On August 28, 2013, six federal agencies, including the Board of Governors of the Federal Reserve System, the U.S. Securities and Exchange Commission, and the Federal Deposit Insurance Corporation (collectively, the "Agencies"), issued a re-proposed rule (the "Proposed Rule") to implement the credit risk retention requirements of Section 15G of the Securities Exchange Act of 1934, as added by Section 941 of the Dodd-Frank Act.
This memorandum summarizes key points of the Proposed Rule that may affect the collateralized loan obligation ("CLO") market practice.
- Two risk retention options would be available: (a) retention of horizontal or vertical interests or a combination of the two; or (b) in connection with an "open market CLO," a new option that requires the lead underwriter of corporate loans to hold five percent of the face amount of the term loan tranche purchased by the CLO.
- Additional disclosure and certification requirements are proposed with respect to "open market CLOs."
- The risk retention requirements for CLOs would become effective two years after the final adoption of the Proposed Rule (i.e., no earlier than the fourth quarter of 2015).
- Comments to the Proposed Rule must be submitted no later than October 30, 2013.
Combined Vertical and Horizontal Risk Retention Option
The Proposed Rule brings more flexibility in satisfying the requirements by allowing a sponsor to retain any combination of vertical and horizontal interests as long as its total interests retained is at least five percent of the "fair value" of all ABS interests (rather than the prior 50%-50% split).1 The Proposed Rule also makes clear that the sponsor may hold interests through majority-owned affiliates.
This standard risk retention option is replete with various additional requirements, including the disclosure requirements for the fair value methodology used, the certification requirements relating to eligible horizontal residual interest ("EHRI") recovery percentages, and certain limits on payments that exceed the expected percentage of the EHRI's fair value (compared to all ABS interests).
Lead Arranger Risk Retention for "Open Market CLOs"
The Proposed Rule allows a new option available for "open market CLOs."2 An "open market CLO" must acquire more than 50 percent of its assets from non-affiliate syndicates. Accordingly, the proposed "open market CLO" option is intended to exclude "balance sheet" CLOs.
In addition to the definitional scope of an open market CLO, the proposed new option (the "Open Market CLO Option") has the following requirements:
- The lead arranger3 for each loan purchased by the CLO must retain at the origination of the syndicated loan at least five percent of the face amount of the term loan tranche purchased by the CLO.
- The lead arranger would be required to retain this portion of the loan tranche until the repayment, maturity, involuntary and unscheduled acceleration, payment default, or bankruptcy default of the loan.
- This requirement would apply regardless of whether the loan tranche was purchased on the primary or secondary market, or was held at any particular time by an open market CLO issuing entity.
The Agencies anticipate that this would effectively create a new type of "CLO-eligible loan tranches" in the market.
In addition, the sponsor of an open market CLO could avail itself of this option only if the following conditions are satisfied:
- the CLO does not hold or acquire any assets other than CLO-eligible loan tranches and servicing assets;
- the CLO does not invest in ABS interests or credit derivatives (other than permitted hedges of interest rate or currency risk); and
- all purchases of assets by the CLO (directly or through a warehouse facility used to accumulate the loans prior to the issuance of the CLO's liabilities) are made in open market transactions.
The sponsor under the Open Market Option would be required to disclose a complete list of each asset held by the open market CLO (or before the CLO's closing, in a warehouse facility in anticipation of transfer into the CLO at closing).4
It is too early to fully anticipate the practicality of the Open Market Option other than to note that for the Open Market CLO Option to become a meaningful alternative, the syndicated loan market would have to achieve some notable changes. Given current market practices, the following challenges and potential drawbacks may arise for any sponsor to utilize the Open Market CLO Option.
First, it is not clear what the long-term impact would be if the Proposed Rule creates a subset of leveraged loans by making them CLO-eligible. While the CLO-eligible tranche and the non-CLO-eligible tranche may share the same terms and conditions and would have the same credit risk associated with them, the CLO-eligibility may create different supply-demand dynamics that may affect the price and the liquidity of these loans. If the CLO-eligible loans were to receive special treatment in the syndicated loan market, it is likely that trading of those loans would be less frequent. This may result in CLOs, and by extension, CLO noteholders, paying more for the same loan issued by the same obligor.
Second, it is not clear what incentives corporate loan underwriters would have to create CLO-eligible loans. It is possible, under certain market conditions, that a successful syndication of certain corporate loans would be difficult without creating CLO-eligible loans. That consideration would need to be measured against the potential regulatory capital cost of owning the five percent retention piece.
In particular, these banks (which may have not other involvement in the securitization markets) may be further disincentivized in the context of one bank taking on an obligation to hold the five percent retention piece of a loan in one or more CLOs to be underwritten by a competitor bank.
Furthermore, the Proposed Rule would require that these banks hold (without hedging) the retention piece until the loans pay in full or default. This means additional credit risk would be borne by the originating banks that may or may not benefit from CLO business. The market will need to help determine whether there is a compatible economic solution to the proposed regulatory approach.
Continuing Discussion of CLO Risk Retention Rules
The Agencies have requested comments on a long list of questions, and robust industry feedback is expected to develop throughout the comment period, which expires on October 30, 2013.
For ease of reference, the Agencies' list of questions is reproduced in the appendix. 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.
