The new EU securitisation regulations (Regulations)1 came into force on 17 January 2018, and will be directly applicable across the European Union from 1 January 2019. EU retail funds (Undertakings for Collective Investment in Transferable Securities (UCITS)) are within the scope of the Regulations, which provide for a harmonised set of EU rules on due diligence, risk retention and disclosure applying to all “securitisations” and introduce rules for issuing simple, transparent and standardised transactions (STSs). With the implementation date for the Regulations fast approaching, UCITS investment managers should consider the impact of the Regulations on their existing investment strategies and investment portfolios, and in particular should be aware that many U.S. securitisations are not compliant with EU risk retention requirements and thus may not be acquired.
The Regulations replace the existing sector-specific securitisation regulations with a set of rules that apply uniformly to all securitisations.2 The Regulations are a key building block of the EU’s Capital Markets Union and represent its efforts to develop a level playing field for investors in securitisations with a simple, transparent and standardised securitisation market.
The existing risk retention requirements laid down in various pieces of sectoral legislation will be repealed and replaced by the Securitisation Regulation,3 which provides (among other things) that “institutional investors” can only hold an “exposure to a securitisation” where “the originator, sponsor or original lender” retains a net economic interest of not less than 5% in the securitisation. This risk retention compliance obligation has not been changed significantly by the Updated Risk Retention Rules in the Regulations. The applicability of the Updated Risk Retention Rules, however, has been changed to cover a larger set of institutional investors with effect from 1 January 2019.
While credit institutions, insurance companies and EU alternative investment fund managers (AIFMs) previously were subject to compliance as institutional investors with the risk retention rules noted above, the Updated Risk Retention Rules will also apply to the following types of institutional investors (among others) that, until now, have not been subject to any risk retention obligations: (i) institutions for occupational retirement provision (IORPs) or their appointed investment manager; and (ii) UCITS.
Application to UCITS
In order to ensure cross-sectoral consistency and to remove misalignment between the interests of firms that repackage loans into tradeable securities as well as other financial instruments (originators) and UCITS that invest in those securities, Article 50a of the UCITS V Directive4 required the European Commission to adopt, by means of delegated acts, the requirements that: (i) must be met by an originator of a securitisation in order for a UCITS to be allowed to invest in securities or other financial instruments issued by such originator (including a requirement that ensures that the originator retains a net economic interest of not less than 5% in the securitisation issued by such originator) and (ii) must otherwise be met on a qualitative basis prior to investment by a UCITS.
Article 5 of the Securitisation Regulation (which is directly applicable as a delegated act in the legislation of the home domicile of a UCITS) requires a UCITS management company or a self-managed UCITS to: (i) conduct certain due diligence on any securities or financial instruments with securitisation exposure prior to any investment, and (ii) monitor their holdings and perform ongoing due diligence during the period of investment in such securities.
The Regulations further replace the text of Article 50a of the UCITS V Directive with text requiring that where a UCITS is exposed to securitisation positions that no longer meet the requirements of the Securitisation Regulation, the UCITS shall “in the best interests of the investors in the relevant UCITS, act and take corrective action.”5
Due Diligence Requirements
As with other types of institutional investors subject to the Securitisation Regulation, a UCITS, prior to holding a securitisation position, must verify that all of the following criteria are met:
- Where the originator or original lender established in the EU is not an EU credit institution or an investment firm, the originator or original lender grants all the credits giving rise to the underlying exposures on the basis of sound and well-defined criteria and clearly established processes for approving, amending, renewing and financing those credits, and has effective systems in place to apply those criteria and processes in accordance with Article 9(1) of the Securitisation Regulation (Criteria for Credit Granting).
- Where the originator or original lender is established in a third country outside of the EU, the originator or original lender grants all the credits giving rise to the underlying exposures on the basis of sound and well-defined criteria and clearly established processes for approving, amending, renewing and financing those credits, and has effective systems in place to apply those criteria and processes to ensure that credit-granting is based on a thorough assessment of the obligor’s creditworthiness.
- If established in the EU, the originator, sponsor or original lender retains on an ongoing basis a material net economic interest in accordance with Article 6 (Risk Retention) (i.e., not less than 5% retained by the originator), and the risk retention is disclosed to the institutional investor in accordance with Article 7 (Transparency Requirements).
- If established in a third country outside of the EU, the originator, sponsor or original lender retains on an ongoing basis a material net economic interest which, in any event, shall not be less than 5%, determined in accordance with Article 6 (Risk Retention), and discloses the risk retention to institutional investors.
- The originator or sponsor has made available, where applicable, the information required by the Transparency Requirements.
A UCITS also must carry out a “due-diligence assessment,” which enables the UCITS to assess the risks involved in any investment in a securitisation (prior to the investment). Any assessment by the UCITS must consider (among other things) all of the following criteria:
- The risk characteristics of the individual securitisation position and of the underlying exposures;
- All structural features of the securitisation that can materially impact the performance of the securitisation position (including the contractual priorities of payment and priority of payment-related triggers, credit enhancements, liquidity enhancements, market value triggers, and transaction-specific definitions of default); and
- With regard to a securitisation notified by securitising entities as an STS,6 compliance of that securitisation with the requirements provided for an STS in the Securitisation Regulation).7
Procedures, Stress Testing and Reporting
To comply with the Securitisation Regulation on an ongoing basis, a UCITS (as an institutional investor) is required to establish appropriate written procedures, which are proportionate to the UCITS and its investment risk profile. Where relevant with respect to securitisations purchased by a UCITS and their underlying exposures, the UCITS’ written procedures must include monitoring of, among other things: exposure type; default rates; prepayment rates; loans in foreclosure; recovery rates; repurchases; loan modifications; payment holidays; collateral type and occupancy; frequency distribution of credit scores or other measures of credit worthiness across underlying exposures; industry and geographical diversification; and frequency distribution of loan-to-value ratios with band widths that facilitate adequate sensitivity analysis.
In the absence of sufficient data on cash flows and collateral values, or stress tests on loss assumptions, a UCITS is also required to regularly perform stress tests on the cash flows and collateral values supporting the underlying exposures of certain securitisations, having regard to the nature, scale and complexity of the risk of the securitisation position.
A UCITS must periodically report to its Board of Directors any material risks arising from securitisation positions, in order to assist in the management of risks.
The Regulations apply to securitisation transactions and new securitisation positions issued on or after 1 January 2019. Securitisation transactions or positions issued before 1 January 2019 will continue to be subject to the existing applicable sector-specific regulations, unless new securitisation positions are created.
Next Steps for UCITS Managers
There are a number of structures in the market that are commonly described as “securitisations” or as “asset-backed securities” that, by reason of their structure, may not constitute “securitisations” for the purposes of the Securitisation Regulation (e.g., Fannie Mae, Freddie Mac and Ginnie Mae securities). As a result, UCITS managers should be prepared to review their portfolios and catalogue any “securitisation” exposure issued on or after 1 January 2019 (or positions issued before 1 January 2019 where new securitisation positions are created). UCITS managers also should determine the impact of the Securitisation Regulation on a sub-fund’s portfolio holdings, its investment strategy and performance on a going-forward basis. Further, prior to 1 January 2019, UCITS managers should determine whether new policies and procedures need to be adopted by the UCITS and its investment manager to account for the due diligence, reporting, valuation and stress testing requirements of the Regulations.