March 20, 2019 - Will there be Japanese Risk Retention for CLOs? Last Friday, the Japanese Financial Services Agency (JFSA) published its long awaited final rule (the Final Rule) on risk retention/capital costs for investments by Japanese investors in securitizations (including CLOs). The JFSA also published responses to many of the comments they received on their initial draft rule as well as a series of FAQs explaining the finer points of the rule. As Dechert notes in its helpful memo, the bottom line for US CLOs is that “there is a path forward for CLOs that does not include a Japanese risk retention obligation.” This outcome is welcome because Japanese investors provide a material portion of all AAA investments in US CLOs. However, as the LSTA and Sidley pointed out in their recent webinar, the Final Rules and FAQs raise a number of issues that will need to be clarified and resolved over the coming months in order to properly pave the path forward. This article will review what the Final Rule, comments and FAQs say, what we think they mean, what issues still need to be resolved, what is happening with Japanese investors today, and how we think the process is likely to play out in near future.
Late last summer, the JFSA initiated informal conversations with Japanese banks and other securitization stakeholders (including US arrangers) to discuss possible capital rule changes for certain securitizations. Shortly thereafter, through its Japanese counsel, Sidley Austin Nishikawa, the LSTA initiated a high-level, informal dialogue with the JFSA regarding the treatment of open market CLOs. The LSTA provided the JFSA with extensive information and data about all facets of the broadly syndicated loan and CLO markets. The JFSA published proposed rules on December 31, 2018. The proposal would triple regulatory capital charges (capped at 1250%) for certain securitization positions that do not comply with a 5% risk retention requirement. Similar to European risk retention, the onus would be on investors to determine that “originators” or “sponsors” of the securitization hold the risk, whether in a vertical, horizontal or L-shape form. Even if the securitization were risk retention compliant, an investor would still be subject to the higher capital charges if it did not have the resources and organizational structure to be capable of monitoring on an ongoing basis comprehensive information with regard to the structure, risks, assets and performance of the securitization. Importantly, the higher risk weighting would not apply in circumstances where “it is determined on the basis of the originator’s involvement in the original assets, the nature of the original assets or any other relevant circumstances that the original assets were not inappropriately formed.”
On January 28th, the LSTA submitted a comment letter to the JFSA responding to the proposal. The Japanese language version of the comment letter is available here, the English language version is available here, and our summary of the comment letter is available here. In early February, the LSTA, its counsel and a prominent manager met with the JFSA in Tokyo to discuss the proposed rule and our comments.
The Final Rule, Comments and FAQs
Very little is different in the language of the Final Rule compared to the proposed rule but what is different is material. The Final Rule now clearly covers all securitizations, including open market CLOs, and clarifies that parties that did not originate assets are eligible to retain credit risk. The Final Rule clearly aligns with what the JFSA has from the beginning signaled, i.e., that all securitizations are covered by the rule.
The JFSA also confirmed that not only are open market CLOs covered but they would not categorically be exempted based on their structure or characteristics. This is also consistent with what the JFSA staff told us in our February meeting.
The Final Rule continues to have two principal components. First, as a threshold matter a Japanese investor must hold increased capital (up to 1250%) against any securitization investment unless it establishes (I) systems necessary for (i) continuously collecting comprehensive information on (a) the risk characteristics concerning the securitization exposure it holds; and (b) the risk characteristics and performance of the underlying assets in the securitization; and (ii) identification of structural characteristics of the securitization transaction related to the securitization exposure held by the investor; and (II) controls and procedures necessary to implement the above requirements. While little attention has been paid to this first leg of the Final Rule, it appears designed to ensure that smaller Japanese investors refrain from investing in securitizations unless they develop the due diligence and control capabilities necessary to satisfy the JFSA.
The second part of the Final Rule requires that Japanese investors hold excess capital against all securitization exposures unless (ii) the “originator” (including a CLO manager) retains at least 5% of the fair value of the securitization on a horizontal, vertical or “L-shaped” basis, or (ii) “it is determined, on the basis of the originator’s involvement in the original assets, the nature of the original assets or any other relevant circumstances that the original assets were not inappropriately formed.”
What does it mean?
Much ink has been spilled in comments to the JFSA on how to determine whether assets are “not inappropriately formed”. While the JFSA’s comments and FAQs make clear what should not be part of that assessment and they do identify some factors that should be considered, much uncertainty remains because of the vagueness of the factors that should be considered. The JFSA determined that investors could not assure themselves of the quality of the assets based on the open market nature of their purchase, the existence of a robust syndications process, the independence of the CLO manager from the origination process, the existence of independent credit ratings or pricing services, or a the historical performance of the asset class. Instead, investors will have to undertake “In-depth analysis…of the quality of the original assets” underlying the securitization. The elements the JFSA identified that would have to be satisfied for an investor’s analysis to support the conclusion that the assets were not “inappropriately formed” include: (i) the appropriateness of the originator’s underwriting criteria; (ii) whether loan covenants are “conducive to investor protection; (iii) the appropriateness of the terms and nature of the collateral supporting the loan; and (iv) the adequacy of the “claim collection abilities” of relevant parties. Moreover, the adequacy of practices with regard to these factors is to be determined in relation to the investment criteria established by the investor.
The JFSA also identified various processes for investors to demonstrate that they have undertaken this “confirmation and verification” analysis related to loan quality. These include: (i) direct review and analysis of the loan assets underlying the securitization; (ii) review of the manager’s loan acquisition criteria and practices to ensure (a) “that objective and reasonable standards have been established…for…loan acquisitions” for both the initial assets and investment period acquisitions; and (b) verification that the manager is in fact applying those standards (e.g., through a sample check), and (iii) other equivalent types of inquiries to confirm and verify.
What is likely to happen in the near term?
Clearly, Japanese investors can be expected to undertake even more extensive due diligence than they traditionally have. Indeed, some managers are anecdotally reporting that this has been already happening even before the March 31st effective day of the Final Rule. Interestingly, Moody’s recently commented that the new exemptive conditions to Japanese risk retention are credit positive for just this reason. But Japanese investors and CLO managers seeking their investment will have to address a series of open questions for determining that relevant loans qualify as “not inappropriately formed”. Substantive issues include the use of cov-lite loans, what constitutes adequate collateral, underwriting standards and “claims collection ability”. Procedural issues that will need to be worked out include, for open market CLOs in particular, how to describe, implement and verify the manager’s use of appropriate selection criteria. We expect this to play out in the coming months in a process driven by Japanese investors and their advisors, presumably through discussions with CLO managers and the JFSA but, for now, at least some Japanese investors appear to be comfortable relying on the enhanced level of due diligence that they have recently been conducting; there are reportedly numerous CLO transactions in the pipeline that are relying on their investments. The LSTA will continue its engagement with managers and the JFSA as this process of discovery plays out. A recording of the LSTA’s recent webinar and the slides are available here.