It can be difficult to structure securitization transactions that comply with both the US and EU regulatory regimes, a task made even more complicated by the new EU rules that came into effect on January 1, 2019. While the jurisdictional scope of the two sets of rules overlaps, their requirements differ in many respects.
Both United States and European Union laws require 5 percent credit risk retention for securitization transactions. While the jurisdictional scope of the US rules and EU rules overlaps, their requirements vary significantly, so it has always been a challenge to structure a transaction that is economically efficient and where retention of the same 5 percent interest complies with both regimes. A variety of new EU securitization rules that came into force on January 1, 2019, make this challenge even more difficult.
The US credit risk retention rules were adopted in December 2014 to implement the mandate of Section 941(b) of the Dodd-Frank Act Wall Street Reform and Consumer Protection Act of 2010 (the Dodd-Frank Act), which has been codified as Section 15G of the Securities Exchange Act of 1934, as amended (the Exchange Act).
The EU credit risk retention rules were mandated by the G20 summit in September 2009 as a means of ensuring a stronger alignment of the interests of securitization issuers and of the final investors. These rules originally came into force in July 2014, and the difficulties of complying with both the original EU rules and the US rules were discussed in a prior version of this LawFlash.
The current EU risk retention rules are set out in Regulation (EU) 2017/2402 of the European Parliament and of the Council of 12 December 2017 (the Securitization Regulation) and apply to securitizations the securities of which are issued (or for securitizations which do not involve the issuance of securities, the securitization positions of which are created) on or after January 1, 2019.
On July 31, 2018, the European Banking Authority (EBA) published its Final Draft Regulatory Technical Standards (the New Final Draft RTS) addressing requirements relating to eligible forms of retention, the use of synthetic or contingent forms of retention, levels of retention, the prohibition on hedging of retention interests, retention on a consolidated basis, and retention exemptions for certain index trades. As of the date of this LawFlash, the New Final Draft RTS had not been formally adopted by the European Commission. Until it is adopted, these matters will continue to be governed by the transitional arrangements involving elements of the previously applicable rules. Further, the New Final Draft RTS was drafted with a view to continuing (to the extent feasible) the equivalent provisions of the prior rules so, except as otherwise noted, we believe that the New Final Draft RTS will be adopted substantially in the form published by the EBA. For this reason, until the New Final Draft RTS is finalized, both the transitional and the forthcoming EU rules should be considered when analyzing a securitization.
The new EU risk retention requirements are contained in a broader set of securitization rules that also impose, among other things, extensive transparency and disclosure requirements. Until regulations supplementing the Securitisation Regulation and addressing these matters are adopted, relevant parties’ obligations will be based on the transitional arrangements involving elements of the previously applicable rules.
In sum, the current EU securitization rules are based on a complex interaction of new and old regulations, not all of which are finalized, subject to an uncertain transitional period. When and how US issuers must comply with these rules remain matters of intense debate in the securitization industry.
The US risk retention rules apply to sponsors of “securitization transactions” within the jurisdictional scope of the United States, but the scope of that jurisdiction is unclear. Therefore, the rules provide a limited safe harbor for certain foreign transactions. Under this safe harbor, the risk retention requirements do not apply to a securitization transaction if the securities are not required to be and are not registered under the Securities Act of 1933; no more than 10 percent of the dollar value (or equivalent if sold in a foreign currency) of all classes of ABS interests are sold or transferred to US persons or for the account or benefit of US persons; neither the sponsor nor the issuing entity is organized under the laws of the United States or a US state or territory or is an unincorporated branch or office located in the United States of an entity not organized under the laws of the United States or a US state or territory; and no more than 25 percent (based on unpaid principal balance) of the securitized assets were acquired by the sponsor or issuing entity, directly or indirectly, from a majority-owned affiliate of the sponsor or issuing entity that is organized under the laws of the United States or a US state, or an unincorporated branch or office of the sponsor or issuing entity that is located in the United States. The foreign safe harbor is not available for any transaction or series of transactions that technically complies with the safe harbor but is part of a plan or scheme to evade the risk retention requirements. The adopting agencies intended the US rules to apply widely, and for the safe harbor “to exclude only those transactions with limited effect on U.S. interests, underwriting standards, risk management practices, or U.S. investors.”
The EU securitization rules, including their risk retention components, apply to any transaction that constitutes a “securitisation” for the purposes of the EU rules. They apply indirectly via various types of EU-regulated investors including insurance and reinsurance undertakings, institutions for occupational retirement, alternative investment fund managers (AIFMs) who manage or market alternative investment funds in the European Union, management companies of undertakings for the collective investment in transferable securities (UCITS) funds (or internally managed UCITS), and credit institutions (and certain consolidated affiliates) and investment firms (and certain consolidated affiliates) (EU Institutional Investors). They also apply directly to sponsors, originators, and original lenders (and in some cases, the relevant securitization special purpose entity (SSPE)) at the heart of a securitization. The application of the risk retention and associated due diligence requirements to certain investors (including non-EU AIFMs and UCITS and UCITS managers) was introduced for the first time in the new rules that became effective on January 1, 2019.
