Overview
On Monday 10 October 2022, the European Commission (the "Commission") delivered its report1 (the "Commission Report") to the European Parliament and the Council on the functioning of the EU Securitisation Regulation2. In this Client Alert we examine the Commission Report as it relates to the jurisdictional scope of the EU Securitisation Regulation, and the Commission Report's ramifications for existing and future securitisations and the near-term growth of the CLO market.
We focus on the scope of the obligation to make specific information3 ("EU Transparency Reports") available to institutional investors4 pursuant to Article 7 of the EU Securitisation Regulation ("Article 7") as this applies to securitisations where none of the originator, sponsor or SSPE is established in the European Union ("Third Country Securitisations").
Since the entry into force of the EU Securitisation Regulation in its final form in 2019, the securitisation market in general, and the loan securitisation market in particular, has taken the view that EU Transparency Reports do not need to be made available to investors in Third Country Securitisations in the specific (and administratively burdensome) format mandated by Article 7.
As we discuss more fully through this Client Alert, in our view it is possible not only that the market approach to the provision of EU Transparency Reports by US-based CLO managers in particular will start to shift, but that we are already seeing the beginning of a trend in that direction.
The Commission Report: Genesis and Summary
Article 46 of the EU Securitisation Regulation mandated the Commission to produce the Commission Report and was preceded by advice5 (the "ESAs' Opinion") and a final report6 (the "ESAs' Report") from the Joint Committee (the "Joint Committee") of the European Supervisory Authorities7 (the "ESAs") which amongst other things8:
- identified, in the case of the ESAs' Report, significant legal uncertainty in the jurisdictional scope of application of the EU Securitisation Regulation, with the ESAs' Opinion recognising that Third Country Securitisations were unlikely to use ESMA's templates9 for Article 7 reporting; and
- invited the European Commission to amend the EU Securitisation Regulation or provide interpretative guidance10 on its correct jurisdictional application.
The Joint Committee particularly noted, in the ESAs' Report, the confusion arising from the use of the words "where applicable" in Article 5(1)(e)11 of the EU Securitisation Regulation and postulated that these could be read as intending to limit the Article 7 reporting obligation, such that "verification of compliance with the disclosure requirements is not applicable when the originator, sponsor or SSPE to parties is not located in the EU"12.
This interpretation, which was recognised in the Commission Report13, also found favour with the High Level Forum on the Capital Markets Union, which in the seventh of the key recommendations in its Final Report dated June 2020 (the "HLF Final Report")14 for the development of a robust securitisation market invited15 the Commission to clarify that Article 5(1)(e) did not apply to Third Country Securitisations. Instead, the High Level Forum recommended that such investments should instead be subject to proportionate due diligence as required under Article 5(3) of the EU Securitisation Regulation.
For all these exhortations and suggestions from academics, industry, national regulators and the ESAs, the Commission has instead largely chosen its own approach to the question of jurisdictional application. In the Commission Report, the Commission:
- invites16 ESMA to review the Article 7 reporting templates, with the aim of better aligning these with investors' needs;
- invites17 ESMA to bifurcate Article 7 reporting templates to differentiate public securitisations from private securitisations, with the latter being simplified and tailored to the needs of national supervisors;
- concludes that the definition of "private securitisation" is working well and does not need changing18;
- declares that "institutional investors must verify that the sell-side parties of the transaction, irrespective of their location, comply with the respective obligations under [Articles 6, 7 and 9 of the] regulation" ... "EU institutional investors may not invest in securitisations if the sell-side entities are found to be not in compliance with these obligations"19; and
- recognises that "the current text of Article 5(1)(e) ... de facto excludes EU institutional investors from investing in certain [Third Country Securitisations] ... because the third-country sell-side parties might not be interested in providing [EU Transparency Reports]".
Disappointingly, despite the prior volumes of academic analysis, the Commission Report provides no commentary on the inclusion of the words "where applicable" in Article 5(1)(e), choosing to ignore that aspect of the debate entirely. Article 4620 of the EU Securitisation Regulation also contemplated that the Commission might "if appropriate" accompany its Commission Report with a legislative proposal. However, the Commission has declined to do this, commenting instead that it "is of the opinion that the [EU] Securitisation Regulation seems overall to be fit for purpose and does not see the need for major legislative change at this juncture"21.
