not available in transactions with an issuing entity that issues series of ABS interests at different times collateralised by segregated independent pools of securitised assets within the issuing entity such as a series trust, or an issuing entity that issues shorter-term ABS interests collateralised by a static pool of securitised assets or an issuing entity with a pre-determined re-investment period that precedes an ultimate amortisation period.
The 5% test must be satisfied at the closing of each issuance of ABS interests and at least monthly (based on the relevant transaction's seller's interest measurement date); and if the test is not satisfied and the relevant securitisation transaction documents specify a cure period, the test must be satisfied within the earlier of the relevant cure period and one month after the seller's interest measurement date.
Are all 'asset-backed' transactions subject to retention?
The US risk retention rules apply to 'asset-backed securities' and not to loan structures. Some market participants are promoting the view that the characteristics of a variable funding note are more akin to a loan than a security, and that:
- consequently a variable funding note is not within the definition of an 'ABS'; and
- therefore, the risk retention rules do not apply.
With that perspective in mind, some securitisation transactions are being documented (or re-documented) as loan facilities and loan facilities are in some instances being revised to remove provisions providing for the issuance of related loan notes. Although the legal analysis of what constitutes a 'loan' versus a 'security' is complex and highly reasoned, parties might reasonably conclude that a securitisation involves a loan.
Other securitisation transactions can be asset backed, but not necessarily 'securities'. Sales of pools of receivables probably are not covered by the US risk retention rules; but the more credit support or tranching that is involved in the transaction, the more likely one of those tranches will be viewed as a security.
In addition, some participants in term note transactions may take the position that the term notes are not ABS. For example, in a whole business securitisation, since payments depend on more than just cash flows, the transaction may fall outside the retention rules (ie, they may be securities, but not ABS within the definition).
'Grandfathering' and amendments to existing transactions
The US risk retention rules apply to any offer or sale of an ABS occurring on and after the effective date of the rules in relation to the relevant asset class. Consequently, the rules apply only to securities offered or issued on and after December 24 2016 (the rules have applied to RMBS since December 24 2015).
Under US securities laws, any amendment to a security which substantially affects the legal rights and obligations of the holders of outstanding securities could constitute the offering of a new investment security. Absent any guidance on this point from the regulators in the rules, the adopting release or otherwise, an amendment to an existing securitisation may trigger the need to comply with the US risk retention rules if an exemption does not otherwise apply. Under existing securities laws, changes to certain economic terms of debt securities have been identified as being so fundamental that an amendment of such terms gives rise to the offer of a new security. Those fundamental terms include changes to payment of principal and interest, interest rate, interest payment date, maturity date, redemption provisions or sinking fund provisions.
For further information on this topic please contact Dennis Dillon at Hogan Lovells International LLP by telephone (+44 20 7296 2000) or email ([email protected]). The Hogan Lovells International website can be accessed at www.hoganlovells.com.
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