APPENDIX – REQUEST FOR COMMENTS FROM THE AGENCIES
50(a). Does the proposed CLO risk retention option present a reasonable allocation of risk retention among the parties that originate, purchase, and sell assets in a CLO securitization?
50(b). Are there any changes that should be made in order to better align the interests of CLO sponsors and CLO investors?
51. Are there technical changes to the proposed CLO option that would be needed or desirable in order for lead arrangers to be able to retain the risk as proposed, and for CLO sponsors to be able to rely on this option?
52(a). Who should assume responsibility for ensuring that lead arrangers comply with requirement to retain an interest in CLO-eligible tranches?
52(b). Would some sort of ongoing reporting or periodic certification by the lead arranger to holders of the CLO-eligible tranche be feasible?
52(c). Why or why not?
53(a). The agencies would welcome suggestions for alternate or additional criteria for identifying lead arrangers.
53(b). Do loan syndications typically have more than one lead arranger who has significant influence over the underwriting and documentation of the loan?
53(c). If so, should the risk retention requirement be permitted to be shared among more than one lead arranger?
53(d). What practical difficulties would this present, including for the monitoring of compliance with the retention requirement?
53(e). How could the rule assure that each lead arranger's retained interest is significant enough to influence its underwriting of the loan?
54(a). Is the requirement for the lead arranger to take an initial allocation of 20 percent of the broader syndicated credit facility sufficiently large to ensure that the lead arranger can exert a meaningful level of influence on loan underwriting terms?
54(b). Could a smaller required allocation accomplish the same purpose?
55(a). The proposal permits lead arrangers to sell or hedge their retained interest in a CLO-eligible loan tranche if those loans experience a payment or bankruptcy default or are accelerated. Would the knowledge that it could sell or hedge a defaulted loan in those circumstances unduly diminish the lead arranger's incentive to underwrite and structure the loan prudently at origination?
55(b). Should the agencies restrict the ability of lead arrangers to sell or hedge their retained interest under these circumstances?
55(c). Why or why not?
56(a). Should the lead arranger role for CLO-eligible loan tranches be limited to federally supervised lending institutions, which are subject to regulatory guidance on leveraged lending?
56(b). Why or why not?
57(a). Should additional qualitative criteria be placed on CLO-eligible loan tranches to ensure that they have lower credit risk relative to the broader leveraged loan market?
57(b). What such criteria would be appropriate?
58(a). Should managers of open market CLOs be required to invest principal in some minimal percentage of the CLO's first loss piece in addition to meeting other requirements for open market CLOs proposed herein?
58(b). Why or why not?
59(a). Is the requirement that all assets (other than servicing assets) consist of CLO-eligible loan tranches appropriate?
59(b). To what extent could this requirement impede the ability of a CLO sponsor to diversify its assets or its ability to rely on this option?
59(c). Does this requirement present any practical difficulties with reliance on this option, particularly the ability of CLO sponsors to accumulate a sufficient number of assets from CLO-eligible loan tranches to meet this requirement?
59(d). If so, what are they?
59(e). Would it be appropriate for the agencies to provide a transition period (for example, two years) after the effective date of the rule to allow some investment in corporate or other obligations other than CLO-eligible loan tranches or servicing assets while the market adjusts to the new standards?
59(f). What transition would be appropriate?
59(g). Would allowing a relatively high percentage of investment in such other assets in the early years following the effective date (such as 10 percent), followed by a gradual reduction, facilitate the ability of the market to utilize the proposed option?
59(h). Why or why not?
59(i). What other transition arrangements might be appropriate?
60(a). Should an open market CLO be allowed permanently to hold some de minimis percentage of its collateral assets in corporate obligations other than CLO-eligible loan tranches under the option?
60(b). If so, how much?
61(a). Is the requirement that permitted hedging transactions be limited to interest rate and currency risks appropriate?
61(b). Are there other derivative transactions that CLO issuing entities engage in to hedge particular risks arising from the loans they hold and not as means of gaining synthetic exposures?
62(a). Is the requirement that the holders of a CLO-eligible loan tranche have consent rights with respect to any material waivers and amendments of the underlying legal documents affecting their tranche appropriate?
62(b). How should waivers and amendments that affect all tranches (such as waivers of defaults or amendments to covenants) be treated for this purpose?
62(c). Should holders of CLO-eligible loan tranches be required to receive special rights with respect those matters, or are their interests sufficiently aligned with other lenders?
63. How would the proposed option facilitate (or not facilitate) the continuance of open market CLO issuances?
64(a). What percentage of currently outstanding CLOs, if any, have securitized assets that consist entirely of syndicated loans?
64(b). What percentage of securitized assets of currently outstanding CLOs consist of syndicated loans?
65(a). Should unfunded portions of revolving credit facilities be allowed in open market CLO collateral portfolios, subject to some limit, as is current market practice?
65(b). If yes, what form should risk retention take?
65(c). Would the retention of 5 percent of an unfunded revolving commitment to lend (plus 5 percent of any outstanding funded amounts) provide the originator with incentives similar to those provided by retention of 5 percent of a funded term loan?
65(d). Why or why not?
66(a). Would a requirement for the CLO manager to retain risk in the form of unfunded notes and equity securities, as proposed by an industry commenter, be a reasonable alternative for the above proposal?
66(b). How would this meet the requirements and purposes of section 15G of the Exchange Act?