The Financial Times published leaked drafts of proposed EU legislation on securitisations on August 25.1 The draft regulations, which would be directly effective in EU member states if adopted, propose changes to the current risk retention regime which include changes designed to deal with concerns around the originator loophole raised in the Bank of England/European Central Bank report published last December.2
The “originator loophole” concern relates to the definition of Originator in the Capital Requirements Regulation as “an entity which ...(b) purchases a third party's exposures for its own account and then securitises them." While market practice has grown up requiring such an originator to be an entity of substance and hold credit risk on any such exposures purchased, regulators have voiced concerns that this vehicle is open to abuse so that originator and investor interests are not aligned. The leaked draft legislation seeks to address this point by limiting the definition of originator for risk retention purposes. Article 4(2) states, “For the purpose of the application of [the risk retention provisions], an entity shall not be considered to be an originator if it has been established or operates primarily for the purpose of securitising exposures." As you will be aware, this drafting creates significant difficulties for the CLO market, particularly U.S. CLOs issuing into Europe, where originator structures are often used by collateral managers to act as retainers.
The draft legislation also raises concerns around grandfathering and extra-territorial application. In our view the draft legislation is also a missed opportunity to address the often voiced concerns around the narrow definition of the term Sponsor. With these concerns in mind we have collaborated with other leading CLO firms to suggest alternative wording that addresses the regulators’ concerns while allowing the securitisation market to recover to a sustainable position as an effective funding channel to the economy.
In particular, we suggested that a “limb (b) originator” is redefined as set out below. This is intended to address the potentially disruptive language in the leaked draft and the concerns of regulators that “entity of substance” was insufficiently certain raised by the Bank of England/ECB:
Article 4(2)(a) “For the purpose of the application of this article (risk retention), for an entity to be considered to be an originator under article 2(3)(2) of this Regulation, the entity shall satisfy at least one of the following conditions at the time of the completion of the relevant securitisation:
- It shall have a business strategy and a capacity to meet a payment obligation consistent with a broader business enterprise and involving material support from capital, assets, fees or other income available to the entity but disregarding the exposures to be securitised in the relevant securitisation and any interests retained or proposed to be retained in accordance with this article (risk retention), as well as any corresponding income from such exposures and interests.
- It shall operate for purposes consistent with a broader business enterprise rather than operating for the sole purpose of securitising exposures."
We have also used the opportunity to propose broadening the sponsor definition for risk retention purposes and to allow investment firms with CRD 3 permissions and U.S. Registered Investment Advisors to act as sponsors. The suggested language is as follows:
Article 4(2)(b) “For the purposes of the application of this article (Risk Retention), an entity shall also be considered to be a sponsor if it is an investment firm as defined in article 4(2) of the Capital Requirements Regulation disregarding the exclusion set out in sub-paragraph (c) of that article and it establishes and manages an asset-backed commercial paper programme or other securitisation transaction or scheme that purchases exposures from third-party entities.”
[Article to be confirmed] “For the purpose of the application of this article [refer to the article which will seek to preserve the indirect application approach for non-EU transactions], an entity shall also be considered to be a sponsor if it satisfies conditions (a) and (b) of the definition of ‘recognised third-country investment firm’ in article 4(25) of the Capital Requirements Regulation and it establishes and manages an asset-backed commercial paper programme or other securitisation transaction or scheme that purchases exposures from third-party entities.”
The first official draft legislation is due to be published on September 30. We will keep you updated on the legislation’s progress.