July 5, 2017 - The sound you may be hearing is CLO managers’ and underwriters’ collective sigh of relief. As detailed in a Cadwalader’s very comprehensive memo, three European Union legislative institutions have agreed on compromise amendments to proposed EU rules for “simple, transparent and standardized” (“STS”) securitization (the “Securitization Regulation”). They have also reached agreement to proposed regulations impacting the Capital Requirements Regulation (“CRR”). The good news, as Cadwalader notes, “The result of these negotiations will be a regime that is much more supportive of the European securitization market than that which would have arisen from Parliament’s draft of the Securitization Regulation.” More particularly, the final rules affecting CLOs are significantly more benign than those proposed by the EU Parliament which could have had very damaging ramifications. The balance of this note will focus on what the compromise means for CLOs.
Background. The European Commission published its original proposal for STS and CRR in September 2015 and the European Council published proposed amendments to the Commission’s proposals that November. The European Parliament then considered the Commission’s proposal in its “ECON” Committee throughout 2016 and in December published its own report. Since that time, representatives of Parliament, the Council and the Commission have met in a process known as “trilogue” in an effort to reach a common position. While some of the differences were technical and easily resolved, many difficult positions taken by Parliament were political and more challenging. For example, on risk retention, Parliament would have required minimum retention levels of 10% and given regulators the authority to impose levels as high as 20%.
CLOs and the Final Rules. The final compromise contains these elements that impact CLOs and many other securitization asset classes.
Risk retention levels. Critically, Parliament conceded on retention levels, agreeing to preserve the status quo, i.e., the current 5% level for all modes of risk retention including first loss, vertical and L-shaped.
Applicability of Regulation. While retaining the “indirect” approach, i.e., the onus for compliance with the risk retention rules is on investors, the three EU institutions added a direct obligation on one of the originator, sponsor or original lender so long as at least one of them is established as an EU institution. As Cadwalader notes, the jurisdictional ambit of the direct rule is not clear insofar as the determination of EU status.
Definition of “Originator”. The Trialogue compromise includes the “sole purpose” test originally proposed by the Commission and Council (but not Parliament), meaning that an entity is not considered an originator if it was established or operates for the sole purpose of securitizing exposures.
Definition of “Sponsor”. The definition of Sponsor has been widened to include “credit institutions, (i.e., banks) whether or not located in the EU, and “investment firms” as defined in the MIFID II Directive. This should broaden the types of entities that can act as sponsors since it adopts a much more inclusive definition.
Eligible Parties. The Trialogue rejected Parliament’s recommendation to restrict not only who could act as retention holder but also who could invest in EU securitizations. Parliament would have required both retainers and investors to be EU regulated entities, a position that would have closed off important sources of capital.
There are many additional issues covered in the Trialogue compromise that are explained in detail in the Cadwalder memo.
Next Steps. Final legislative texts reflecting the compromise must still be published and the Securitization Regulation and CRR amendment approved by the Council and Parliament. Once that process is completed, the regulations will be published and go into force 20 days later across the EU without the need of transposition into national law by EU member states.
Conclusion. The European CLO market has largely come to terms with the risk retention rules that have evolved since the financial crisis. The compromise reached by the Trialogue is much more benign than what was passed by the EU Parliament and should allow for a continued healthy level of issuance going forward.