United States: Reproposed Credit Risk Retention Requirements For Asset-Backed Securities Transactions

Introduction

The Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act") was signed into law by President Obama on July 21, 2010.  On April 29, 2011, the Federal banking agencies (the Office of the Comptroller of Currency, the Federal Deposit Insurance Corporation and the Board of Governors of the Federal Reserve System), the Securities and Exchange Commission ("SEC"), the Department of Housing and Urban Development ("HUD"), and the Federal Housing Finance Agency ("FHFA") (collectively, the "Agencies") published a joint notice of proposed rulemaking¹ containing proposed rules (the "Original Proposal") to implement the credit risk retention requirements of Section 941 of the Dodd-Frank Act, codified as Section 15G ("Section 15G") of the Securities Exchange Act of 1934 (the "Exchange Act"). On August 28, 2013, after receipt of comments from over 10,500 persons, institutions and groups on the Original Proposal, the Agencies released a notice of proposed rulemaking (the "NPR")² containing a revised set of proposed rules (the "Proposed Rules") to implement the credit risk requirements of Section 15G. 

The Agencies have requested comments to the Proposed Rules by October 30, 2013. The regulations will become effective, with respect to residential mortgage-backed securities ("RMBS"), one year after publication of the final rules in the Federal Register, and, with respect to all other asset-backed securities ("ABS"), two years after such publication. 

Significant Changes from the Original Proposal

The Proposed Rules, which are described in detail below, contain a number of changes from the Original Proposal, the most significant of which are:

• Fair Value.  The standard risk retention requirement has been modified to apply to the "fair value," determined in accordance with U.S. generally accepted accounting principles ("GAAP"), rather than the par value of the ABS interests issued in the securitization.  Additional disclosures are required about the methodologies, inputs and assumptions used by the sponsor to determine fair value.
• PCCRA Eliminated.  Because the fair value methodology eliminates the Agencies' concern that the risk retention requirement could be subverted through structuring retained classes with relatively low values while selling excess spread at a premium, the controversial requirement in the Original Proposal to fund a premium capture cash reserve account ("PCCRA") has been eliminated.
• Combination of Retention Options Permitted.  Sponsors are now permitted to satisfy their risk retention requirement by holding any combination of eligible vertical and horizontal interests, rather than being limited to selecting only vertical retention, horizontal retention or a 50/50 "L shaped" combination, as contemplated in the Original Proposal.
• Representative Sample Eliminated.  Because of the complexity involved in implementing it, the Agencies have eliminated the Original Proposal's option to satisfy the risk retention requirement through the retention of a "representative sample" of the assets designated to be securitized.
• QRM Equals QM.  The detailed definition contained in the Original Proposal of "qualified residential mortgage" or "QRM", which provides an exemption from the risk retention requirement for ABS backed solely by QRMs, has been conformed to the definition of "qualified mortgage" or "QM" under the Consumer Financial Protection Bureau's ability to repay rule.  This will allow more residential mortgage loans to qualify as QRMs than would have qualified under the Original Proposal because, among other things, the QM definition allows a back-end debt-to-income ratio of up to 43%, versus 36% as required under the Original Proposal, and there is no maximum loan-to-value ratio ("LTV") under the QM definition, whereas the QRM definition in the Original Proposal contained an 80% maximum LTV requirement.
• Sunsets on Transfer and Hedging Restrictions.  The Original Proposal restricted transfer, hedging and non-recourse financing of the interest required to be retained for the life of the transaction.  Recognizing that underwriting risks diminish as loans become more seasoned, the Proposed Rules provide for sunset periods on the transfer and hedging restrictions, which differ for RMBS and other types of ABS.  In addition, the Proposed Rules provide that where the risk retention is satisfied in CMBS transactions by the holding of a horizontal interest by the sponsor or a qualified third-party purchaser, the sponsor or purchaser may transfer the interest on or after five years from the date of issuance to another qualified third-party purchaser, subject to the same conditions that the initial third-party purchaser is required to satisfy.
• Expansion of Master Trusts that May Use a Seller's Interest.  The Original Proposal restricted the use of a retained seller's interest to satisfy the sponsor's risk retention requirement for master trusts to trusts solely containing revolving assets.  The Proposed Rules now permit a seller's interest to satisfy the sponsor's risk retention requirement in revolving master trusts used to securitize short-term non-revolving assets.
• Alternative for Open Market CLOs.  The Proposed Rules confirm the view of regulators that, with respect to collateralized loan obligation transactions ("CLOs"), the manager of a CLO (a "CLO Manager") is a "securitizer" for purposes of Section 15G, but permit the risk retention with respect to certain "open market CLOs" to be held by the lead arranger of the securitized loans.
• Alternative for Tender Option Bonds.  The Proposed Rules add a tailored alternative method of satisfying the risk retention requirements for tender option bonds.
• Blending of Certain Qualified and Non-Qualified Loans.  The Original Proposal contained an exemption for ABS backed exclusively by "qualifying" commercial, commercial real estate or auto loans.  The Proposed Rules allow qualified loans to be mixed with non-qualified loans of the same asset type in a single securitization to proportionately reduce the amount of risk retention required based on the percentage of qualified loans in the pool, but not below 2.5% of the fair value of the ABS.
• Additional Exemptions Added, Including for Certain Student Loan ABS.  The Proposed Rules add new exemptions, which eliminate or reduce the required amount of risk retention for (i) certain resecuritizations of "first pay" classes that are already subject to risk retention, (ii) certain utility cost recovery securitizations, (iii) securitizations by the FDIC acting as receiver or conservator, (iv) student loan securitizations collateralized by FFELP loans and (v) ABS collateralized by seasoned loans.

I. The Proposed Rules

A. General

Section 15G generally requires the applicable Agencies to jointly prescribe regulations (i) to require a securitizer to retain at least 5% of the credit risk of any asset it, through the issuance of asset-backed securities, transfers, sells, or conveys to a third-party, and (ii) to prohibit a securitizer from directly or indirectly hedging or otherwise transferring the credit risk that the securitizer is required to retain under Section 15G and the rules implemented thereunder. 

The Proposed Rules generally require sponsors to satisfy the 5% risk retention requirements for assets they securitize and provide some alternatives for retention by originators and other third parties as discussed below.  The party or parties required to hold retained credit risk are generally prohibited from directly or indirectly hedging or transferring the credit risk required to be retained.  However, as described below, the Proposed Rules permit transfers, under limited circumstances, by sponsors and qualified third-party purchasers in CMBS transactions, and the restrictions on hedging or transferring the retained risk are subject to sunset provisions, the terms of which differ for RMBS and all other ABS.  The Proposed Rules also contain some exemptions that eliminate or reduce the required risk retention for certain ABS.

The Proposed Rules would apply to a sponsor of an ABS offering regardless of whether such offering is registered with the SEC under the Securities Act of 1933 (the "Securities Act") or is exempt from registration.

II. Party to Retain Risk

A. Sponsor

Under the Proposed Rules, the "sponsor"³ of a "securitization transaction"⁴ in which "asset-backed securities" ("ABS")⁵ are issued would generally be required to retain an economic interest in the credit risk of the "securitized assets",⁶ unless otherwise exempted under the Proposed Rules.  If there is more than one sponsor of a securitization transaction, each sponsor is required to ensure that at least one of the sponsors retains an economic interest in the credit risk of the securitized assets.

