Potential Effects on the CLO Market of the Proposed Risk Retention Rules

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.

Summary of Risk Retention Rule for CLOs

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:

1. All assets (the “CLO Assets”) held by the CLO would be senior, secured syndicated loans; and
2. Less than 50% of the CLO Assets would consist of loans syndicated or originated by affiliates of the CLO.³

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:

1. Acquire only CLO-eligible loans and servicing assets (and this requirement would have to be specified in the CLO governing documents);
2. Abstain from purchasing any ABS interests or credit derivatives (other than permitted hedges); and
3. Purchase all assets in open market transactions.⁴

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. 

Further Points to Consider

• Is the Proposed CLO Retention Alternative Viable?: The current leverage loan market does not generally include any retention obligation for lead arrangers. Thus, this proposal raises the following question: have the Agencies created sufficient incentives in the Re-Proposed Rule such that lead arrangers will want to comply?
  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.

• Removal of Managers: All CLO transactions include an investor protection mechanism which allows for the removal of a Manager for cause (and in some cases without cause) and the replacement by a successor. Managers are also allowed to resign subject to the appointment of a successor. Under one potential interpretation of the Re-Proposed Rule, when the Proposed CLO Retention Alternative is not applicable, the retention obligation falls on the entity that is then acting as the Manager of the CLO. Thus, if a Manager is removed or resigns, a successor collateral manager may then need to acquire the 5% risk retention of the removed Manager. If this is the case, the likelihood of finding a possible successor will decrease, since the universe of managers with the wherewithal and willingness to fund that position may be relatively small. There would also be other questions about how to price the investment and the mechanism for arriving at a price may vary depending on whether a successor was chosen following a removal with cause or without cause or by resignation.

• Equity Payments: As described above, if a Manager purchases an eligible horizontal residual interest in a CLO, it will need to certify that its recovery on its equity investment will not occur at a faster rate than the other CLO tranches. This certification will necessarily place hard limits on the amount of excess interest that can be paid on the Manager’s horizontal equity interest under the waterfall unless other tranches are paid contemporaneously (which would not ordinarily occur during the reinvestment period). A Manager satisfying its retention obligation by purchasing exclusively a vertical interest will not be subject to this excess interest limitation, because the certification contained in the Re-Proposed Rule only applies when there is an “eligible horizontal residual interest.” Structurers will need to consider whether the Manager’s horizontal equity interest will thus have different payment terms than equity sold to third parties and what the CLO will do with the excess interest if it is not paid out (e.g., should it be held in a separate account and used as an additional reserve account or should it be reinvested in the deal?). Also, when income items are reinvested and not used to pay expense items, phantom income may be created — thus, even though the Manager does not receive the excess interest it may have to pay income taxes as if it did.

• Transition Period: For CLOs, the final risk retention rule will only become effective two years after the date that the final rule is published. However, in order for the Proposed CLO Retention Alternative to be a commercially viable option, lead arrangers would need to include a retention obligation in loans that are made during this two year period even though the CLOs themselves are not requiring the lead arrangers to do so. Otherwise there may be no inventory of qualifying loans when the rule becomes effective. The Agencies have requested comments on the transition process and whether a delay for effectiveness would be valuable.
  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.

• Asset Mix: The Proposed CLO Retention Alternative requires that all Open Market CLOs be limited to owning senior secured loans, with no allowance for corporate bonds or second lien loans (that currently feature in CLO 2.0 transactions) or other bond types and more esoteric assets (that were factors in the CLO market of the mid 2000s). As such, if this restriction remains in the final rule, the performance, quality and asset mix of CLOs established after the effectiveness of the final rule and using this alternative compliance method may be different from current CLOs and other CLOs created after such effectiveness that do not rely on this compliance method. Larger Managers able to satisfy the Retention Requirements directly (and not through the Proposed CLO Retention Alternative) may gain a further advantage over their competitors by offering a wider array of investment opportunities in their CLO transactions.

• Combination of Retention Requirement and Proposed CLO Retention Alternative: Participants may want to consider whether to propose to the Agencies a combination of Manager retention and the Proposed CLO Retention Alternative. We envision a structure where the Manager purchases some of the structure (say, for example, 2.5% of the fair value of the CLO); then only 50% of the deal would need to be CLO-eligible loans. In this case, the net effect would be the same dollar amount of retention — it is just allocated differently between the Manager and the lead arrangers. Other combinations could also work (e.g. 1% for the Manager and 80% of the loans are required to be CLO eligible). With other revisions to the Re-Proposed Rule this combination potentially could also be a mechanism to give Managers more flexibility in the asset mix. This may be difficult to monitor efficiently, as prepayments of certain assets might cause the CLO to no longer satisfy the Retention Requirement, but we could imagine drafting language to describe necessary steps to move back in compliance (as many CLOs currently have with regard to concentration limitations).

• Financing Possibilities: Theoretically, a Manager could find a financing source to fund the Retention Requirements and thereby obtain sufficient capital to satisfy its obligations.
  • In general, a Manager would be prohibited from transferring or hedging an interest that it is required to retain under the proposed rules, or financing the retained interest on other than a full recourse basis. This prohibition may dramatically reduce financing options, but it is not clear it would be fully prohibitive of all possible financing transactions.
  • A Manager would be permitted to transfer a retained interest to a “majority-owned affiliate” of the Manager (i.e., an entity that directly or indirectly majority controls, is majority controlled by, or is under common majority control with, the Manager). This provision could create some financing options using an affiliate entity.

• Qualifying Commercial Loans: The Re-Proposed Rule confirms that a static pool composed entirely of what are qualifying commercial loans will not be subject to the Retention Requirement. If a pool is partially composed of such qualifying loans, the Retention Requirement can be proportionately reduced subject to a 50% maximum. Due to the tight requirements for satisfying the definition of a qualifying commercial loan (e.g. a leverage ratio of 3.0 or less, a debt service coverage ratio of 1.5 or greater, total liabilities of 50% or less and was funded within six months of closing the CLO) we question to what extent the exemption for qualify commercial loans will be made use of by the CLO industry.

Contacts

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.