As we described in a previous article, “U.S. Regulatory Update – Credit Risk Retention for CLOs,” published on September 10, 2013, six federal agencies (the “Agencies”) are seeking public comments on a re-proposed rule (the “Re-Proposed Rule”) to implement the credit risk retention requirements under the Dodd-Frank Act.
This memorandum summarizes the Re-Proposed Rules’ main changes that may affect the management activities of collateralized loan obligations (“CLOs”).
- If adopted in their current form, the Re-Proposed Rules may have a material impact on how a CLO manager would launch and manage a new CLO transaction. In particular, a newly proposed limitation on equity distributions may fundamentally change—or worse, stifle—the CLO market.
- A newly proposed “open market CLO” option appears unlikely to provide a meaningful alternative.
- In order to satisfy the risk retention rule under the horizontal option, additional disclosure requirements must be met.
If you manage a CLO, you are a “securitizer.”
A CLO manager is deemed to be a “securitizer” because the Agencies believe that it is “a person who organizes and initiates an asset-backed securities transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the issuer.” In the Re-Proposed Rules, the Agencies have explicitly set out their rationale for declining to accept numerous comments arguing for the inapplicability of the term “securitizer” to CLO managers.
You must hold, at minimum, a 5% risk retention piece of each CLO you manage.
A CLO manager may satisfy the risk retention requirement by owning1 any combination of vertical and horizontal interests of a CLO it manages, as long as the total interests retained are at least five percent of the “fair value” of all ABS interests. Referred to as the “combined risk retention option” in the Re-Proposed Rules, this option would permit a CLO manager to satisfy the requirement by retaining an “eligible vertical interest,” an “eligible horizontal residual interest,” or any combination thereof, in a total amount equal to no less than five percent of the fair value of all ABS interests in the CLO issuer.
What do you retain? – The numerator.
To satisfy the five percent threshold, a CLO manager would hold the aggregate amount of any combination of the vertical and horizontal interests, which would count towards the numerator for this calculation. While any “combination” would satisfy the rules, the manager must hold the requisite percentage in every CLO tranche if a vertical interest is used in the combination.
What is included in “ABS interest”? – The denominator.
In the Re-Proposed Rules, the Agencies declined to make substantial changes to the original definition of the term “ABS interest.”2 The Agencies, however, added one more eligible component, calling it the “servicing assets.”3Essentially the cash equivalents, the servicing assets are similar to “eligible assets” in Rule 3a-7 under the Investment Company Act of 1940, as amended (the “Investment Company Act”).
Newly proposed “Open Market CLO” option is unlikely to be available.
Another option specifically proposed for “open market CLOs” is not likely to be a realistic option for CLO managers because it relies on market developments beyond the control of the CLO manager. To become useful, this option would require the underlying U.S. corporate loan market to adopt a set of new practices to create “CLO eligible loans.” Most market participants and other observers have stated that it would be difficult to implement such a framework. For more details of the open market CLO option, see the additional discussion under the heading, “Lead Arranger Risk Retention for ‘Open Market CLOs’” in the “U.S. Regulatory Update – Credit Risk Retention for CLOs” article.
What’s Fair in the 5% Retention Option?
A CLO manager must also adhere to additional requirements in order to satisfy the horizontal risk retention option, including:
You must disclose how you determine fair values.
A CLO manager relying on the horizontal risk retention option must disclose the reference data set or other historical information which would meaningfully inform third parties of the reasonableness of the key cash flow assumptions underlying the measure of fair value (such as default, prepayment, and recovery).
The Agencies proposed a list of disclosure items to be provided to potential investors a reasonable time prior to the sale of CLO notes. See Appendix for a list of the disclosure items.
There are limits on distributions to the horizontal risk retention piece.
In their efforts to “establish economically meaningful horizontal risk retention that better aligns the sponsor’s incentives with those of investors,” the Agencies proposed to impose limits on payments to the holder of the eligible horizontal residual interests4 (the “EHRIs”).