The EU rules currently do not explicitly address the jurisdictional scope of their direct obligations, so that scope remains unclear.
Neither set of rules gives any credit to a transaction for complying with the other regime. Therefore, it may be necessary to structure a securitization transaction to comply with both sets of rules. For example, a securitization transaction issued by a US issuer will be required to comply with the EU rules in addition to the US rules if any purchaser is to be an EU Institutional Investor. Similarly, a securitization transaction issued by an EU issuer will be required to comply with the US rules in addition to the EU rules if more than 10 percent of the dollar value of the bonds issued is to be sold to US persons in the initial offering, or if more than 25 percent of the asset pool was acquired from US entities.
The US rules apply to any “securitization transaction,” which is defined as “an offer and sale of asset-backed securities by an issuing entity.” For these purposes, “asset-backed security” has the definition provided by the Exchange Act pursuant to the Dodd-Frank Act (Exchange Act ABS). This broad definition encompasses all securities that are collateralized by self-liquidating financial assets that allow securityholders to receive payments based primarily on the cash flows from those assets, whether offered publicly or privately, including collateralized debt obligations, securities issued or guaranteed by a government-sponsored enterprise such as Fannie Mae or Freddie Mac, municipal ABS, and any security that the SEC, by rule, determines to be an asset-backed security. Synthetic securitizations, such as transactions effectuated through the use of credit default swaps, total return swaps, or other derivatives, are not covered.
Thus, in order for the US rules to apply, the transaction must first involve the issuance of a “security,” and that security must be an Exchange Act ABS. While the line between a security and a loan under case law is somewhat vague, a traditional credit agreement entered into by a bank or other traditional loan financing source, particularly if it does not involve the issuance of a note, is unlikely to be covered by the US rules. In addition, although the definition of Exchange Act ABS is quite broad, there are types of securities ordinarily thought of by the markets as asset-backed securities that may not fall within its ambit. For example, some practitioners take the position that aircraft securitizations, where repayment of the bonds ultimately depends more upon the ultimate re-lease or sale of the aircraft than on the proceeds of the current lease, are not Exchange Act ABS.
There is no explicit requirement of tranching in the US rules. While in our view there is a sound policy argument that the definition of Exchange Act ABS should not encompass untranched exposures (or transactions without various other features that are common to asset-backed securities, such as being issued by a special purpose entity and having an asset pool consisting of multiple assets and multiple obligors), this argument is not free from doubt.
The EU rules apply to any “securitisation,” which means “a transaction or scheme, whereby the credit risk associated with an exposure or a pool of exposures is tranched, having all of the following characteristics: (a) payments in the transaction or scheme are dependent upon the performance of the exposure or of the pool of exposures; (b) the subordination of tranches determines the distribution of losses during the ongoing life of the transaction or scheme; [and] (c) the transaction or scheme does not create exposures which possess all of the characteristics [of a specialized lending exposure].” Subject to certain other criteria, a “specialized lending exposure” means an exposure to an entity that was created specifically to finance or operate physical assets and would cover, for example, certain project financing or real estate transactions. These transactions are thereby excluded from the otherwise broad scope of the securitization definition and, as a result, from the ambit of the EU rules.
Notably, the application of the EU rules does not require the issuance of a security and does not draw a distinction between a loan and a security, so the EU rules can apply to warehouse financing arrangements.
The US rules generally require risk to be held by the “sponsor,” defined as the entity that “organizes and initiates an asset-backed securities transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the issuing entity.” While the definition of “sponsor” is skeletal, other key factors to be considered in identifying the sponsor under the US rules include active selection of the pool assets (the most important factor) and undertaking asset selection and securitization activities through the sponsor’s own employees, rather than at the direction of a third party or as a “rubber stamp.” Other typical sponsorship functions include owning the depositor’s equity; forming the issuing entity; selecting the transaction parties and negotiating their fees and agreements; structuring the securitization; and overseeing the drafting of the transaction documents. Under the US rules, even if there are multiple sponsors, only one sponsor must hold the required risk retention, and the other sponsors are responsible for ensuring that the holding sponsor complies with its obligations.
The EU rules require that the “sponsor,” “originator,” or “original lender” retain the relevant risk and that such risk cannot be split between different types of retaining entities.
The EU rules define a “sponsor” more narrowly than the US rules as either a credit institution or an investment firm (other than an originator) that establishes a securitization that purchases exposures from third parties and manages that securitization or delegates that management to certain types of authorized entities.
Under the EU rules, where there are multiple sponsors, the required risk retention may be held either by the one sponsor whose interest is most appropriately aligned with investors (as agreed among the sponsors on the basis of objective criteria such as the fee structures, the involvement in establishing and managing the securitization program, and the exposure to credit risk of the securitizations), or by each sponsor proportionately to the number of sponsors.
The US rules provide a very limited ability to allocate risk retention to an “originator,” defined as the original entity that created a securitized financial asset, by allocating proportionate risk retention only to originators that contribute at least 20 percent of the assets to the asset pool. The originator must acquire its risk retention interests in the same manner and proportion as they were originally established by the sponsor, and the sponsor remains responsible for compliance by the originator.