Note:  The Proposed Rules contemplate that, in a multi-sponsor transaction, the required risk retention may be allocated among the sponsors.⁷ No particular parameters are specified with respect to  the amount of any allocation among sponsors, other than that the risk be retained by "at least one sponsor," which  raises the question of whether the originator allocation limitations described below would apply to a sponsor who is also an originator of less than all of the underlying assets.

Note:  The NPR provides no guidance on how sponsors can definitively satisfy their obligation to "ensure" compliance by another sponsor, raising the question of whether contractual provisions will be enough or whether active monitoring and disclosure to investors by the non-retaining sponsors is required. 

B. Originator 

The Proposed Rules would permit a sponsor to allocate its risk retention obligations to originator(s)⁸ of the securitized assets in certain circumstances and subject to certain conditions.

For purposes of the Proposed Rules, an "originator" is the original creditor of a loan or receivable (i.e., the entity that "created" such loan or receivable), and not a subsequent purchaser or transferee.  A sponsor that satisfies its risk retention requirement by holding either an eligible vertical interest or an eligible horizontal residual interest (including funding an eligible horizontal cash reserve account) would be allowed to allocate a portion of its risk retention obligation to any originator of underlying assets in the securitization transaction that contributes at least 20% of the underlying assets to the pool by selling a portion of the retained interest to the originator for cash or a reduction in the price paid by the sponsor to the originator for the securitized assets.  The amount of risk retention that the originator may assume must be at least 20% but cannot exceed the percentage, by unpaid principal balance, of securitized assets it originated.  The originator would be subject to all of the same requirements for holding the risk retention amount and would be subject to the same restrictions on transfer, hedging and financing imposed on the sponsor as summarized in Part III.H of this memorandum.  Although a sponsor may transfer a portion of the retained risk to an originator, the sponsor is obligated to monitor compliance by the originator with the requirements of the Proposed Rules and to notify the holders of ABS interests of any instances of noncompliance by the originator.  The sponsor is also required to disclose to investors, a reasonable period of time prior to sale of the ABS and, upon request, to the SEC and its applicable Federal banking regulators, certain information about the originator and the form, amount and nature of payment for, the interest retained by the originator.

Note:  Although the percentage of the risk retention requirement that can be allocated to an originator cannot exceed the percentage of securitized assets originated by such originator, the risk retention by such originator is with respect to the entire pool of securitized assets, not just the assets originated by such originator.

Note:  In some transactions, notably most CMBS "conduit" transactions, there are multiple sponsors that are also originators.  The Proposed Rules are unclear about whether the obligation of a sponsor to ensure a minimum 5% risk retention overrides the limitation on such sponsor, in its role as originator, from retaining more than its pro rata portion of the aggregate 5% requirement (although presumably this was the Agencies' intention).  Given the limitations that prevent a less-than-20% originator from helping to satisfy a transaction's risk retention requirement, a greater than pro rata burden is, by definition, imposed upon sponsors in any transaction where an originator contributes less than 20% of the collateral. 

Note:  In CMBS transactions where the sponsors elect to partially satisfy their risk retention obligation through the third-party purchaser retention option described below, it is not entirely clear whether the originator 20% minimum requirement applies to the aggregate 5% sponsor obligation (which would mean that no originator could retain less than 1% of fair value) or if it refers to the net obligation of the sponsors after taking into account B-piece buyer retention.

C. Other Parties 

As discussed below, the sponsor could satisfy its risk retention obligations if risk is retained by B-piece buyers in CMBS transactions, originator-sellers in certain asset-backed commercial paper conduits or lead arrangers of CLO-eligible tranches in certain Open Market CLOs. 

III. Form and Amount of Risk Retention

Unless one of the exemptions described in Part IV of this memorandum applies to reduce or eliminate the risk retention requirement, the sponsor is required to retain a portion of the transaction equal to at least 5% of the fair value of all ABS interests in the issuing entity issued as part of the transaction, including those retained by the sponsor.  The fair value of the ABS interests is required to be determined in accordance with U.S. GAAP and as of the day on which the price of ABS sold to third party investors is determined.

Note:  The price paid by investors for different classes in an ABS transaction may be determined on different days or, in the case of "at the market" offerings, investors who purchase at different times may pay different prices for the same class of ABS interests.

A. Standard Risk Retention

A sponsor may satisfy its risk retention requirements by retaining an "eligible vertical interest" or an "eligible horizontal residual interest" or any combination thereof having a fair value at least equal to 5% of the fair value of all ABS interests in the securitization.⁹

Note:  In the NPR, the Agencies state that they "preliminarily believe that non-economic residual interests would constitute ABS interests."  Failure by the Agencies to rethink this preliminary belief and at least carve out non-economic REMIC residual interests would be highly problematic for RMBS and CMBS transactions. In the case of vertical risk retention, it would force the sponsor to hold 5% of the REMIC residual which, in addition to requiring the sponsor to assume tax liabilities and burdens unrelated to the credit quality of the collateral, would create an untenable situation if the sponsor is a "disqualified organization," as defined in the REMIC regulations, because the credit risk retention rules mandate that the sponsor keep the residual, while the tax rules mandate that it dispose of it.  Similarly, if the sponsor elects to hold a horizontal interest, because a REMIC residual, even though it is non-economic, is entitled, and indeed required, to receive any remaining cash flow after all classes of securities have been paid, even if no such cash flow is expected, the non-economic REMIC residual may be considered the most subordinate ABS interest in the structure and would thereby need to be retained in its entirety by the sponsor to satisfy the conditions for an eligible horizontal residual interest.

Note:  Not only would considering non-economic REMIC residual interests to be ABS interests be problematic for sponsors, it would actually be counterproductive to the fundamental purpose of the Proposed Rules to require sponsors to retain 5% of the overall fair value of the ABS interests.  Because non-economic REMIC residual interests generally have a negative value, since they are not entitled to any cash flow and have net tax liabilities associated with their ownership, including them in the fair value calculation would actually reduce the amount of risk that the holder of an eligible horizontal residual interest is required to retain.   

Vertical Risk Retention.  An eligible vertical interest is an interest in each class of ABS interests issued in the securitization that constitutes the same portion of the fair value of such class. Therefore, to satisfy its risk retention obligation solely through the use of an eligible vertical interest, a sponsor would need to retain 5% of the fair value of each ABS interest issued by the issuing entity.  As an alternative to holding multiple interests in the issuing entity, which may increase the sponsor's administrative burden, the Proposed Rules specify that a "single vertical security," entitling the sponsor to specified percentages of the principal and interest paid on each class of ABS interests in the issuing entity (other than such single vertical security), which specified percentages "result in the fair value of each interest in each such class being identical" would also meet the definition of eligible vertical interest.

Note:  In the NPR, the Agencies note that the eligible vertical interest would require holding an interest in each class of ABS interests, regardless of whether certificated or uncertificated.  Given the breadth of the definition of ABS interests, it might be helpful for the Agencies to clarify that uncertificated REMIC interests used in RMBS and CBMS transactions to structure cash flows for tax purposes and either held solely by one of the REMICs constituting the issuing entity or combined into a single certificated security would not be considered ABS interests for purposes of risk retention.

