April 1, 2014

The U.S. Chamber of Commerce has been voicing its opposition to the federal agencies against the proposed risk retention rules, holding that the rules could hamper the future formation of collateral loan obligations (CLO) and consequently raise financing costs for businesses.

The proposed risk retention rules, which are part of broader Dodd-Frank banking legislation, would require CLO managers to hold capital equal to 5 percent of each CLO issued. Due to the potentially large capital requirements needed, this could squeeze out many but the largest managers from the market. The U.S. Chamber of Commerce contends that CLOs are not "originate to distribute" securitizations. Such securitizations are commonly associated with certain types of mortgage-backed securities in which banks originate mortgages and then sell them for a fee to broker dealers to repackage into securities for resale. The leveraged loan and CLO market instead involves a number of third party CLO investment mangers analyzing and ultimately making investment decisions on loans available in the open market.

Citing a survey from the Loan Syndications and Trading Association (LSTA), the U.S. Chamber of Commerce contends that the proposed risk retention rules could shrink the market for future CLOs by over 70 percent. The risk retention rules had been put on the backburner in light of the December release of the Volcker Rule, but as written, risk retention will very likely have a larger impact on new CLO issuance than Volcker.

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: a) the relevant CLO manager purchases a 5% vertical or horizontal interest (or combination thereof) in such CLO or b) 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.

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”) 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. 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.

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.

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.

Reported by Shambo Dey


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