The ability to allocate risk retention to an originator under the EU rules is much broader. “Originator” is defined as “an entity which: (a) itself or through related entities, directly or indirectly, was involved in the original agreement which created the obligations or potential obligations of the debtor or potential debtor giving rise to the exposures being securitised; or (b) purchases a third party’s exposures on its own account and then securitises them.”
In a report of the EBA dated December 22, 2014 (the EBA Report), with respect to the prior EU rules, the EBA noted:
As a result of the wide scope of the “originator” definition in the CRR, it is possible to establish an ‘originator SSPE’ with third-party equity investors solely for creating an ‘originator’ that meets the legal definition of the regulation and which will become the retainer in a securitization. . . . The EBA considers these types of structures as non-compliant with the “spirit” of the retention requirements.
The EBA Report also indicated that “in the opinion of the EBA, the ‘originator’ definition should in principle ensure that the entity claiming to be the ‘originator’ is of real substance and holds actual economic capital on its assets for a minimum period of time,” and contemplated working toward narrowing down the scope of the originator definition.
In this context, the Securitisation Regulation now provides that “an entity shall not be considered to be an originator where the entity has been established or operates for the sole purpose of securitising exposures.” The New Final Draft RTS requires appropriate consideration be given to the following principles in making such an assessment:
a) the entity has a business strategy and the capacity to meet payment obligations consistent with a broader business enterprise and involving material support from capital, assets, fees or other income available to the entity, relying neither on the exposures being securitised by that entity, nor on any interests retained or proposed to be retained in accordance with [the Securitisation] Regulation, as well as any corresponding income from such exposures and interests; [and]
(b) the responsible decision makers have the required experience to enable the entity to pursue the established business strategy, as well as an adequate corporate governance arrangement.
Although risk retention still may be held by a wide scope of originator entities, including indirect participants in the origination of the receivables and subsequent purchasers of the securitized exposures, careful consideration will need to be given to the old and new EU rules especially during the transitional period before the adoption of the New Final Draft RTS.
Separately, the EU rules also permit the required risk retention to be held by the “original lender” of the securitized exposures, a concept much more akin to the originator under the US rules. Original lender means “an entity which, itself or through related entities, directly or indirectly, concluded the original agreement which created the obligations or potential obligations of the debtor or potential debtor giving rise to the exposures being securitized,” which again offers potential flexibility in the designation of a risk retainer.
Where there are multiple originators (or multiple original lenders), the EU rules generally require each to hold the required risk retention in proportion to the total securitized exposures for which it is the originator (or original lender). As an exception to such requirements, the required risk retention may be held by a single originator or original lender, so long as such originator or original lender either has established and is managing the securitization, or has established the securitization and has contributed more than 50 percent of the total securitized exposures.
The US rules generally permit the required risk to be retained by one or more majority-owned affiliates of the sponsor (or of any other party that is permitted to retain the required risk), in addition to the sponsor. A “majority-owned affiliate” of a party is an entity other than the issuer that directly or indirectly majority controls, is majority controlled by, or is under common majority control with that party. For these purposes, “majority control” means ownership of more than 50 percent of the equity of an entity, or ownership of any other controlling financial interest in the entity, as determined under US generally accepted accounting principles (US GAAP). In our experience, to reach a determination that an entity has a controlling financial interest in another, major accounting firms typically have required that the controlling entity hold at least 20 percent of the equity interests in the controlled entity and virtually all of the voting rights in and other control features over the controlled entity (save, potentially, a veto right over merger, dissolution, and other fundamental corporate transactions).
Under the EU rules, the risk retention requirement may be satisfied on the basis of the consolidated situation of a parent institution, financial holding company, or mixed financial holding company established in the European Union where that institution or one of its subsidiaries, as an originator or sponsor, securitizes exposures from one or more credit institutions, investment firms, or other financial institutions that are included in the scope of the relevant supervision on a consolidated basis. There is no provision for the risk retention obligations to be undertaken by affiliates of a nonregulated sponsor, originator, or original lender. The EBA Report considered and rejected an expansion of these provisions.
The US rules adopt a “direct” approach to risk retention, which imposes a direct legal obligation on the sponsor to retain the required credit risk exposure.
The EU rules apply an “indirect” approach to EU Institutional Investors, who are subject to various due diligence obligations (including verification that the originator, sponsor, or original lender retains the required risk retention and has made the required disclosures). These provisions therefore influence the structuring of securitization transactions indirectly. The EU rules also impose a “direct” approach with respect to the originator, sponsor, or original lender, one of which is required to hold the required risk retention, and the originator, sponsor, or SSPE, one of which is required to fulfill certain transparency and disclosure obligations.