Note:  While the language of the Proposed Rules literally states that the fair value of each interest in each class represented by a single vertical security would have to be identical, the more logical construction, and one supported by the Agencies' description in the NPR, is that the percentage of the fair value of each class represented by the single vertical security would need to be equal.  A technical correction to the text of the Proposed Rules would seem in order.

Horizontal Risk Retention.  An eligible horizontal residual interest is an ABS interest in the issuing entity that has the most subordinated claim to payments of both principal and interest by the issuing entity and, with respect to which, on any payment date on which the issuing entity has insufficient funds to satisfy its obligation to pay all contractual interest or principal due, any resulting shortfall will reduce amounts paid to the eligible horizontal residual interest prior to any reduction in the amounts paid to any other ABS interest, whether through loss allocation, operation of the priority of payments, or any other governing contractual provision (until the amount of such ABS interest is reduced to zero).  The Proposed Rules permit multiple classes to constitute an eligible horizontal residual interest, as long as they are the most subordinate classes in the capital stack.

Because of concerns by the Agencies that the risk alignment between securitizers and investors would be diminished if an eligible horizontal interest were structured in such a fashion as to have its balance reduced disproportionately faster than that of other ABS interests in the securitization, the Proposed Rules require that the transaction be structured such that, based on the structuring assumptions, the sponsor not receive payments on its eligible horizontal residual interest at a faster rate than principal is received by investors in all ABS interests in the securitization.  This is accomplished by requiring the sponsor to make and certify, prior to the issuance of the eligible horizontal residual interest, a one-time calculation of (i) the Closing Date Projected Cash Flow Rate for each payment date for the eligible horizontal residual interest and (ii) the Closing Date Projected Principal Repayment Rate for each payment date for all ABS interests in the securitization.  Prior to the issuance of the eligible horizontal residual interest, the sponsor must certify to investors that it has calculated the Closing Date Projected Cash Flow Rate and the Closing Date Projected Principal Repayment Rate for each payment date and that the Closing Date Projected Cash Flow Rate for each payment date does not exceed the Closing Date Projected Principal Repayment Rate for such payment date.

The "Closing Date Projected Cash Flow Rate" is the projected rate of payments on the eligible horizontal residual interest on each payment date, calculated as of the closing date of the securitization and using the same discount rates and assumptions used to calculate the fair value of the eligible horizontal residual interest.  This calculation is performed by projecting the cumulative cash flow to be paid to the holder of the eligible horizontal residual interest through such payment date and dividing it by the projected cumulative cash flow to be paid to the holder of the eligible horizontal residual interest through maturity.  The "Closing Date Projected Principal Repayment Rate" is the projected rate of payments on all of the ABS interests (including the eligible horizontal residual interest) on each payment date, calculated as of the closing date of the securitization and using the same discount rates and assumptions used to calculate the fair value of the ABS interests.  This calculation is performed by projecting the cumulative amount of principal on all ABS interests through such payment date and dividing it by the aggregate principal amount of all the ABS interests issued in the securitization (including the eligible horizontal residual interest).

As part of its disclosures to investors prior to sale of the ABS interests, the sponsor must disclose the number of securitization transactions securitized by the sponsor during the previous five-year period in which the sponsor retained an eligible horizontal residual interest and the number (if any) of payment dates in each such securitization on which actual payments to the sponsor with respect to the eligible horizontal residual interest exceeded the cash flow projected to be paid to the sponsor on such payment date in determining the Closing Date Projected Cash Flow Rate.

The Agencies have proposed for comment an alternative condition on eligible horizontal residual interests.  The proposed requirement described above that the transaction be structured, as of the issuance date, so as not to provide disproportionate distributions on the eligible horizontal residual interest, does not actually restrict distributions to the sponsor on any payment date that are greater than anticipated if prepayments, losses and other factors vary from those assumed at issuance.  By contrast, the alternative proposal would not impose any structuring conditions, but would instead prohibit distributions on the eligible horizontal residual interest on any payment date in excess of the eligible horizontal residual interest's proportionate share of cumulative distributions.  The horizontal interest's proportionate share would be the proportion represented at issuance by the fair value of the eligible horizontal residual interest of the total fair value of all ABS interests.

Note: The imposition of a "projected cash flow" vs. "projected principal repayment" test essentially requires that the rate of cash flow to retained junior securities does not, on any payment date, exceed the rate of principal amortization on the transaction as a whole.  This restriction may make horizontal retention unworkable in any ABS transaction where principal amortization occurs relatively later in the life of the transaction.  For instance, CMBS transactions generally contain loans that require amortization based on an amortization schedule that is longer than the term of the loan (e.g., a 30-year amortization schedule on a 10-year loan), with many loans having an "IO period" during which no amortization is required. Such loans require a balloon payment at maturity, resulting in a highly disproportionate percentage of principal being paid in the later years of the transaction.  In an extreme example of a single loan CMBS transaction in which the underlying loan has an initial IO period, the retained B-piece would not be permitted to receive any cash flow, including accrued interest, in the early part of the transaction, even though the loan is fully performing and interest cash flow on the underlying loan is available for distribution, but could only begin to receive cash when the underlying loan begins to amortize.  Since the Agencies seem to understand that most commercial mortgage loans provide for back-ended principal amortization (see the discussion of Qualifying CRE Loans in Part IV.B.2 of this memorandum), it is unclear whether the Agencies intended this result.  A similar unintended consequence could occur in RMBS transactions in which, due to the front-loading of interest in the actuarial amortization schedule used on the vast majority of residential mortgage loans, interest cash flow on the collateral is received at a faster rate than principal is received during the early years of a transaction.

A simple solution to the problem noted above would be for the Agencies to base the concept of Closing Date Projected Principal Repayment Rate on the rate on which total cash flows, rather than principal payments, are projected to be received on the ABS interests through any payment date.  Interestingly, in the alternative condition described above, the Agencies did, in fact, choose to compare the horizontal interest's cash flow to total cash flow, rather than total principal payments.

Note:  The interaction of the new fair value methodology with the definitions of eligible horizontal residual interest and ABS interest raises an interesting issue.  Because fair value must be determined at the time of sale of the ABS interests, it is not possible to know the exact size of the eligible horizontal vertical interest until the transaction structure has already been set.  A sponsor could presumably structure conservatively to make sure that the most subordinated class will represent at least 5% of the fair value of the ABS interests, but if that class turns out to represent, for example, 6% of the fair value at the time of sale of the ABS interests, the Proposed Rules are not clear about whether the sponsor could sell a portion of the class, representing 1% of fair value, to a third party.  This is because an eligible horizontal residual interest is defined, in part, as an ABS interest that has the most subordinated claim to payments of principal and interest by the issuing entity and that will suffer a reduction in the amounts paid to it on any payment date on which the issuing entity has insufficient funds to make all payments of principal and interest due prior to any reduction in the amounts paid to any other ABS interest.  Since the definition of ABS interest, in turn, refers to "any type of interest or obligation issued by an issuing entity, whether or not in certificated form," the question arises as to whether the "extra" 1% of the most subordinate class would itself be a separate ABS interest, thereby disqualifying the 5% piece from qualifying as an eligible horizontal residual interest because it is pari passu with, and not subordinated to, the 1% interest.

