January 29, 2019 - Early this week, the LSTA submitted a comment letter to the Japanese Financial Services Agency (“JFSA”) responding to its recent proposal to impose significantly higher capital charges on Japanese investors who purchase interests in certain securitizations that are not risk retention compliant. (For the Japanese language version of the comment letter click here and for the English language version click here).

We recently explained the background of this proposed rule in detail, observing that because Japanese banks have traditionally purchased a significant portion of US AAA CLO notes, the implications of the rule, if applied to open market CLOs, could be significant.  We also noted that the LSTA would be forming a working group with the goal of submitting a comment letter to the JFSA by the January 28th deadline.

Background

Late this summer, the JFSA initiated informal conversations with Japanese banks, institutional investors and other securitization stakeholders (including US arrangers) to discuss possible capital rule changes for certain securitizations.  Shortly thereafter, 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 open market CLO markets.

The Proposal

As expected, the JFSA published proposed rules just before year-end.  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 is risk retention compliant, a Japanese investor would still be subject to the higher capital charges if it did not have the resources to monitor on an ongoing basis comprehensive information with regard to the structure, risks, assets and performance of the securitization.  Importantly, the higher risk weighting will 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.”

There are two other aspects of the proposed rule that are both noteworthy and puzzling, both going to the question of whether open market CLOs are even subject to the capital rules.  First, the “originator”, the person charged with holding risk retention, is defined as the person who is involved in the origination of the original assets of a securitization transaction directly or indirectly.  CLO managers would certainly not fit within that definition and there is no other provision in the proposal that recognizes managers as the appropriate holders of risk retention.  Moreover, even the definition of “securitization transaction” may be too narrow to cover open market CLOs.  Under the proposal, the somewhat circular definition seems to cover only transactions that involve “original assets” which are assets that must be transferred into the securitization by originators (not managers on behalf of the CLO).  On the other hand, the JFSA has made it clear to the LSTA, other stakeholders and even to reporters at Bloomberg that it does not intend to make broad unconditional exceptions for any particular securitization product in any region.

The LSTA Comment Letter

The LSTA addressed three major points in advocating that investors in open market CLOs should be excluded from higher capital charges.  The first point is that the assets of OM CLOs, broadly syndicated loans, are underwritten (or “formed”) in a multi-tiered, robust, way that is “not inappropriate”.  Among the factors supporting this assertion: (i)   The loans are arranged by leading financial institutions; (ii) A syndicate of arrangers also scrutinizes the loans; (iii) The loans must “clear the market” of sophisticated institutional investors; (iv) The loans are rated by independent rating agencies; and (v) The loans must be structured in such a way that they stand the scrutiny of a robust and transparent secondary market.  The second point is that open market CLOs are structured to align the interests of the managers with those of investors.  They do that by requiring: (i) an independently acting managers who purchase the loans on behalf of the CLO and thus do not face the inherent conflict of someone who “originates-to-distribute”; (ii) that managers be regulated registered advisers that have fiduciary duties to the CLO; (iii) that the fee structure aligns the interests of managers with those of investors by deferring a significant portion of a manager’s compensation.  The third point is that open market CLOs are have many structural investor protections that are unique, including:  OC, IC, subordination and other credit enhancements; (ii) active management; (iii) transparency, requiring that investors receive significant amounts of information about the underlying assets, the performance and the structure of the CLO.

The LSTA augments its principal arguments by noting that the language of the proposed rule seems to exclude open market CLOs, suggesting that perhaps the JFSA agrees with the LSTA’s position that OM CLOs be excluded (a position that was validated by the U.S. Circuit Court in DC with regard to U.S. risk retention rules).

The LSTA concludes by addressing a technical issue regarding the rule that could cause consternation for certain middle market balance sheet CLOs.  The situation would arise for middle market balance sheet CLOs that are not organized by the originators of the loans (but rather by buyers of loans in the secondary market who then transfer the loans to a securitization).  Under the current definition of originator, the initiator of that type of securitization would have no way to technically comply with risk retention because of the rule’s narrow definition of “originator” and “sponsor” (i.e., the originator of the loan who sells the assets to the securitization).  The LSTA also points out that if the JFSA were to conclude that open market CLOs are not excluded from the excess capital charges, there would be no way for managers or their affiliates to comply with risk retention.  The LSTA proposes that the JFSA expand the definition of originator/sponsor to align with the definition in effect in the EU. This would address the technical issue for non-originator balance sheet CLOs, allow middle market balance sheet CLOs to structure globally compliant CLOs, and allow open market CLO managers to comply in the event that the JFSA does not accept the LSTA’s position.

What’s next?

We will be meeting with the JFSA in Tokyo on February 6th to discuss our letter and answer questions.  The JFSA is expected to publish a final rule in February or early March when they will also publish FAQs to address the questions and comments they receive, including ours.  The final rule is expected to go into effect on March 31, 2019.

We are very grateful to Richard Klingler of Sidley Austin in Washington, D.C., and Tomoo Nishikawa and Tomoki Ishiara of Sidley Austin Nishikawa in Tokyo, who drafted (and translated) the letter on our behalf and provided important guidance along the way. We are also grateful to the members of our very engaged working group who provided extraordinarily helpful insights and comments that helped materially improve our early drafts.

For additional information or if you have questions, please reach out to LSTA general counsel, Elliot Ganz at eganz@lsta.org.

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