The jurisdictional scope of these obligations is unclear. Market participants have requested further clarification on the jurisdictional scope, particularly as to whether it applies to EU established entities only, to EU regulated entities generally, or to other entities. This question is particularly pointed with respect to the extensive transparency (i.e., disclosure) requirements directly or indirectly imposed by the Securitisation Regulation on originators, sponsors, and SSPEs, which include asset-level disclosures that are supposed to be provided in prescribed formats. These asset-level data requirements may be particularly problematic for US issuers. Asset-level disclosures are not required for private US ABS offerings, and are only required for registered public offerings in certain asset classes. Other issuers may not have systems in place to reliably capture and provide asset-level data. Even for US transactions where asset-level data is required to be provided, the fields may differ from those required in the European Union. In the EBA’s analysis accompanying the New Final Draft RTS, the EBA states (in the context of discussing the direct risk retention obligations) that “a ‘direct’ obligation should apply only to originators, sponsors and original lenders established in the EU as suggested by the Commission.” While as of the date of this LawFlash market views are not uniform, a growing number of non-EU issuers are taking the same view and complying with the Securitisation Regulation only to the extent they are indirectly required to do so, in order to enable EU Institutional Investors to fulfill their due diligence obligations.
Under the new EU rules, originators, sponsors, and original lenders could face potentially significant (and potentially criminal) sanctions if they breach their risk retention obligation. Institutional investors that fail to conduct adequate diligence face potential regulatory sanctions via the regulatory regime through which they are regulated. Investors that are required to maintain regulatory capital are subject to the possibility of penal regulatory capital charges.
Under the US rules, the risk retention requirements in any securitization may be satisfied by a sponsor (or its majority-owned affiliates) that retains an “eligible vertical interest” consisting of at least 5 percent of each class of ABS interests issued as part of the securitization transaction, or a single vertical security representing the same economics.
Alternatively, a sponsor (or its majority-owned affiliates) may retain an eligible horizontal residual interest in an amount equal to at least 5 percent of the fair value of all ABS interests issued as part of a securitization transaction. An “eligible horizontal residual interest,” which represents a first loss position with respect to the entire asset pool, may consist of one or more ABS interests that collectively require any shortfall in funds available to pay principal or interest to reduce amounts payable to the horizontal interest before reducing amounts payable to any other ABS interest, and have the most subordinated claim to payments of both principal and interest. The fair values of the eligible horizontal residual interest and of the other ABS interests issued in the securitization are determined using a fair value measurement framework under US GAAP, as of the closing date.
The US rules permit a sponsor (or its majority-owned affiliates) to retain any combination of eligible vertical interests and eligible horizontal residual interests, so long as the total percentages of the eligible vertical interest and of the fair value of the eligible horizontal interest equal no less than 5 percent.
The EU rules permit five different options (or modalities) for risk retention to be held by an originator, sponsor, or original lender. The first EU alternative is retention of at least 5 percent of the nominal value of each of the tranches sold or transferred to investors. This option is quite similar to the US eligible vertical interest, except that it only requires retention of tranches sold or transferred to investors, whereas the US option requires retention of the required percentage of each class of ABS interests issued.
The second EU alternative applies to revolving securitizations or securitizations of revolving exposures, and permits retention of the originator’s interest of at least 5 percent of the nominal value of the securitized exposures. This option is somewhat similar to the US rules’ “seller’s interest” option for revolving pool securitizations, which provides a special method of risk retention for entities more commonly known as “master trusts,” which are often (but not exclusively) used to securitize revolving receivables. Under the US rules, in a revolving pool securitization, the sponsor (or one or more majority-owned affiliates) may maintain a seller’s interest in an amount not less than 5 percent of the aggregate unpaid principal balance of all outstanding investor ABS interests in the issuing entity. For these purposes, a “seller’s interest” generally is an ABS interest or interests that is collateralized by the issuing entity’s assets (other than certain assets allocated only to a specific series or that are ignored in determining the proportions of assets held with respect to outstanding ABS interests) that is pari passu with (or partially or fully subordinated to) each series of investor ABS interests as to distributions and losses before an early amortization event, which adjusts for fluctuations in the outstanding principal balance of the pool assets.
The third EU alternative is retention of randomly selected exposures equivalent to at least 5 percent of the nominal value of the securitized exposures where such retained exposures would otherwise have been securitized, so long as there were at least 100 potentially securitized exposures at origination. This option is quite similar to the “representative sample” option that was originally proposed for the US rules but was not adopted (and therefore is not permitted under the US rules).
The fourth EU alternative is retention of the first loss tranche and, if necessary, other tranches having the same or a more severe risk profile than those transferred or sold to investors and not maturing any earlier than those transferred or sold to investors, so that the retention equals in total no less than 5 percent of the nominal value of the securitized exposures. A “first loss tranche” is defined in the Securitisation Regulation as “the most subordinated tranche in a securitization that is the first tranche to bear losses incurred on the securitized exposures and thereby provides protection to the second loss and, where relevant, higher ranking tranches.” In its simplest form, this option is fairly similar to the US eligible horizontal residual interests, but there are some differences. The required percentage is calculated by reference to nominal value of the securitized exposures, rather than the US GAAP fair value of the ABS interests issued. This may be of particular significance in transactions that involve reinvestment and/or where assets are or can be acquired at less than par. Also, the more principles-based definition of “first loss tranche” may provide greater flexibility in structuring than the more prescriptive definition of “eligible horizontal residual interest.” The EU rules permit the use of the first loss tranche option in a variety of other ways that are not permitted under the US rules. The EU rules permit the use of a first loss overcollateralization position alone if the tranches are overcollateralized by at least 5 percent of the nominal value of the securitized exposures. The EU rules also permit the use of synthetic or contingent forms of retention. The EU rules do not permit “excess spread” to be taken into account when measuring the retainer’s net economic interest.