What does this mean for EU investors in Third Country Securitisations
Regardless of any academic dissection of the Commission Report and its legal propriety22, the Commission's pronouncements are certain to have a compelling effect on the investment activities of regulated European investors and the regulatory activities of national competent authorities.23 We examine its practical impact on market participants below.
New transactions
Absent an ECJ judgment to the contrary, EU investors will likely take the prudent approach of ceasing to invest in Third Country Securitisations that do not provide EU Transparency Reports. The short term effect is likely to be a reduced investment universe for EU investors and a corresponding reduction in the diversity of their portfolios until relevant Third Country Securitisation markets get up to speed on the requirements and necessary practical steps to compliance.
For new transactions, including those that are still being marketed, the position is therefore straightforward, and we expect that the vast majority of Third Country Securitisations that target European investors will provide for day-1 EU Transparency Reports using the current ESMA templates. It should be noted in this regard that sponsors of US CLOs that constitute Third Party Securitisations will be outside the boundaries of the administrative sanctions and remedial measures set out in Article 32 of the EU Securitisation Regulation regarding the content and delivery of the reports and, where they so elect, would simply be complying with the requirements in order for European investors to meet their due diligence requirement.
As an alternative, sponsors or originators of such Third Country Securitisations, such as the vast majority of US CLOs, whose platforms have historically complied with the 5% risk retention obligation imposed under Article 5(1)(d) and Article 6(1) of the EU Securitisation Regulation but not the Article 7 reporting requirements, may elect to tailor their standard retention compliance covenant package to include a "springing" covenant that the relevant retention holder will agree to comply with the Article 7 requirements where required as a result of a future amendment of the EU Securitisation Regulation (as is contemplated by the Commission Report).
Footnotes
1. The English language version of the Commission Report can be found here.
2. Regulation (EU) 2017/2402, as amended. Note that, as part of the "onshoring" of EU legislation to the UK during the Brexit process, amendments to the EU Securitisation Regulation made by the Securitisation (Amendment) (EU Exit) Regulations 2019 led to a divergence between the UK Securitisation Regulation and its EU counterpart.
3. This information includes (a) quarterly reports on underlying exposures (Article 7(1)(a)), (b) copies of transaction documents (Article 7(1)(b)), (c) a transaction summary (Article 7(1)(c)), and (d) quarterly investor reports (Article 7(1)(e)). Anecdotally, Milbank's understanding is that investors make little to no use of the quarterly reports. Rather, for both public and private securitisations, deals are marketed, and investors rely, on issuers' contractual undertakings to provide detailed periodic portfolio reports. These reports, which, unlike the regulatory templates, are continually refined and improved to reflect changing market conditions and investor sentiment, reflect decades of rating agency and investor interactions. The need to process the mass of resulting data has also produced a pocket-industry of expert services, that collate and compare deal reports, and provide sophisticated analytical tools allowing investors to interpret and manipulate information to inform their investment decisions. In the CLO market, for instance, the appropriateness of the historical reporting framework and the discipline that they, alongside the transaction structures and underlying eligibility criteria, imposed on the transaction parties was reflected in the way that sector of the market ultimately emerged almost entirely unscathed from the global financial crisis (the "GFC") of 2007-2008.
4. Article 2(12) of the EU Securitisation Regulation.
7. Being the European Banking Authority (the "EBA"), the European Insurance and Occupational Pensions Authority ("EIOPA") and the European Securities and Markets Authority ("ESMA"). The ESAs established the Joint Committee Securitisation Committee (the "JCSC") in accordance with Article 36(3) of the EU Securitisation Regulation and the JCSC authored the ESAs' Opinion and ESAs' Report.