The Re-Proposed Rules would “prohibit the sponsor from structuring a deal where it receives such amounts at a faster rate than the rate at which principal is paid to investors in all ABS interests in the securitization, measured for each future payment date.” This approach would be inconsistent with the typical CLO priority of payments. In fact, it is not clear if one can structure a CLO with this type of prohibition on equity distribution. The implementation of this restriction could substantially dampen market demand for CLO equity, effectively closing the CLO market to many CLO managers.
If adopted as proposed, this requirement may cause significant, negative impact on the CLO market.
What to Expect In the Near Future
The comment period expires on October 30, 2013 and the final rule is expected to become effective two years after the adoption of the final rules. While it is not clear when the risk retention rules will be finalized, many market observers believe that the Agencies are under substantial pressure to finalize and implement the rules.
Please feel free to contact us if you would like to discuss further the details of the re-proposed rules and how they may impact your business.
- The Re-Proposed Rule makes clear that the sponsor may hold interests through majority-owned affiliates.
- It refers to “all types of interests or obligations issued by an issuing entity, whether or not in certificated form, including a security, obligation, beneficial interest or residual interest, the payments on which are primarily dependent on the cash flows on the collateral held by the issuing entity. The term, however, does not include common or preferred stock, limited liability interests, partnership interests, trust certificates, or similar interests in an issuing entity that are issued primarily to evidence ownership of the issuing entity, and the payments, if any, on which are not primarily dependent on the cash flows of the collateral held by the issuing entity.”
- It refers to “any rights or other assets designed to assure the servicing, timely payment, or timely distribution of proceeds to security holders, or assets related or incidental to purchasing or otherwise acquiring and holding the issuing entity’s securitized assets. These may include cash and cash equivalents, contract rights, derivative agreements of the issuing entity used to hedge interest rate and foreign currency risks, or the collateral underlying the securitized assets.”
- An interest qualifies as an ‘‘eligible horizontal residual interest’’ under the proposed rules only if it is an ABS interest that is allocated all losses on the securitized assets until the par value of the class is reduced to zero and has the most subordinated claim to payments of both principal and interest by the issuing entity.
APPENDIX – LIST OF DISCLOSURE ITEMS
- The fair value (expressed as a percentage of the fair value of all ABS interests issued in the securitization transaction and dollar amount (or corresponding amount in the foreign currency in which the ABS are issued, as applicable)) of the eligible horizontal residual interest that will be retained (or was retained) by the sponsor at closing, and the fair value (expressed as a percentage of the fair value of all ABS interests issued in the securitization transaction and dollar amount (or corresponding amount in the foreign currency in which the ABS are issued, as applicable)) of the eligible horizontal residual interest required to be retained by the sponsor in connection with the securitization transaction;
- A description of the material terms of the eligible horizontal residual interest to be retained by the sponsor;
- A description of the methodology used to calculate the fair value of all classes of ABS interests;
- The key inputs and assumptions used in measuring the total fair value of all classes of ABS interests and the fair value of the eligible horizontal residual interest retained by the sponsor (including the range of information considered in arriving at such key inputs and assumptions and an indication of the weight ascribed thereto) and the sponsor’s technique(s) to derive the key inputs;
- For sponsors that elect to utilize the horizontal risk retention option, the reference data set or other historical information that would enable investors and other stakeholders to assess the reasonableness of the key cash flow assumptions underlying the fair value of the eligible horizontal residual interest. Examples of key cash flow assumptions may include default, prepayment, and recovery;
- Whether any retained vertical interest is retained as a single vertical security or as separate proportional interests;
- Each class of ABS interests in the issuing entity underlying the single vertical security at the closing of the securitization transaction and the percentage of each class of ABS interests in the issuing entity that the sponsor would have been required to retain if the sponsor held the eligible vertical interest as a separate proportional interest in each class of ABS interest in the issuing entity; and
- The fair value (expressed as a percentage of the fair value of all ABS interests issued in the securitization transaction and dollar amount (or corresponding amount in the foreign currency in which the ABS are issued, as applicable)) of any single vertical security or separate proportional interests that will be retained (or was retained) by the sponsor at closing, and the fair value (expressed as a percentage of the fair value of all ABS interests issued in the securitization transaction and dollar amount (or corresponding amount in the foreign currency in which the ABS are issued, as applicable)) of the single vertical security or separate proportional interests required to be retained by the sponsor in connection with the securitization transaction.