The fifth EU alternative is retention of a first loss exposure of at least 5 percent of every securitized exposure in the securitization. While many commenters on the US rules requested the ability to satisfy the risk retention requirement by retaining a participation interest in assets transferred to the issuing entity, no such option was adopted.
Only one of the EU risk retention alternatives may be used for any given securitization; there is no combined option similar to the combined vertical/horizontal option under the US rules. The US rules also have a variety of other retention options that apply only to specific types of securitizations. The “B-piece” option for commercial mortgage-backed securities permits retention by up to two third-party B-piece buyers of a residual B-piece equal to at least 5 percent of the fair value of all ABS interests issued by the issuing entity. The “originator-seller” option for asset-backed commercial paper (ABCP) conduits permits the retention by each originator-seller of a residual interest equal to at least 5 percent of the fair value of all ABS interests backed by receivables of that originator-seller and certain of its affiliates. The Fannie Mae/Freddie Mac guarantee option allows a guarantee provided by Fannie Mae or Freddie Mac to satisfy the risk retention requirement. The tender option bond option permits retention of an eligible horizontal interest that meets the requirements of an eligible vertical interest upon a tender option termination event, or retention of at least 5 percent of the face value of the deposited municipal securities. None of these asset class–specific methods of risk retention has a corresponding provision in the EU rules.
The original US risk retention rules applied the risk retention requirements to the collateral manager of a collateralized loan obligation (CLO) transaction, and provided a mostly unused CLO option that permitted the retention of at least 5 percent of the face amount of each eligible loan tranche by the lead arranger of that loan. However, the US Court of Appeals for the DC Circuit ruled that an open-market CLO manager is not a sponsor because it does not sell or transfer assets to the issuing entity, leaving open-market CLOs exempt from the US risk retention requirements. There is no similar exemption under the EU rules.
Under the US rules, securitizations consisting solely of performing “qualified residential mortgages,” or QRMs, are exempt. The definition of QRM includes loans that meet the definition of “qualified mortgage” as adopted by the Consumer Federal Protection Bureau from time to time. Securitizations with an asset pool consisting entirely of qualified commercial loans, commercial real estate loans, or consumer auto loans (but not auto leases) underwritten to high standards are exempt from the risk retention requirements. Qualified commercial loans, commercial real estate loans, or consumer auto loans securitized in blended pools with nonqualified assets will have a zero percent risk retention requirement, so long as overall risk retention with respect to the securitized pool is a minimum of 2.5 percent, but blended pool treatment is not available for QRMs.
The US rules also exempt certain securitizations in which the ABS or the pooled assets have the benefit of government guarantees. There are two very narrow exemptions for resecuritizations, one of which will permit multiple-class resecuritizations of certain “first pay” mortgage-backed securities that reallocate prepayment (but not credit) risk. There is a partial exemption for securitization transactions collateralized by student loans originated under the Federal Family Education Loan Program (FFELP). A securitization transaction collateralized solely by FFELP loans will have a risk retention ranging from zero percent to 3 percent, depending on the lowest guaranteed amount for any FFELP loan in the pool. There also is an exemption for certain seasoned loans.
The EU rules contain a different, and much narrower, list of exemptions, generally limited to securitized exposures on, or that are fully, unconditionally, and irrevocably guaranteed by, (i) central governments or central banks; (ii) regional governments, local authorities, and public sector entities of EU member states; (iii) certain institutions to which a regulatory capital 50 percent risk weight or less applies; (iv) certain national promotional banks or institutions; and (v) certain multilateral development banks. Unlike the US rules, the EU rules generally do not provide any qualifying asset class exemptions.
Under the EU rules, the required risk retention may be achieved on a synthetic or contingent basis, including through the use of derivatives, under any of the permissible risk retention options, so long as “the amount retained is at least equal to the requirement under the option to which the synthetic or contingent form of retention can be equated” and the retainer complies with various related disclosure requirements. However, this option is practically useful only where the retaining entity is a credit institution because other entities retaining interests on a synthetic or contingent basis must fully collateralize those interests in cash, which is held on a segregated basis as client funds.
The US rules do not permit sponsors (or their majority-owned affiliates) to satisfy the risk retention requirements on a synthetic or contingent basis.
Under the US rules, a sponsor or majority-owned affiliate holding a required risk retention interest generally may not transfer that interest except to another majority-owned affiliate (or, if held by a majority-owned affiliate, to the sponsor), with other parties permitted to hold the required interest being subject to similar restrictions.
