The European risk retention rules have been in a state of flux for some time. Proposals surfaced in 2015 which placed a greater emphasis on ensuring compliance with the spirit of the rules and outlawing any circumvention thereof through originator entities which are established or operate for the sole purpose of securitising assets. For a time, this led investors to shy away from originator structures. However, the pendulum has now swung back due to Brexit and the concern that UK based managers will lose their status as investment firms licensed under the Markets in Financial Instruments Directive (MiFID), and consequently no longer come within the "sponsor" definition for risk retention purposes.
This has created concerns for both investors and CLO managers that CLOs issued by the sponsor route may become non-compliant upon Brexit. This is a turnaround in fortunes for originator structures. Once viewed by CLO managers and investors as more risqué and exposed to regulatory scrutiny, they are now being perceived as a safer bet to weather the storms and choppy waters of Brexit. Furthermore, it is fair to say that where the originator is also the CLO manager there would seem to be a clear alignment of interest between investors and the entity, i.e. the CLO manager, which is driving and making all the key decisions for the CLO. Therefore, it seems appropriate, and within the spirit of the rules, that the CLO manager be the risk retainer even if it is unable to come within the technical wording of the sponsor definition. Indeed the only option for compliance here is to adopt the originator approach, which is the method used by most U.S. CLO managers who, also unable to come within the sponsor definition, resort to this in order to access funding for their U.S. CLOs from the European investor base. This is substantively different from the scenario where the risk retainer is an external third party originator, very much separate from the CLO manager.
It needs to be borne in mind that to date in Europe, compliance with the risk retention rules has been imposed by the Capital Requirements Regulation (CRR) on the investors in securitisations, with increased capital charges being imposed on regulated investors who invest in non-compliant structures. There is no direct regulatory obligation on the sponsors or originators of securitisations to comply. Rather they are currently commercially motivated to structure compliant CLO transactions in order to obtain financing from the EU investor base. Comfort would typically be provided to investors' satisfaction through adequate disclosure in the offering document and the CLO manager providing appropriate representations, warranties and undertakings.
The Securitisation Regulation proposals in their current form would maintain the compliance obligation on investors. However, in addition they would also place a corresponding obligation on sponsors and originators, thus making it vital to the CLO manager that the CLO is in compliance. Essentially preventing the CLO manager from seeking to use disclosure or caveats to its obligations or representations as a way of reducing any risk to it of non-compliance. This also brings sharply into focus the potential consequences for the CLO manager if, due to Brexit, it ceases to qualify as a sponsor and as a result breaches its representations, warranties and undertakings to that effect and its regulatory obligations. Consequences that could include both breach of contract and regulatory sanctions.
Brexit, of course, does not mean that UK CLO managers no longer need worry about risk retention. The exit negotiations between the UK and the EU may preserve the status quo in many areas and result in large swathes of EU financial regulation continuing to apply unchanged in the UK. That aside, if CLO managers want to access the regulated EU investor base then they will need to structure their CLOs to be compliant with EU risk retention rules.
Sponsor/Originator Switch Mechanic
The most obvious way to navigate forward would be for CLO managers to structure future transactions via the originator risk retention method. However, an alternative halfway house could be for CLO managers who until now have adopted the sponsor approach to instead take a two pronged approach. Continuing to be a sponsor at the outset for new transactions but including mechanics that would permit them to switch to being an originator for risk retention purposes if at some point they ceased to qualify as a sponsor. For example the inclusion of alternative representations, warranties and undertakings depending on the CLO manager's status. The risk retention rules require that the same retention option and methodology be used during the life of the transaction unless exceptional circumstances require a change. However, it could be said that Brexit and the CLO manager, as a result, ceasing to qualify as a sponsor are an exceptional circumstance and merit a switch being permitted from sponsor to originator. In order to be able to make the switch the CLO manager would need to have originated assets for the CLO (as further described below), and we would envisage this being done prior to and on closing.
It is also possible that any Brexit deal that is negotiated could preserve the position of UK asset managers as regulated investment firms under European regulation, and mean that UK CLO managers remain as sponsors post-Brexit and such deals continue to be compliant.
Structuring an Originator Manager
There are two routes to being an "originator" for the purposes of the European risk retention rules, either through an entity: (i) being involved, directly or indirectly, in the original agreement which created the assets; or (ii) purchasing the assets for its own account and then securitising them. The first is an unlikely scenario for most CLO managers. However, the second is a possibility, particularly in light of the fact that not all the assets in the CLO need to be "originated" by the CLO manager for it to qualify as an "originator".
If the originator is not managing the securitisation then it needs to have contributed over 50 per cent. of the total securitised assets. Alternatively, and the more likely scenario for a CLO manager, if the originator has established and is managing the securitisation there is no specified minimum amount of assets that it needs to have originated for the CLO. However, in order to comply with the spirit of the rules it should not be a fig leaf but rather a reasonable number. Often we see a requirement that, as of the CLO's issue date, assets equal to 10 per cent. of the target par amount have been originated by the CLO manager but there is no magic number. We would suggest that as a minimum requirement it may be possible to justify a range of between 5 – 15 per cent., although the more the better.