Horizontal Cash Reserve Account.  In lieu of holding all or any part of an eligible horizontal residual interest, the Proposed Rules would allow a sponsor to fund a horizontal cash reserve account to be held with the securitization trustee in an amount equal to the fair value of the eligible horizontal residual interest or portion thereof.  The account would be required to be structured to absorb the same first loss risks as would be absorbed by retained horizontal residual securities.  To that end, cash in the reserve account must be released to satisfy payments on ABS interests in the issuing entity on any payment date on which the issuing entity has insufficient funds from any source to satisfy an amount due on any ABS interest.  Until all ABS interests are paid in full or the issuing entity is dissolved, amounts in the account (other than interest payments received in the account in respect of permitted investments specified in the Proposed Rules) may not be released to the sponsor unless (1) the sponsor has complied with its calculation and certification responsibilities with respect to the Closing Date Projected Cash Flow Rate and the Closing Date Principal Repayment Rate and (2) the amounts released to the sponsor or other holder of the horizontal cash reserve account do not exceed, on any release date, the Closing Date Principal Repayment Rate as of that release date.  In calculating the Closing Date Projected Cash Flow Rate and the Closing Date Principal Repayment Rate, funds released from the horizontal cash reserve account are treated like amounts that would be paid on an eligible horizontal residual interest.

Required Disclosures:  The Proposed Rules would require that the sponsor cause to be provided to potential investors a reasonable time prior to the sale of the related ABS and, upon request, to the SEC or appropriate Federal banking agency (if any) written disclosures under the caption "Credit Risk Retention" as follows:

Horizontal interest. With respect to any eligible horizontal residual interest held, a sponsor must disclose:

• The fair value (expressed both as a percentage of the fair value of all of the ABS interests issued in the securitization transaction and as an absolute dollar amount (or foreign currency amount, if the ABS interests are not denominated in U.S. dollars)) of (i) the eligible horizontal residual interest the sponsor will retain (or did retain) at the closing of the securitization transaction, and (ii) the eligible horizontal residual interest that the sponsor is required to retain under the Proposed Rules;
• A description of the material terms of the eligible horizontal residual interest to be retained by the sponsor;
• A description of the methodology used to calculate the fair value of all classes of ABS interests, including any portion of the eligible horizontal residual interest retained by the sponsor;
• The key inputs and assumptions used in measuring the total fair value of all classes of ABS interests, and the fair value of the eligible horizontal residual interest retained by the sponsor, including but not limited to quantitative information, as applicable, about discount rates, loss given default (recovery), prepayment rates, defaults, lag time between default and recovery, and the basis of forward interest rates used; and
• The reference data set or other historical information used to develop the key inputs and assumptions used to measure fair value of all classes of ABS interests, including loss given default and actual defaults.

If the sponsor retains risk through the funding of a horizontal cash reserve account, the sponsor must disclose:

• The amount to be placed (or that is placed) by the sponsor in the horizontal cash reserve account at closing, and the fair value (expressed both as a percentage of the fair value of all of the ABS interests issued in the securitization transaction and as an absolute dollar amount (or foreign currency amount, if the ABS are not denominated in U.S. dollars)) of the eligible horizontal residual interest that the sponsor is required to fund through the cash reserve account under the Proposed Rules;
• A description of the material terms of the horizontal cash reserve account; and
• The same information required in connection with holding an eligible horizontal residual interest regarding methodology, inputs and assumptions used to determine the fair value of all ABS interests and the data and historical information used to develop key inputs and assumptions.

Note:  The requirement to disclose the dollar value of the retained interest a reasonable amount of time prior to the sale of the ABS interests creates a circularity issue.  Because the fair value of the ABS interests is required to be measured at the date that they are sold to third parties, by definition the dollar value of the retained interest can't be known prior to sale.

Note:  The requirement to disclose the value of the eligible horizontal residual interest (or, as noted below, the eligible vertical interest) that the sponsor is required to retain is somewhat confusing, in that the Proposed Rules generally do not require a specific interest to be retained, but only mandate the minimum percentage of fair value of the ABS to be retained in any combination of eligible interests.  For example, a sponsor with a 5% risk retention requirement may choose to hold 2% through an eligible vertical interest and 2% through an eligible horizontal residual interest and fund 1% through an eligible horizontal cash reserve account.  It might be clearer if, rather than specifying disclosure, with respect to each type of risk retention, of the amount that the sponsor is required to hold, the Agencies were to mandate that the sponsor disclose the total percentage of the fair value of the ABS that it is required to retain.

Vertical interest.  With respect to any eligible vertical interest, the sponsor must disclose:

• Whether the sponsor will retain (or did retain) the eligible vertical interest as a single vertical security or as a separate proportional interest in each class of ABS interests in the issuing entity issued as part of the securitization transaction;
• With respect to an eligible vertical interest retained as a single vertical security:
  • The fair value amount of the single vertical security that the sponsor will retain (or did retain) at the closing of the securitization transaction and the fair value amount of the single vertical security that the sponsor is required to retain under the Proposed Rule; and
  • Each class of ABS interests in the issuing entity underlying the single vertical security at the closing of the securitization transaction and the percentage of each class of ABS interests in the issuing entity that the sponsor would have been required to retain under the Proposed Rule if the sponsor held the eligible vertical interest as a separate proportional interest in each class of ABS interest in the issuing entity;
  • With respect to an eligible vertical interest retained as a separate proportional interest in each class of ABS interests in the issuing entity, the percentage of each class of ABS interests in the issuing entity that the sponsor will retain (or did retain) at the closing of the securitization transaction and the percentage of each class of ABS interests in the issuing entity that the sponsor is required to retain under the Proposed Rules; and
  • The same information as required in connection with holding an eligible horizontal residual interest regarding methodology, inputs and assumptions used to determine the fair value of all ABS interests and the data and historical information used to develop key inputs and assumptions.
  • Sponsors are required to retain all required disclosures, as well as the certifications relating to the projected payment rate of any eligible horizontal residual interest, for three years after all ABS interests in the related securitization transaction are no longer outstanding.

B. CMBS B-Piece Buyer Retention

For CMBS transactions, the Proposed Rules allow a sponsor to satisfy all or a portion of its risk retention obligation if a third-party purchaser ("B-piece buyer") purchases and holds (for its own account) an eligible horizontal residual interest in the same form, amount and manner as would be held by a sponsor under the horizontal risk retention option.  The Proposed Rules permit the use of the B-piece buyer retention option for either the entire risk retention obligation or for a portion of the risk retention obligation in combination with a vertical interest held by the sponsor.

The eligible horizontal residual interests can be acquired by up to two B-piece buyers as long as each interest is pari passu with the other interest.  Each B-piece buyer would be required to satisfy, and would be subject to, all of the requirements set forth in the Proposed Rules that would otherwise apply to a sponsor that was retaining an eligible horizontal residual interest, including the prohibitions on hedging and transferring any portion of the risk required to be so retained, except as set forth below.

Definition of Commercial Real Estate Loan.  Use of the B-piece buyer alternative is only available for ABS transactions that are collateralized solely by commercial real estate loans and related servicing assets.¹⁰ The Proposed Rules define "commercial real estate loans" as loans that are secured by five or more single family units or by nonfarm nonresidential real property if 50% or more of the source of repayment is expected to be the proceeds of the sale or refinancing of the property or rental income¹¹ from the property.  Excluded from the definition of a "commercial real estate loan" are (i) a land development and construction loan (including one-to-four family residential or commercial construction loans), (ii) any other land loan and (iii) an unsecured loan to a developer.