There also are stringent hedging prohibitions, prohibiting a sponsor or any affiliate from entering into any transaction or agreement if payments on a related financial instrument, derivative, or other position are materially related to the credit risk of any ABS interests that the sponsor (or a majority-owned affiliate) is required to retain, if the position would in any way limit the financial exposure of the sponsor (or majority-owned affiliate) to the credit risk of interests it was required to retain. Issuing entities’ hedging activities are similarly limited, so any credit protection or hedge obtained by an issuing entity may not limit the financial exposure of the sponsor (or any majority-owned affiliate) on any interest required to be retained.
Neither a sponsor nor any affiliate may pledge an interest it is required to retain as collateral for any financing (including a transaction structured as a repurchase agreement) unless the financing is full recourse to the borrower. “Full recourse” is not defined, but at a minimum any financing of the risk retention piece clearly should be full recourse by its terms to the financing sponsor or majority-owned affiliate, placing no restrictions on the ability of the lenders to enforce the terms of the financing against that entity. In the event of a default under such a financing where the retained interest is taken by the lender, the borrower will have violated the prohibition on transfer.
The US rules do not specifically prohibit a majority-owned affiliate from issuing to others the portion of its economic equity that is not required to be retained by the sponsor, nor do they prohibit a sponsor’s equity from being owned by any entity in any amount. Cautious practitioners will consider whether the prohibitions on transfer and hedging may be violated by such arrangements, especially when the retained interests also are the subject of a secured financing, on the theory that using techniques that are otherwise permitted by the rules may move the benefits and burdens of ownership of the risk retention interest so far away from the securitization that the retention no longer serves as an effective incentive for a high-quality securitization.
The EU rules broadly prohibit the retained net economic interest from being sold or transferred or being subject to any credit risk mitigation or any hedging. These restrictions are to be applied in the light of the purpose of the retention requirement, taking account of the economic substance of the transaction as a whole, so hedges are permitted only where they do not hedge the retainer against the credit risk of either the retained securitization positions or the retained exposures. Retained securitization positions or exposures may be used as collateral for secured funding purposes including where the relevant funding arrangements involve a sale, transfer, or other surrender of all or part of the rights, benefits, or obligations arising from the retained net economic interest (e.g., pursuant to a repurchase agreement), as long as that use does not transfer the exposure to the credit risk of the retained exposures or securitization positions to a third party.
Under the US rules, there are sunset dates after which all restrictions on transfer and hedging expire. For all asset-backed securities other than residential mortgage-backed securities, the restrictions generally will expire on the latest of the date that the total unpaid principal balance (if applicable) of the securitized assets has been reduced to 33 percent of the cut-off date unpaid principal balance; the date that the total unpaid principal balance of the ABS interests issued has been reduced to 33 percent of the closing date unpaid principal balance; and two years after the closing date. For residential mortgage-backed securities, the restrictions will expire on the later of five years after the closing date and the date that the total unpaid principal balance of the underlying mortgages has been reduced to 25 percent of the unpaid principal balance as of the closing date, but no later than seven years after the closing date. For commercial mortgage-backed securities, a retained B-piece may be transferred five years after closing, provided that the transferee satisfies all requirements applicable to an initial third-party purchaser. The transfer and hedging restriction sunset provisions do not apply to any sponsor of a revolving pool securitization that satisfies its risk retention requirements by retaining a seller’s interest.
All requirements of the EU rules apply for the life of the transaction.
Under the US rules, the requirements for risk retention generally are determined separately for resecuritization bonds and for the underlying resecuritized bonds. The US rules include two narrow resecuritization exemptions for resecuritizations, and resecuritizations generally are subject to the risk retention requirements. Therefore, while risk may have been retained on the underlying security (if it was issued after the compliance date of the risk retention rules and did not fall under an exemption), the required risk retention position also must be retained by the sponsor (or a majority-owned affiliate) of the resecuritization.
Under the EU rules, resecuritizations (that is, any securitization that includes another securitization as an underlying exposure) are prohibited except for certain approved transactions conducted for limited insolvency–related or investor protective “legitimate” reasons or for certain fully supported ABCP programs.
Assume that a US finance company is securitizing receivables that it generated, and it wants to sell the bonds in both the United States and the European Union. Assume further that it wants a single 5 percent interest to satisfy its retention obligations under both the US rules and the EU rules.
Assume that the securitization involves a simple unified principal and interest “waterfall” (i.e., priority of payments), in which interest is paid first to the senior bonds and then to the subordinated bonds, after which principal is paid first to the senior bonds then to the subordinated bonds, with the remainder being paid to the holder of the residual interest, which the finance company plans on retaining for independent economic reasons. Therefore, the finance company would prefer to use its retention of that residual to satisfy the requirements of the eligible horizontal interest option under the US rules and the first loss tranche option under the EU rules. However, the finance company anticipates that both the notional value and the fair value of the residual at closing will be less than the required 5 percent.