8. The ESAs Opinion also suggests (in paragraph 13(a)) that where an EU Securitisation Regulation breach occurs after issuance, an EU investor should sell its holding. In Milbank's view the relevant legislation is more nuanced than this, and does not require the fire-sale of non-compliant holdings. See "What does this mean for EU investors in Third Country Securitisations"
9. These templates were enacted in Commission Delegated Regulation (EU) 2020/1224 (the "Disclosure RTS").
10. The suggestion for, and subsequent use of, interpretative guidance is a curious approach to legislation and one which, for all its timeliness, creates legal uncertainty and arguably ill-serves the securitisation community and wider financial markets. Although Article 17(1) of the Treaty on European Union broadly empowers the Commission, and charges it to oversee the application of Union law, the specific competencies of the European Union's institutions are addressed in Article 288 of the Treaty on the Functioning of the European Union (the "TFEU"), which provides that only regulations, directives and decisions are to have [legally] binding effect. The competency to provide rulings on the interpretation of acts (e.g. regulations) of the EU institutions is reserved to Court of Justice of the European Union in accordance with Article 267 of the TFEU. Interpretative guidelines and answers to legislative questions are customarily addressed by the EBA in its Single Rulebook.
11. ticle 5(1)(e) (Due-diligence requirements for institutional investors) of the EU Securitisation Regulation provides that "Prior to holding a securitisation position, an institutional investor, other than the originator, sponsor or original lender, shall verify that ... the originator, sponsor or SSPE has, where applicable, made available the information required by Article 7 in accordance with the frequency and modalities provided for in that Article;" [emphasis added].
12. Paragraph 20(ii), footnote (9) of the ESAs' Report. This ambiguity was the subject of our 12 December 2018 Client Alert: Securitisation Regulation: Application of Disclosure to Non-EU CLOs with widespread recognition amongst national supervisors (per feedback on Question 4 of the feedback statement accompanying the Commission Report), legal commentators and market participants, including the Financial Markets Law Committee who addressed the issue in their letter to the Commission dated 5 November 2019.
13. Section 11.2 of the Commission Report.
14. A New Vision for Europe's Capital Markets.
15. See pages 54 and 64 of the HLF Final Report.
16. Section 5 of the Commission Report. ESMA has not wasted any time in responding to this request, reaching-out to industry associations such as AFME on 12 October 2022 for their input and suggestions on improving the reporting templates with a view to revising the Disclosure RTS.
17. Section 6.2 of the Commission Report.
18. Section 6.3 of the Commission Report. This is welcome news for the CLO industry as under Article 7(2) of the EU Securitisation Regulation, "private securitisations" are exempt from the obligation to make EU Transparency Reports available through a securitisation repository which imposes additional administrative overheads and costs on public securitisations.
19. Section 11.1 of the Commission Report.
20. "By 1 January 2022, the Commission shall present a report to the European Parliament and the Council on the functioning of this Regulation, accompanied, if appropriate, by a legislative proposal...".
21. Section 3, page 7 of the Commission Report.
22. For the reasons set out in note [9], this approach by the Commission is arguably ultra vires or, in the European vernacular, a "détournement de procedure". It is somewhat curious in light of the express authority (noted above) under Article 46 of the EU Securitisation Regulation given to the Commission to accompany its Commission Report with a legislative proposal to improve the functioning of the EU Securitisation Regulation. This alleged impropriety in the Commission's provision of interpretative guidance is compounded by the fact that the wording of Article 5(1)(e) went through multiple iterations as part of the legislative process. The critical words "where applicable" were not included in what was then Article 3(1)(c) of the Commission's original proposal, but were added to the EU Securitisation Regulation by the Council in the third Presidency compromise proposal (ST 14537/15) of 30 November 2015 ECON Committee Members (Petr Jezek, Michael Theurer & Sylvie Goulard) as published in the 'Amendments 109-316' draft report issued by the EU Committee on Economic and Monetary Affairs on 27 July 2016. This new wording was then adopted by all co-legislators in the provisional agreement resulting from interinstitutional negotiations of 28 June 2017. Further, Petr Jezek's contribution during the sitting of the European Parliament of 25 October 2017 (video available here – see 18:11:52) made it clear that the intention behind the EU Securitisation Regulation's final position achieved through the interinstitutional negotiations was growth and not "stifling" of the securitisation markets. As such, it is unclear whether the European Parliament and the Council would share the Commission's view as to the legislative intent of Article 5(1)(e).
23. Prior customary practice for Article 7 by Third Country Securitisations marketed to EU investors was to provide for risk retention under Article 6 of the EU Securitisation Regulation but not to provide for EU Transparency Reporting.
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