Note: The Agencies stated in the NPR that a "commercial real estate" loan does not include a loan made to the owner of a fee interest in land that is ground leased to a third party who owns the improvements on the property.  Therefore, such loans could not be included in a CMBS pool where the sponsor is relying on the B-piece buyer alternative for risk retention.

General Requirements.  Satisfaction of all or a portion of the risk retention requirement for CMBS transactions by use of the B-piece buyer retention alternative is subject to satisfaction of the following conditions (among others):

• The CMBS are collateralized solely by commercial real estate loans, as defined above, and related servicing assets.
• Each B-piece buyer must pay for the eligible horizontal residual interest in cash at the securitization closing.
• A B-piece buyer may not obtain direct or indirect financing for the purchase of such interest from any other party (or an affiliate) to the securitization (other than a person that is a party solely by virtue of being an investor).
• Each B-piece buyer must conduct an independent review of the credit risk of each asset in the pool prior to the sale of the CMBS, which review must include, at a minimum, a review of the underwriting standards, collateral and expected cash flows of each loan in the pool.
• No B-piece buyer may be affiliated with any party to the securitization transaction (including, but not limited to the sponsor, depositor or servicer) other than (i) an investor, (ii) the special servicer or (iii) one or more originators that in the aggregate originated less than 10% of the unpaid principal balance of the asset pool.
• The securitization provides for the appointment of an operating advisor that is not affiliated with any of the other securitization parties and has no financial interest in the transaction (other than fees for its role as operating advisor), with the following rights and responsibilities:
  • the operating advisor is required to act in the best interest of, and for the benefit of, investors as a collective whole;
  • the operating advisor must meet standards of experience, expertise and financial strength that are set forth in the CMBS transaction documents (although the Proposed Rules do not set forth any such standards, leaving the transaction parties to determine what standards should apply);
  • when the horizontal residual interest is reduced to 25% or less of its initial principal balance, the special servicer must be required to consult with the operating advisor in connection with, and prior to, making any material decisions relating to the servicing of the mortgage loans, including, without limitation, any material modification or waiver of the terms of a loan agreement, foreclosure or acquisition of a mortgaged property;
  • the operating advisor must have adequate and timely access to information and reports necessary to fulfill its duties;
  • the operating advisor must be responsible for reviewing the actions of the special servicer, reviewing the reports of the special servicer, reviewing for accuracy and consistency the calculations made by the special servicer and issuing a report to investors periodically on whether the special servicer is operating in compliance with the standards provided for in the transaction documents (including any standards with which it believes the special servicer failed to comply); and
  • the operating advisor must have the authority to recommend replacement of the special servicer if the operating advisor determines that (i) the special servicer has failed to comply with the standards provided in the transaction documents and (ii) such replacement would be in the best interest of the investors as a collective whole. If the operating advisor makes such a recommendation, then the special servicer may be replaced upon the affirmative vote of a majority of all CMBS holders voting on the matter (with a minimum of 5% of all CMBS holders constituting a quorum for such a vote).

Note:  Although the NPR states that the purpose of the operating advisor is to serve as a check on a B-piece buyer's control over special servicing, the Proposed Rules do not make any distinction between transactions in which the holder of the B-piece is given special servicing control rights and those in which the holder of the B-piece has no such rights (such as large-loan or single asset CMBS).  In addition, the Proposed Rules contain no phase-out for the role of the operating advisor after the B-piece buyer's interest has been written down as a result of realized losses.  In fact, the Proposed Rules increase the operating advisor's role following a 75% reduction in the principal balance of the retained horizontal interest, which is typically when the B-piece buyer's rights are diminished.

Note:  There is no requirement for an operating advisor if a sponsor retains a horizontal residual interest even if the interests held by the sponsor grant it control over special servicing activities.

Disclosure.  The Proposed Rules require the sponsor to disclose the name and form of organization of each initial B-piece buyer, a description of each initial B-piece buyer's experience in investing in CMBS, and any other information regarding each B-piece buyer that is material to investors in light of the circumstances of the transaction.  Additionally, the sponsor must disclose the percentage of the fair value of CMBS that is represented by the eligible horizontal residual interest that each B-piece buyer will retain, the purchase price paid by each B-piece buyer and a description of the material terms of the interest retained by each B-piece buyer.

Note:  The requirement to disclose the purchase price for which each B-piece buyer acquires its position seems to be particularly troublesome, because issuers, underwriters and investors generally consider that information as proprietary and confidential.

Exception to Transfer Restriction.  In general, each B-piece buyer must comply with the same restrictions on hedging, transfer and financing as are applicable to a sponsor that retains an eligible horizontal residual interest.¹² However, on or after the date that is five years after the closing date of a CMBS transaction, the B-piece buyer (and any subsequent B-piece buyer thereafter) can transfer a retained interest to another B-piece buyer who will in turn be subject to similar restrictions as the initial B-piece buyer (i.e., no more than two B-piece buyers, must purchase the interest for cash, may not obtain direct or indirect financing from any party to the securitization (or any affiliate), may not be affiliated with any of the deal parties (other than special servicer and less than 10% originator) and restrictions on hedging, transfer and financing).

Note: Given these requirements, which are intended to ensure that the subsequent B-piece buyer exercises the same discipline as the initial B-piece buyer (or a retaining sponsor), it is unclear why the five-year holding period by the sponsor and the initial B-piece buyer is justified, particularly with respect to the sponsor, who is otherwise permitted to transfer its retained interest to a B-piece buyer on the date of issuance.

Responsibility for Compliance.  Although a sponsor can satisfy all or a portion of its risk retention obligations through the B-piece buyer retention alternative, the sponsor remains responsible for compliance by each B-piece buyer and each subsequent B-piece buyer with the risk retention rules.  As such, the Proposed Rules require the sponsor to maintain and adhere to policies and procedures to monitor each B-piece buyer's compliance.  If the sponsor determines that a B-piece buyer no longer complies with the retention requirement it must notify investors in the related CMBS.

C. Revolving Master Trusts (Seller's Interest)

Revolving master trusts are often used for securitizations when the underlying assets consist of revolving lines of credit (e.g., credit card accounts) or to create ABS having longer maturities than the short-term assets securitized by using the proceeds of maturing assets to acquire new assets during an initial non-amortization period.  These trusts issue multiple series of ABS interests that are backed by a single pool of assets that are expected to change in composition over time.  The sponsors of these trusts typically hold a direct interest in the assets backing the ABS interests.  Prior to the occurrence of an early amortization event, the sponsor's interest in the assets backing the ABS interests is typically pari passu with the interests of the holders of the ABS interests. 

The Proposed Rules would allow a sponsor of a revolving asset master trust to satisfy the risk retention requirement by maintaining a "seller's interest" in an amount not less than 5% of the unpaid principal balance of all outstanding investors' ABS interests issued by the issuing entity.¹³ The seller's interest may be retained by one or more wholly-owned affiliates of the sponsor, including one or more depositors of the revolving master trust.