Any CLO manager "originator" needs to be able to demonstrate that the assets it originates have been purchased by it "for its own account". This would imply that prior to the securitisation the CLO manager should be exposed to risk and reward on the assets. That brings into play the following considerations:
- Seasoning: what should not be countenanced is that assets can simply be flipped through an entity to make it an originator. The time period for which assets are held by the originator is one element in showing that it is genuinely exposed to the assets. Often we see it stipulated in documentation that the originator must have held any originated assets for a minimum period of 15 business days before it can transfer them to the CLO. However, the CRR does not proscribe a minimum timeframe nor have regulators given much guidance on this point.
- Credit risk: one key way of showing exposure to the assets is through the originator taking credit risk on the assets during the holding period and bearing the loss if there were to be any default.
- Market value risk: many originator structures will include forward purchase agreements so that the CLO will agree to acquire any assets originated by the CLO manager at the price which the CLO manager paid for them. This would mean that the CLO manager is largely immune from market value risk unless the assets were to become ineligible for the CLO prior to closing or the CLO were not to be consummated in which case the market value risk on the assets would lie squarely with the CLO manager. It would be helpful to the analysis if the CLO manager did have market value risk on the originated assets but it is not vital, provided that other elements in the structure can robustly demonstrate that the originated assets have been held for the account of the CLO manager prior to being securitised.
- Receipt of cashflows: the inverse of bearing the risk exposure is entitlement to the benefit from the assets during the holding period. The CLO manager being the recipient of any cashflows prior to issuance of the CLO would be indicative of them being owned for its account.
It is not essential, in our view, that the CLO manager be lender of record for any assets which it originates provided the beneficial interest, if not legal title, can be said to be vested in it. In which case the assets could be settled directly into the CLO, as opposed to being settled to the CLO manager first.
Recognition of the assets on the CLO manager's balance sheet is also an important and helpful factor.
One pitfall to be aware of when having the CLO manager originate assets is that if the manager is originating bonds then it is likely that these would be treated as "investments", and the act of acquiring the assets and then selling them to the CLO could be treated as "dealing" for regulatory purposes. This would require CLO managers authorised by the FCA to have permission to deal in investments as principal. This is a permission which many CLO managers will not have. On the other hand, this is not an issue for originating loans, as market practice is to characterise loans as not being investments. Therefore CLO managers should be aware that any bond assets to be acquired for the CLO should be warehoused directly in the CLO and only loan assets should be originated by the CLO manager.
In the ensuing rush by the CLO market to adopt a manager originator model a few things should be kept in mind. The report on the proposed Securitisation Regulation from the ECON committee of the European Parliament, prepared by Dutch MEP and Rapporteur Paul Tang and released in June of this year, suggested that the risk retention rules should be amended to provide that not only the sponsor but also the originator is a regulated entity. However, this should only apply to CLOs issued after the Securitisation Regulation comes into force, with prior deals being grandfathered. It is also possible that any requirement that an originator be regulated may not apply across the board but only be brought in as a prerequisite for simple, transparent and standardised (STS) securitisations. In any event, the originator approach may be a short-term solution but it may not be a long-term panacea.
Risk Retention Quantum
Rapporteur Paul Tang's report also raised the spectre that the risk retention quantum be increased from 5 per cent. to 20 per cent., although the report proposed the European Banking Authority (EBA) could deviate from this level where it has reason to do so. More recently, comments on the proposals from the European Parliament's Committee on Economic and Monetary Affairs have revealed support for increasing risk retention still further in some quarters, while elsewhere there is opposition to any increase above 5 per cent. Any increase in the risk retention amount could see greater attention turned to structures where third party capital is injected into the CLO manager itself or a separate originator entity, in place of such third parties subscribing directly for CLO notes. It remains to be seen how this will play out.
Passporting concerns for non-EU managers
Brexit may well result in UK CLO managers losing their ability to "passport" into other EU member states, which could be an issue given that CLO vehicles tend to be established in Ireland or The Netherlands. Although, due to the importance of London as a financial services centre, it could transpire that passporting rights are retained pursuant to any deal negotiated for Brexit. When MiFID II is implemented it will enable non-EU managers to provide services within the EU pursuant to the third country EU passport regime provided that the EU determines that such third country has an equivalent regime. Whether, and when, the EU will award the UK with equivalence cannot be guaranteed.