Assume that it is fairly clear that the finance company is the sponsor under the US rules, in that it selected the pool assets, transferred them to the issuing entity, and will undertake all other securitization activities through its own employees. However, assume that the finance company does not wish to hold the risk retention interest directly; rather, it wishes for an affiliate that is under 100 percent common control to do so. The members of the finance company group are not EU based or subject to EU regulatory supervision on a consolidated basis.
The residual interest in the securitization would appear to qualify as an eligible horizontal residual interest under the US rules and a first loss tranche under the EU rules, but as noted above, it would not alone represent either the required 5 percent fair value under the US rules or the nominal value under the EU rules. What are the sponsor’s options to make up the difference?
Under the US rules, it could hold a vertical strip representing the remainder under the combined option, but this is not permissible under the EU rules.
Both the US rules and the EU rules permit the retention of the next most senior interest—in this case, the subordinated bonds—as part of the eligible horizontal residual interest/first loss tranche options. The subordinated bonds in this case meet the EU requirement as they have the same or a more severe risk profile than the bonds transferred or sold to investors, and do not mature any earlier than the bonds transferred or sold to investors.
Under the US rules, the subordinated bonds have the most subordinated claim to payments of principal and payments of interest, but because interest on the subordinated bonds is paid before principal on the senior bonds, it does not appear that any shortfall in funds available to pay principal or interest will always reduce amounts payable to the subordinated bonds before reducing amounts payable to any other ABS interest. Therefore, in order for the subordinated bonds to count as part of the eligible horizontal residual interest for US purposes, the waterfall would need to be restructured in some way. Some possible solutions might be to change the payment priorities so that interest and principal are paid on the senior bonds before either interest or principal is paid on the subordinated bonds, or to recast the subordinated bonds as “zero coupon” bonds that do not bear interest. The drawback of these approaches is that they may make the portion of the subordinated bonds that is sold less marketable. Another potential option is to make use of the “first principal payment/regular principal payment” structure that is common in US automobile deals, but that structure may not be common or accepted in the particular asset class. In any event, the US rules’ requirement to use US GAAP fair value rather than nominal value probably means that the finance company will need to retain significantly more of the subordinated bonds than would be required solely to satisfy the EU rules.
If the finance company does not wish to restructure the waterfall, then in order to avoid holding separate or overlapping interests to satisfy the requirements of both regimes, the only remaining option would be to use the eligible vertical interest/nominal value of each tranche option. However, this would not be economically desirable because it would not give full credit to the retention of the residual interest that the finance company already intends to retain.
In the United States, many practitioners would agree that any affiliate that either is under majority common control with the sponsor or meets the US GAAP common control test could be an appropriate holder of the required risk retention interest, even if it is a limited-purpose entity. If a substantial amount of the equity in the affiliate were sold to third parties, especially if the interest was financed by means of a facility where the true credit source was one or more of these third parties, a cautious practitioner might consider whether the arrangement could be considered to violate the rules’ prohibition on hedging. However, holding of the required risk retention interest by a 100 percent affiliate, as the example assumes, would cause few concerns.
There is no majority-owned affiliate option under the EU rules, and under our example the relevant entities are not established in the European Union or subject to EU regulatory supervision on a consolidated basis (which could permit compliance with the EU rules on a consolidated basis). Therefore, the only way that an affiliate of the finance company could hold the required risk retention interest would be to independently meet the requirements of the definition of sponsor, originator, or original lender. That would be quite difficult for a newly formed special purpose affiliate, even one that is under 100 percent common control. Only an existing independent affiliate with significant involvement in the finance company’s business is likely to meet the EU requirements. For example, the relevant affiliate might fit within leg (a) of the definition of “originator” under the EU rules. That determination would require a facts-and-circumstances analysis as to whether such affiliate was “itself or through related entities, directly or indirectly, . . . involved in the original agreement which created the obligations or potential obligations of the debtor or potential debtor giving rise to the exposures being securitised.” While such factual analysis is not specifically required under the US rules, it would be key to the EU analysis.
Due to the requirement of the EU rules that the required interest be retained for the life of the transaction, any otherwise liquid classes of bonds that were retained (i.e., a portion of the class of subordinated bonds if the waterfall were restructured to allow compliance with the US eligible horizontal interest requirements, or the 5 percent vertical portion of the senior and subordinated bonds if the vertical interest option were chosen) could never be monetized by sale (except as part of a permitted financing), even after the expiration of the US rules’ prohibition on transfer.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact one of the authors, Charles A. Sweet, Paul Matthews, or Theresa D. Kradjian, or any of the following Morgan Lewis lawyers:
 See Credit Risk Retention, SEC Rel. No. 34-73407, 79 Fed. Reg. 77,602 (Dec. 24, 2014). For more details on the US credit risk retention rules, see our previous LawFlash titled “A Guide to the Credit Risk Retention Rules for Securitizations.” The US rules became effective for residential mortgage-backed securities (RMBS) on December 24, 2015, and for other asset classes on December 24, 2016.