The Proposed Rules define a "revolving master trust" as an issuing entity that is (i) a master trust; and (ii) established to issue on multiple issuance dates one or more series, classes, subclasses, or tranches of ABS all of which are collateralized by a common pool of securitized assets that will change in composition over time.  This definition is intended to be consistent with market practices and is intended to include revolving trusts that securitize short-term loans, such as insurance premium finance loans, and use the proceeds of maturing loans in order to acquire new loans to collateralize longer-term securities.

The Proposed Rules define a "seller's interest" as an ABS interest or ABS interests (i) collateralized by all of the securitized assets and servicing assets owned or held by the issuing entity other than assets that have been allocated as collateral only for a specific series; (ii) that are pari passu to each series of investors' ABS interests issued by the issuing entity with respect to the allocation of all distributions and losses with respect to the securitized assets prior to an early amortization event (as defined in the securitization transaction documents); and (iii) that adjust for fluctuations in the outstanding principal balance of the securitized assets in the pool. 

Note:  Both the definition of "revolving master trust" and "seller's interest" are intended to be consistent with market practices.  The definition of "seller's interest" is also designed to make sure that the interest retained by the sponsor would be aligned with the interests of investors at a series, rather than a pool, level.

The required seller's interest must meet the 5% test at the closing of each issuance of ABS interests by the issuing entity, and at every seller's interest measurement date specified under the securitization transaction documents, but no less than monthly, until no ABS interest in the issuing entity is held by any person not affiliated with the sponsor.

In the case of a revolving master trust that holds collateral certificates issued by another revolving master trust having the same sponsor, the Proposed Rules allow the sponsor's risk retention to be met by retaining a seller's interest for the assets represented by the collateral certificates through either revolving master trust, provided that the proportion of the risk retention satisfied by the seller's interest in the master trust that issued the collateral certificates is not less than the proportion the collateral certificates represent of the total assets of the master trust that issues the ABS interests as of each required measurement date. 

The 5% seller's interest required on each measurement date may be reduced on a dollar-for-dollar basis by the balance, as of such date, of an excess funding account in the form of a segregated account that (i) is funded in the event of a failure to meet the minimum seller's interest requirements under the securitization transaction documents by distributions otherwise payable to the holder of the seller's interest; (ii) is pari passu to each series of investors' ABS interests issued by the issuing entity with respect to the allocation of losses with respect to the securitized assets prior to an early amortization event; and (iii) in the event of an early amortization, makes payments of amounts held in the account to holders of investors' ABS interests in the same manner as distributions on securitized assets. 

The Proposed Rules clarify that, in the case of a revolving master trust containing solely revolving assets, a reduction in the seller's interest below the percentage required by the Proposed Rules after an event of default triggers early amortization, as specified in the securitization transaction documents, of all series of ABS interests issued by the trust to persons not affiliated with the sponsor, will not violate the sponsor's risk retention requirement if (i) the sponsor was in full compliance with its risk retention requirement on all measurement dates prior to the event of default that triggered early amortization; (ii) the terms of the seller's interest continue to make it pari passu or subordinate to each series of investors' ABS interests issued by the issuing entity with respect to the allocation of all losses with respect to the securitized assets; (iii) the terms of any horizontal interest relied upon by the sponsor to offset the minimum seller's interest amount continue to require the interests to absorb losses in accordance with the requirements specified by the Proposed Rules for the combination of a seller's interest with a horizontal interest; and (iv) the revolving master trust issues no additional ABS interests after early amortization is initiated to any person not affiliated with the sponsor, either during the amortization period or at any time thereafter.

Required Disclosure.  If a sponsor of a revolving asset master trust elects to use the seller's interest option to satisfy the risk retention requirement, the Proposed Rules require that the sponsor disclose or cause to be disclosed in writing to potential investors a reasonable period of time prior to the sale of the ABS interests in the securitization transaction, under the caption "Credit Risk Retention" (i) the value (expressed both as a percentage of the unpaid principal balance of all of the investors' ABS interests issued in the securitization transaction and as an absolute dollar amount (or foreign currency amount, if the ABS are not denominated in U.S. dollars)) of the seller's interest that the sponsor will retain (or did retain) at the closing of the securitization transaction, the fair value (expressed as a percentage of the fair value of all of the investors' ABS interests issued in the securitization transaction and dollar amount (or corresponding amount in the foreign currency in which the ABS are issued, as applicable)) of any horizontal risk retention that the sponsor will retain (or did retain) at the closing of the securitization transaction, and the unpaid principal balance or fair value, as applicable (expressed as percentages of the values of all of the ABS interests issued in the securitization transaction and dollar amounts (or corresponding amounts in the foreign currency in which the ABS are issued, as applicable)) that the sponsor is required to retain; (ii) a description of the material terms of the seller's interest and of any horizontal risk retention; and (iii) if the sponsor will retain (or did retain) any horizontal risk retention the same information as is required to be disclosed by sponsors retaining horizontal interests.¹⁴ 

A sponsor must retain the required disclosures in written form in its records and must provide the disclosure upon request to the SEC and its appropriate Federal banking agency, if any, until three years after all ABS interests are no longer outstanding. 

D. Asset-Backed Commercial Paper Conduits

A sponsor of an eligible asset-backed commercial paper conduit ("eligible ABCP conduit") that issues commercial paper that has a maturity at the time of issuance not exceeding nine months, exclusive of days of grace ("ABCP"), may satisfy the risk retention requirements if each originator-seller¹⁵ that transfers assets to collateralize the ABCP retains an economic interest in the credit risk of such assets in the same form, amount and manner as would be required using the standard risk retention¹⁶ or revolving master trusts¹⁷ options.

Note:  This risk retention option is narrow in scope and would not be available to many ABCP programs, including structured investment vehicles, securities arbitrage programs and other arbitrage programs and other programs that do not satisfy the "eligible ABCP conduit" criteria.

The Proposed Rules define "eligible ABCP conduit" as an entity that issues ABCP meeting each of the following criteria:

1) The ABCP conduit is bankruptcy remote or otherwise isolated for insolvency purposes from the sponsor and from any intermediate SPV from which it acquires any ABS interest.

2) The ABS acquired by the ABCP conduit are:

i) collateralized solely by the following:

(a) ABS collateralized solely by assets originated by an originator-seller or one or more majority-owned OS affiliates of the originator-seller, and by servicing assets:

(b) Special units of beneficial interests or similar interests in a trust or special purpose vehicle that retains legal title to leased property underlying leases that were transferred to an intermediate SPV in connection with a securitization collateralized solely by such leases originated by an originator-seller or majority-owned OS affiliate, and by servicing assets; or

(c) Interests in a revolving master trust collateralized solely by assets originated by an originator-seller or majority-owned OS affiliate and by servicing assets; and

ii) Not collateralized by ABS (other than those described in paragraphs (A), (B) and (C) above), otherwise purchased or acquired by the intermediate SPV, the intermediate SPV's originator-seller, or a majority-owned OS affiliate of the originator-seller; and

iii) Acquired by the ABCP conduit in an initial issuance by or on behalf of an intermediate SPV (A) directly from the intermediate SPV, (B) from an underwriter of the securities issued by the intermediate SPV, or (C) from another person who acquired the securities directly from the intermediate SPV;

(1) Note:  Paragraph (2) above clarifies that the assets being financed have been originated by the originator-seller or a majority-controlled OS affiliate and not purchased and aggregated.  Eligible ABCP conduits may not purchase ABS interests in the secondary market.