How much of an issue is the loss of passporting to UK CLO managers? For a Dutch CLO vehicle, the CLO manager would need to be appropriately licensed unless either the portfolio consists only of loans and does not include any bonds, or the CLO vehicle appointed the CLO manager on a reverse solicitation basis. It could also be possible for a UK CLO manager to sub-contract any services in relation to bonds to a licensed entity. For an Irish vehicle the situation is different, and no licences should be needed provided that the CLO manager does not have its head or registered office in Ireland, it does not have an Irish branch, and the investment management services are not being provided to Irish individuals. Having an affiliated entity established in Ireland should not of itself breach these conditions. It is conceivable that these factors could sway some managers towards using Irish CLO vehicles. Then again they may be irrelevant if the manager has an affiliate which after Brexit is MiFID licensed in an EU member state or if the manager establishes such an authorised entity in the EU.
An option of last resort, albeit an unattractive one, could be to grant the CLO manager a regulatory call option if, as a result of Brexit, it was unable to comply with its obligations as CLO manager, including not being able to passport or act as risk retainer.
Jurisdictional Tax considerations
Another factor being considered when choosing the CLO jurisdiction is VAT risk. A recent European Court of Justice case, brought by the Dutch authorities, has called into question whether Dutch vehicles should be exempt from VAT since arguably they are not subject to specific state supervision and, therefore, are not within the special investment fund exemption of the EU VAT Directive. It should be noted, though, that currently many Dutch CLO vehicles have the benefit of a tax ruling confirming that the relevant VAT exemption applies to such Dutch CLO vehicles. Therefore, the Dutch tax authorities would be changing their longstanding position if they now pursued Dutch CLOs for VAT. On the other hand, in Ireland it is enshrined in statute that s110 companies, the type of vehicles used for CLOs, are within the exemption from VAT. However, given the purpose of EU regulation is to create a level playing field across the EU, it would be anomalous if Dutch CLOs were subject to VAT but Irish CLOs were not.
In addition, payments made by both Dutch CLO vehicles and Irish s110 companies are generally made free of deductions for withholding tax. With regard to payments made on notes issued by an Irish CLO, this would typically be on the basis of the "quoted eurobond" exemption due to the fact that the CLO notes are listed on a recognised stock exchange. However, in respect of warehouse arrangements the financing would not usually be listed, in which case warehouse lenders to an Irish vehicle would look to rely on an exemption from withholding tax where recipients of payments are located in an EU member state or double tax treaty partner country. This may not be the case for all warehouse lenders though, so care should be taken in this respect when using an Irish vehicle. The same concerns do not exist for Dutch vehicles.
Currently offerings of CLO securities are made in the EU pursuant to the Prospectus Directive, or an exemption therefrom. Following Brexit it is not yet known how offerings to UK based investors will be governed. It may transpire that the status quo is somehow preserved but this is another area to keep an eye on going forward.
As has been widely publicised, the Securitisation Regulation will introduce a simple, transparent and standardised (STS) "kitemark" for qualifying securitisation transactions, which leads to the possibility that they may receive better capital treatment. Unfortunately CLOs cannot qualify for the STS label as they are unlikely to satisfy all the required criteria which include: no active portfolio management on a discretionary basis; the pool of assets being homogenous; the asset pool not including transferable securities, although an exemption is proposed for corporate bonds provided they are not listed on a trading venue; and the debtors on each of the assets having made at least one payment prior to the securitisation.
U.S. Risk Retention
From Christmas this year, U.S. risk retention requirements will apply to CLO transactions, and the burden of such compliance will fall on the CLO manager as the person organising and initiating the securitisation.
Similar to the position in Europe, the requirements can be satisfied through the CLO manager holding either a vertical slice or a first loss piece. As in Europe the vertical slice should be at least equal to 5 per cent. of the par amount of each class of securities issued by the CLO. However, unlike in Europe, if the holding is in the first loss position then this needs to be at least equal to 5 per cent. of the fair value of all securities issued by the CLO, as determined in accordance with GAAP. Therefore, many European CLO transactions where the CLO manager retains through a vertical slice should also qualify as compliant with the U.S requirements but, where the holding is instead through the equity piece, care should be taken that this complies with the quantum stipulated on both sides of the Atlantic.
There is also a safe harbour for transactions where less than 10 per cent. of each class of CLO securities are sold to U.S. persons as part of the initial offering. Secondary sales should not be factored in when measuring the 10 per cent. limit but there are anti-evasion provisions which would capture subsequent sales to U.S. persons if contemplated in the initial offering as part of a scheme to evade the requirements. We are of the view that structuring a transaction to be compliant with Rule 144A and permitted to be sold to U.S. persons in secondary trading should not in and of itself bring a CLO within the scope of U.S. risk retention. As in Europe, there are also provisions concerning the disclosure and record keeping in respect of the retention and specific restrictions on hedging and financing.
In summary, after many years of new regulation being imposed on the financial services industry and having application to CLOs, the way ahead, if not tempestuous, remains clouded with uncertainty. Dentons will continue to follow developments closely and advise its clients regarding the impact of these developments on their CLO transactions.