 The EU rules were first introduced in the Capital Requirements Directive II (CRD II) 2006/48/EC. On January 1, 2014, risk retention provisions specified in CRD II were replaced by Part Five of Regulation (EU) No. 575/2013 (CRR), and the RTS/ITS developed under Article 410 of the CRR, and came into force in July 2014. Prior to January 1, 2019, the EU risk retention rules were contained in Articles 404–410 of the CRR and Commission Delegated Regulation (EU) No. 625/2014 (the Old RTS); Article 51 of Regulation (EU) 231/2013, referred to as the “Alternative Investment Fund Manager Regulation”; and Articles 254 to 256 of Commission Delegated Regulation 2015/35, referred to as the “Solvency II Regulation.” Our prior LawFlash regarding the challenges of complying with both the US rules and these prior EU rules, which is updated here, is titled “Multijurisdictional Securitization in the Age of Risk Retention.”
 Earlier securitizations (which were subject to prior versions of the EU rules) remain subject to certain of the retention, due diligence, and disclosure requirements of those rules.
 Annexes I to VIII of Delegated Regulation (EU) 2015/3.
 The definition of “sponsor” under the US rules is discussed below.
 The definition of “ABS interest” under the US rules is discussed below.
 US regulators have clarified that this restriction generally applies only to the securities sold or transferred in the initial distribution of securities. However, secondary sales into the United States contemplated at the time of issuance could be viewed as a plan or scheme to evade the rule, and thus not covered by the safe harbor.
 A “US person” generally is a natural person resident in the United States; a partnership, corporation, limited liability company, or other entity organized under the laws of any state or the United States; a trust of which the trustee is a US person; an estate of which an executor or administrator is a US person; a trust of which a trustee is US person; an agency or branch of a foreign entity located in the United States; any nondiscretionary or similar account held by a dealer or fiduciary for the benefit or account of a US person; a discretionary or similar account held by a dealer or fiduciary organized or (if an individual) resident in the United States; or a partnership, corporation, limited liability company, or other entity organized under foregoing law by a US person principally for the purpose of investing in unregistered securities. There are also various specific exemptions from the general definition of US person. This definition of “US person” is similar, but not identical, to the definition of US person under Regulation S.
 This development was discussed in our recent LawFlash titled “The EU Securitization Regulation—Application to AIFS and UCITS.”
 As set out in Article 147(8) of Regulation (EU) No. 575/2013.
 For prior discussions regarding the difficulty of identifying the sponsor in complex securitization structures, see our LawFlashes titled “Credit Risk Retention: Who Is the Sponsor of a Securitization?” and “The LSTA Case: DC Circuit Court Delivers Victory for CLO Industry, with Some Broader Ramifications.”
 ABS collateralized by residential or commercial mortgages, or by auto loans or leases, and repacks or resecuritizations.
 Depending on the supervisory powers adopted in each EU member state in connection with the Securitisation Regulation.
 An “ABS interest” includes most types of interests issued by an issuing entity, whether or not certificated, the payments on which primarily depend on the cash flows from pool assets, other than a noneconomic REMIC residual interest.
 The sponsor also may establish a “horizontal cash reserve account” in lieu of retaining all or any part of an eligible horizontal residual interest, containing cash equivalents equal to the same amount that would be required if the sponsor held an eligible horizontal residual interest.
 This “combined” option was known as the “L-shaped” option in the original proposal, which would have required the vertical and horizontal legs to be equal.
 “Excess spread” is defined in the New Final Draft RTS as “finance charge collections and other fee income received in respect of the securitised exposures net of costs and expenses.”
 See our LawFlash titled “The LSTA Case: DC Circuit Court Delivers Victory for CLO Industry, with Some Broader Ramifications.”
 For a loan to be a qualified mortgage, generally, it must fully amortize over its term, which cannot exceed 30 years; underwriting must take into account all mortgage-related obligations, must be based on the maximum rate permitted under the loan during the first five years, and must be on a fully amortized basis; the lender must consider and verify the borrower’s current or reasonably expected income or assets and current debt obligations; the borrower must have a total (or “back-end”) debt-to-income ratio that is less than or equal to 43 percent (based on the highest payment that could occur in the first five years of the loan); and it generally cannot require points or fees in excess of 3 percent of the loan amount (other than “bona fide discount points” on prime loans).
 Except as noted above with respect to “specialized lending exposures” relating to the financing or operation of physical assets.
 “Synthetic form of retention” is defined in the New Final Draft RTS as “the retention of a material net economic interest through the use of derivative instruments.”
 “Contingent form of retention” (as set out in the current form of the New Draft Final RTS) means the retention of a material net economic interest through the use of guarantees, letters of credit, and other similar forms of credit support ensuring an immediate enforcement of the retention.
 However, there are certain types of hedges that are explicitly permitted, including hedges related to interest rates, currency exchange rates, or home prices or tied to other sponsors’ securities, and credit hedges involving instruments tied to certain indexes, which indexes may include the relevant issue only on a limited basis.
 When risk-reducing transactions or instruments cover either the retained ABS interests (e.g., bond insurance) or 100 percent of the credit risk of the securitized assets (e.g., municipal bond insurance), the sponsor may not receive distributions that otherwise would not be available for distribution unless all other amounts due to all other holders of ABS interests have been paid in full.