3) The ABCP conduit is collateralized solely by ABS acquired from intermediate SPVs as described in paragraph (2) above of this definition and servicing assets.

(1) Note:  Not all ABCP conduits utilize the intermediate SPV structure. This provision also prohibits intermediate SPVs from acquiring assets from non-affiliates or in the secondary market.

4)      A regulated liquidity provider¹⁸ has entered into a legally-binding commitment to provide 100% liquidity coverage (in certain specified forms) to all the ABCP issued by the ABCP conduit by lending to, purchasing ABCP issued by, or purchasing assets from, the ABCP conduit in the event that funds are required to repay maturing ABCP issued by the ABCP conduit.  With respect to the 100% liquidity coverage, in the event that the ABCP conduit is unable for any reason to repay maturing ABCP issued by it, the liquidity provider must be obligated to pay an amount equal to any shortfall, and the total amount that may be due pursuant to the 100% liquidity coverage must be equal to 100% of the amount of the ABCP outstanding at any time plus accrued and unpaid interest (amounts due pursuant to the required liquidity coverage may not be subject to credit performance of the ABS held by the ABCP conduit or reduced by the amount of credit support provided to the ABCP conduit and liquidity support that only funds performing receivables or performing ABS interests does not meet the requirements of the eligible ABCP conduits section of the Proposed Rules).

Note:  Not all ABCP conduits have 100% liquidity coverage and, if they do, it is not clear why a "regulated" (as defined in the Proposed Rules) liquidity provider is required so long as such provider has a high enough credit standing.

Note:  Not all ABCP conduits have liquidity coverage that covers the credit risk of the ABS held by the ABCP conduit and it is unclear why the Federal banking agencies would want the regulated provider to cover 100% of the credit risk when the originator-seller already covers the requisite risk retention required by the Proposed Rules.

Note:  If the ABCP conduit does not satisfy the "eligible ABCP conduit" criteria, the sponsor must retain credit risk in accordance with another risk retention option included in the Proposed Rules (unless an exemption for the transaction exists).

Responsibility for Compliance.  The Proposed Rules would require the sponsor of an eligible ABCP conduit that issues ABCP in reliance on this risk retention option to be responsible for compliance with the requirements of this option.  The sponsor must maintain policies and procedures to monitor compliance by the originator-sellers and any majority-owned OS affiliates with the requirements of the proposal and must (A) promptly notify investors, the SEC and its appropriate Federal banking agency, if any, in writing of:  (1) the name and form of organization of any originator-seller that fails to retain risk in accordance with this option and the amount of ABS issued by an intermediate SPV of such originator-seller and held by the ABCP conduit; (2) the name and form of organization of any originator-seller or majority-owned OS affiliate that hedges, directly or indirectly through an intermediate SPV, its risk retention in violation of this option and the amount of ABS issued by an intermediate SPV of such originator-seller or majority-owned OS affiliate and held by the ABCP conduit; and (3) any remedial actions taken by the ABCP conduit sponsor or other party with respect to such ABS; and (B) take other appropriate steps pursuant to the requirements of this option which may include, as appropriate, curing any breach of the requirements of this option, or removing from the eligible ABCP conduit any ABS that does not comply with the requirements of this option.  The sponsor would be required to (i) establish criteria governing the ABS interests, and the assets underlying the ABS interests, acquired by the ABCP conduit, (ii) approve (1) all originator-sellers and any majority-owned OS affiliate and (2) each intermediate SPV from which an eligible ABCP conduit is permitted to acquire ABS interests, and (iii) administer the ABCP conduit and maintain and adhere to policies and procedures for ensuring that all requirements have been met (including policies and procedures that are reasonably designed to monitor compliance by each originator-seller and any majority-owned OS affiliate which sells assets to the eligible ABCP conduit with the applicable risk retention requirements).

Note:  The terms and conditions of the eligible ABCP conduit risk retention option are designed to ensure that the assets of "eligible ABCP conduits" have low credit risk and that originator-sellers and any majority-owned OS affiliates have incentives to monitor the quality of such assets.  However, sponsors may have difficulty monitoring compliance by the originator-sellers and any majority-owned OS affiliates with the requirements of this option.

Required Disclosure.  Sponsors must disclose (A) the name and form of organization of each regulated liquidity provider that provides liquidity support to the eligible ABCP conduit (including a description of the form, amount and nature of such liquidity coverage) and (B) with respect to each ABS interest held by the ABCP conduit:  (i) the asset class or brief description of the underlying receivables; (ii) the standard industrial category code (SIC Code) for the originator-seller or majority-owned OS affiliate that will retain (or has retained), pursuant to the eligible ABCP conduit option, an interest in the securitization transaction; and (iii) a description of the form, fair value (expressed both as a percentage of the fair value of all of the ABS interests issued in the securitization transaction and as an absolute dollar amount (or foreign currency amount, if the ABS are not denominated in U.S. dollars)), as applicable, and nature of such interest in accordance with the disclosure obligations under the standard risk retention option under the Proposed Rules.  In addition, an ABCP conduit sponsor relying upon the eligible ABCP conduit option shall provide, or cause to be provided, upon request, to the SEC and its appropriate Federal banking agency, if any, in writing, all of the information required to be provided to investors in the preceding sentence, and the name and form of organization of each originator-seller or majority-owned OS affiliate that will retain (or has retained), pursuant to this option, an interest in the securitization transaction.

Note:  As is customary in the ABCP market, the names of any originator-seller and any majority-owned OS affiliate are not required to be disclosed to investors under the Proposed Rules.  However, under the eligible ABCP conduit option, the sponsor must promptly notify investors, the SEC and its appropriate Federal banking agency, if any, of the name of any originator-seller or majority-owned OS affiliate that fails to retain risk in accordance with this option or hedges its risk retention in violation of this option.

E. Treatment of Government-Sponsored Enterprises

Guarantees provided by Fannie Mae or Freddie Mac (each, a "GSE") while operating under the conservatorship or receivership of the FHFA with capital support from the United States will satisfy the risk retention requirements of such GSE with respect to ABS issues if the guarantee is of the timely payment of principal and interest on all ABS interests issued by the issuing entity.  The NPR notes that because the GSEs fully guarantee the timely payment of principal and interest on their ABS, GSEs are already exposed to the entire credit risk of the mortgages backing those ABS.  An equivalent guaranty provided by a limited life regulated entity that has succeeded to the charter of a GSE and that is operating under the direction and control of the FHFA with capital support from the United States will also satisfy the risk retention requirements.  If either GSE or limited-life regulated entity were to begin to operate other than under the conservatorship or receivership of the FHFA, such GSE or entity would no longer be able to avail itself of this option.

Required Disclosure.  A GSE satisfying its risk retention obligations under this alternative would be required to disclose to investors and, upon request, to the FHFA, a description of the manner in which it has met its credit risk retention requirement.

Note:  With respect to certain ABS sponsored by the GSEs, only a portion of the related securities are fully guaranteed, with the balance of the securities (generally a relatively small junior interest) not having the benefit of any GSE guaranty.  Guidance from the Agencies is needed on whether risk retention requirements would apply in any such circumstance, and if so, how the required retention should be calculated.

