The re-proposal of the risk retention rules — which generally applies to all asset-backed securities — contains new provisions which are intended to regulate collateralized loan obligation transactions (“CLOs”). As more fully described below, for each CLO, the rule requires that either (x) the relevant CLO manager purchases a 5% vertical or horizontal interest (or combination thereof) in such CLO or (y) the CLO purchases only tranches of loans in which the lead arranger retains a 5% interest. The good news is that the SEC and the other federal agencies have tried to craft a rule that recognizes some of the unique aspects of CLOs. The less good news is that the leveraged loans industry would have to make some potentially significant changes to the way it originates and distributes loans in order to accommodate one of the two methods for compliance with the rule. We expect industry comments to focus the agencies’ attention on possible revisions such that the final rule will not stifle competition among managers in the CLO industry and will not significantly reduce the size of the CLO market, thus diminishing the amount of money which can enter the leveraged loan market through CLOs.
Bingham has separately issued a Client Alert discussing all aspects of the risk retention rule contained in the re-proposal (http://www.bingham.com/Alerts/2013/09/A-Guide-to-the-Re-Proposed-Credit-Risk-Retention). In this Client Alert we will focus solely on the portion of the re-proposal that relates to CLOs. Under “Summary of Risk Retention Rule for CLOs” below we summarize the salient features of the risk retention rule as it applies to CLOs. Under “Further Points to Consider” we include our commentary, views and suggestions on the proposed rule and possible effects it may have on the CLO market and CLO managers.
Section 941 of the Dodd Frank Wall Street Reform and Consumer Protection Act (the “Dodd Frank Act”) requires the “securitizer” of an asset-backed securities deal to retain at least 5% of exposure to the assets collateralizing such deal. In early 2011, the Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, Department of Housing and Urban Development, Federal Housing Finance Agency and Securities and Exchange Commission (collectively, the “Agencies”) proposed a rule (the “Initial Proposal”) to implement this risk retention. On August 28, 2013, the Agencies issued a re-proposed rule (the “Re-Proposed Rule”)1 that amended the Initial Proposal based on comments received by the Agencies.
Generally, the Re-Proposed Rule requires an originator or sponsor of a securitization (the “securitizer”) to retain 5% of the fair value of the asset-backed securities (“ABS”) issued in the applicable securitization (the “Retention Requirement”). A securitizer can satisfy the Retention Requirement in multiple ways. First, the securitizer could retain an interest in the most subordinate class of ABS equal to 5% of the fair value of the ABS issued in the relevant transaction (the “Horizontal Option”), where the projected cash flows of the transaction (as certified by the securitizer to investors on the closing date) demonstrate that the securitizer will not receive repayment of principal or other projected cashflow at a faster rate than is paid on all other ABS interests in the transaction. The Horizontal Option could also be satisfied through the establishment of a reserve account holding cash equal to 5% of the fair value of the ABS, where such cash would be available to the ABS issuer as a source of capital and released to the securitizer at a similar rate as payment under the Horizontal Option. Also the securitizer could retain 5% of the fair value of each class of ABS issued in the transaction (the “Vertical Option”). Finally, the securitizer could satisfy the Retention Requirement with any combination of the Horizontal Option and the Vertical Option in a total amount equal to at least 5% of the fair value of the ABS interests issued as part of the transaction.
With respect to CLOs, the Initial Proposal stated that the “securitizer” of a CLO transaction would be the CLO manager (a “Manager”). The Re-Proposed Rule confirmed that the Manager will be considered the securitizer and therefore must satisfy the Retention Requirement (subject to the Proposed CLO Retention Alternative described below). While, unlike a sponsor or originator of an ABS deal, a Manager typically does not own the applicable collateral before creating the CLO, the Agencies stated that the Manager is a “securitizer” because 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” of the securitization.2
The Agencies recognized that requiring Managers to satisfy the Retention Requirement could diminish competition in the industry and reduce the number of CLO issuances. As such, the Agencies created an alternative option (the “Proposed CLO Retention Alternative”) to satisfy the Retention Requirement for certain CLOs (“Open-Market CLOs”) meeting the following conditions:
Under the Proposed CLO Retention Alternative, the Retention Requirement would be satisfied for an Open Market CLO if the firm acting as lead arranger for each loan to be owned by the CLO were to retain 5% of the face amount of the tranche of such loan being purchased by the CLO. The lead arranger would be required to retain that portion of such tranche of such loan until the maturity, payment in full, acceleration or payment or bankruptcy default of the loan.
The Agencies envision that certain loan tranches meeting this requirement would be designated on issuance as “CLO-eligible” — providing an opportunity for the CLO to satisfy the Proposed CLO Retention Alternative through secondary market purchases. The lead arranger that would satisfy the Retention Requirement must have originated at least 20% of the face amount of the syndicated credit facility, with no other member of the syndicate having a larger allocation or commitment. The Re-Proposed Rule further specifies additional disclosure and documentation obligations for the lead arranger to establish one or more tranches of the loan as CLO-eligible, including covenants in the syndication documents for the lead arranger to satisfy its requirements.
In addition, the loan documents must give holders of a CLO-eligible tranche consent rights with respect to, at a minimum, material waivers and amendments of the loan documents, and the provisions of the loan documents must not be materially less advantageous to the obligor than the provisions that apply to non-CLO-eligible loan tranches.
For an Open Market CLO to take advantage of the Proposed CLO Retention Alternative, the CLO would be required to:
For CLOs relying on the Open Market CLO method of risk retention, the CLO would be required to, among other things, provide a complete list of every asset held by the CLO (or before closing, in a warehouse facility), including the full legal name and SIC code of the obligor, and the name, face amount, price and lead arranger of each loan tranche. This disclosure would be required to be provided (1) to potential investors a reasonable period of time prior to the CLO issuance, (2) upon request from applicable federal agencies and (3) with respect to the information regarding assets held by the CLO, on an annual basis.
Since the Re-Proposed Rule contains two mutually exclusive methods of compliance, it seems unlikely that the “more difficult” path (at least from the lead arrangers’ perspective) will prevail. As more and more, large and well capitalized Managers satisfy the Retention Requirement by purchasing securities of their CLO (either directly or through financing subsidiaries), lead arrangers will be incentivized to favor these Managers. Additionally, to the extent this portion of the CLO market becomes significant or dominant (whether as a result of additional consolidation of managers or otherwise) or demand for leveraged loans can be satisfied by other investors in the leveraged loan market, we question whether the leveraged loan market will be sufficiently motivated to restrict itself with retention obligations. Accordingly, we are particularly concerned about the impact of the Re-Proposed Rule on small and medium sized Managers and possible new entrants into the CLO market.
We are also concerned that while there may be a two year period from the effective date of the final rule to consummate CLO transactions without regard to risk retention, CLO investors may begin to differentiate before then between Managers who can demonstrate sufficient creditworthiness to satisfy risk retention themselves and those who cannot — that is, unless the Proposed CLO Retention Alternative becomes more commonplace.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:
1 Department of the Treasury, Officer of the Comptroller of the Currency, 12 CFR §43, Credit Risk Retention, August 28, 2013 (the “Risk Retention Release”).
2 See Risk Retention Release, pages 143-4.
3 See Risk Retention Release, pages 145-6.
4 See Risk Retention Release, page 148.