Note:  With respect to certain ABS sponsored by third parties, the GSEs will sometimes acquire the senior tranche and then sponsor a fully guaranteed ABS collateralized by that senior tranche, while the third-party sponsor sells the unguaranteed junior tranche (which is relatively small) to investors.  The GSE-guaranteed ABS would presumably be exempt from credit risk retention because it is the only ABS-interest in the related issuing entity.  However, a question arises as to whether the third-party sponsor of the issuing entity that issued both the senior tranche that collateralizes the GSE's guaranteed ABS and the unguaranteed junior tranche should be required to hold a retained interest based on the fair value of both ABS interests or just the junior tranche.

F. CLOs

CLO Manager as Securitizer.  The Proposed Rules confirm the Agencies' view that a CLO Manager is a "securitizer" under Section 15G because it selects the commercial loans to be purchased by the CLO issuing entity and then manages the securitized loans on behalf of the CLO.  However, in recognition of the fact that many CLO Managers are not in a position financially to purchase 5% of each CLO they manage,¹⁹ the Agencies have proposed an alternative risk retention option for "Open Market CLOs" where the risk retention is held by the Lead Arranger of the securitized loans.

Note:  As many industry participants have commented in connection with the Original Proposal, risk retention by CLO Managers is not generally feasible and, absent a viable alternative, would likely lead to consolidation within the CLO management industry and smaller management companies exiting the CLO market entirely.

Note:  It is possible that this retention requirement will lead to the consolidation of the CLO management industry, forcing smaller management companies to exit this space.

Open Market CLOs.  Open Market CLOs can satisfy the risk retention obligation by purchasing and holding only CLO-eligible loan tranches.  In addition, the Lead Arranger of each loan in the CLO-eligible loan tranche must retain at least 5% of the face amount of the term loan tranche purchased by the CLO until repayment, maturity, acceleration, payment default or bankruptcy.  The Proposed Rules further require, among other things, that the Lead Arranger of the underlying loan must take an initial allocation of at least 20% of the face amount of the broader syndicated credit facility, and no other member of the syndicate could take a larger share.

Note:  The rationale for this provision appears to be that the Agencies believe holding the largest allocation of the credit facility will provide the Lead Arranger with significant influence over the negotiation of the loan underwriting terms.

The Proposed Rules define an "Open Market CLO" as a CLO (1) whose assets consist of senior, secured syndicated loans acquired by such CLO directly from the sellers thereof in Open Market Transactions and of servicing assets, (2) that is managed by a CLO Manager, and (3) that holds less than 50% of its assets, by aggregate outstanding principal amount, in loans syndicated by lead arrangers that are affiliates of the CLO or originated by originators that are affiliates of the CLO. 

To qualify under this alternative risk retention proposal, such Open Market CLO must meet the following criteria:

• It may acquire and hold only CLO-eligible loan tranches and servicing assets.
• Its governing documents require it, at all times, to own only Senior, Secured Syndicated Loans that are CLO-eligible loan tranches (and servicing assets).

Note:  The Agencies have requested comments on whether an Open Market CLO should be permitted to hold a small bucket of non-Senior, Secured Syndicated Loans.  For example, such bucket might include second lien loans and/or high yield bonds that are typically found in current CLOs.

• It may not invest in ABS interests or in credit derivatives (other than hedging transactions that are servicing assets to hedge its payment risks).
• It may purchase assets only in Open Market Transactions on an arms-length basis.
• Its CLO Manager is not entitled to receive any management fee or gain on sale at the time the CLO issues its notes.

The Proposed Rules define an "Open Market Transaction" as either (1) an initial loan syndication transaction or a secondary market transaction in which a seller offers Senior, Secured Syndicated Loans to prospective purchasers in the loan market on market terms on an arm's length basis, which prospective purchasers include, but are not limited to, entities that are not affiliated with the seller, or (2) a reverse inquiry from a prospective purchaser of a Senior, Secured Syndicated Loan through a dealer in the loan market to purchase a Senior, Secured Syndicated Loan to be sourced by the dealer in the loan market.

The Proposed Rules define a "Senior, Secured Syndicated Loan" as a loan made to a commercial borrower that:  (1) is not subordinate in right of payment to any other obligation for borrowed money of the commercial borrower; (2) is secured by a valid first priority security interest or lien in or on specified collateral securing the commercial borrower's obligations under the loan; and (3) the value of the collateral subject to such first priority security interest or lien, together with other attributes of the obligor (including, without limitation, its general financial condition, ability to generate cash flow available for debt service and other demands for that cash flow), is adequate (in the commercially reasonable judgment of the CLO Manager exercised at the time of investment) to repay the loan in accordance with its terms and to repay all other indebtedness of equal seniority secured by such first priority security interest or lien in or on the same collateral, and the CLO Manager certifies as to the adequacy of the collateral and attributes of the borrower under this paragraph in regular periodic disclosures to investors.

Note:  This is substantially identical to the standard senior secured loan definition currently used by most CLOs.

The Proposed Rules define a "CLO-eligible loan tranche" as a term loan tranche of a syndicated loan that meets (at all times) the following criteria:

• A minimum of 5% of the face amount of the CLO-eligible loan tranche is retained by the Lead Arranger thereof until the earliest of the repayment, maturity, involuntary and unscheduled acceleration, payment default, or bankruptcy default of such CLO-eligible loan tranche.  Such 5% interest must be retained un-hedged in accordance with the same anti-hedging, transferring and pledging restrictions that apply to ABS risk retention, as discussed above.

Note:  A proposed alternative to the above requirement would be to permit the Lead Arranger to satisfy its retention obligations by retaining a percentage interest in the customary pari passu revolving tranche issued under the same facility as the CLO-eligible loan tranche.  In practice, banks already typically retain such revolving loan tranche.

• The lender voting rights within the credit agreement and any intercreditor or other applicable agreements governing such CLO-eligible loan tranche are defined so as to give holders of the CLO-eligible loan tranche consent rights with respect to, at minimum, any material waivers and amendments of such applicable documents, including but not limited to, adverse changes to money terms, alterations to pro rata provisions, changes to voting provisions, and waivers of conditions precedent.
• The pro rata provisions, voting provisions, and similar provisions applicable to the security associated with such CLO-eligible loan tranches under the CLO credit agreement and any intercreditor or other applicable agreements governing such CLO-eligible loan tranches are not materially less advantageous to the obligor than the terms of other tranches of comparable seniority in the broader syndicated credit facility.

The Proposed Rules define "Lead Arranger" as an institution that:

• is active in the origination, structuring and syndication of commercial loan transactions and has played a primary role in the structuring, underwriting and distribution in the primary market of the CLO-eligible loan tranche;
• has taken an allocation of the syndicated credit facility under the terms of the transaction that includes the CLO-eligible loan tranche of at least 20% of the aggregate principal balance at origination, and no other member (or members affiliated with each other) of the syndication group at origination has taken a greater allocation;

Note:  This allocation requirement could preclude all but a handful of the largest banks with respect to very large loan facilities.

• is clearly identified in the underlying loan credit;
• represents in the underlying credit agreement that such Lead Arranger and the CLO-eligible loan tranche satisfy the requirements of the Proposed Rules; and
• covenants in the underlying loan agreement to undertake the required 5% retention as set forth in the definition of CLO-eligible loan tranche.

Click here to view full article and footnotes.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.