Call to Action: The final risk retention rules will change the status quo for nearly all CLO managers beginning in the fourth quarter of 2016. All managers should begin assessing whether and how they will comply with the final rules once they come into effect and monitor ongoing market developments and work closely with counsel to gauge the viability of emerging innovations adopted to address risk retention requirements.
On October 21 and 22, 2014, six federal agencies, including the Board of Governors of the Federal Reserve System, the U.S. Securities and Exchange Commission, and the Federal Deposit Insurance Corporation (collectively, the "Agencies"), announced that they had approved a final rule requiring sponsors of securitization transactions to retain risk in those transactions (the "Final Rules") to implement the credit risk retention requirements of Section 15G of the Securities Exchange Act of 1934, as added by Section 941 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.
- In the Final Rules, the Agencies adopted the majority of the collateralized loan obligation ("CLO") framework as proposed in August 2013 (the "Second Proposed Rule"), without significant changes.
- A CLO manager may comply under the "standard risk retention framework" by retaining horizontal or vertical interests each of no less than five percent, or a combination of the two as long as the combined amount is no less than five percent.
- The Final Rules no longer require that the CLO defer all cash flows to the holder of the eligible horizontal residual interest.
- While the Final Rules allow an "open market CLO" option1 as proposed, market reaction has confirmed that this option is unlikely to be used.
- The risk retention requirements for CLOs will become effective for new CLOs closing in and after late October 2016.
Standard Risk Retention
The Final Rules provide that the sponsor of a securitization transaction must retain an eligible vertical interest ("Eligible Vertical Interest") or eligible horizontal residual interest ("Eligible Horizontal Residual Interest"), or any combination thereof. The definition of the Eligible Vertical Interest was changed in the Final Rules so that the regulatory five percent threshold is calculated using the principal amount of the ABS interests (i.e., the original outstanding principal balance of each class) rather than the "fair value" of each class as previously proposed. If a sponsor retains only an Eligible Horizontal Residual Interest, the required amount is calculated using a "fair value measurement framework under GAAP."
For the combined risk retention option, where the sponsor retains both an Eligible Vertical Interest and an Eligible Horizontal Residual Interest, the Final Rules provide that "the percentage of the fair value of the eligible horizontal residual interest and the percentage [of the face value] of the eligible vertical interest" must together equal at least five percent of the total credit risk as of the closing date. (emphasis added)
In addition, these required thresholds must be determined as of the closing date (which may create some technical issues where the capital structure is changed immediately prior to closing if the sponsor is attempting to just meet the five percent threshold), and the sponsor may hold interests through majority-owned affiliates.
The standard risk retention option is replete with various additional requirements, including the disclosure requirements for the fair value methodology used. The Final Rules provide additional guidance on how the related quantitative information must be described.
The Final Rules, however, removed the previously proposed limits on payments to the holders of the Eligible Horizontal Residual Interest that exceed the expected percentage of the Eligible Horizontal Residual Interest's fair value (compared to all ABS interests).
Open Market CLO Option Not Viable?
While it is too early to definitively state how the CLO market will react to the "open market CLO" option adopted in the Final Rules, most market participants appear to agree that this option is not likely to be available given the major syndicate banks' reluctance to commit to retaining the necessary position in underlying loans. Skepticism of the viability of this option has been widespread since the announcement of the proposed rules in August 2013.
We previously addressed certain aspects of the proposed open market CLO in our earlier http://www.blankrome.com/sitefiles/publications/Link2Alert.pdf alert in September 2013.
Since the publication of the proposed risk retention rules, numerous industry groups have consistently voiced concerns about the potentially negative impact of the risk retention rules on the CLO market. With the publication of the Final Rules, many market participants and observers continue to warn of the Final Rules' potential chilling effect on significant portions of the CLO market.
The Final Rules will likely change the landscape in the CLO market, but the changes may lead to unexpected consequences. We continue to explore potential alternative financing arrangements that may yield new ways of financing CLO-like structures using semi-permanent financing vehicles, rather than "securitizations," which rely on term-financing.
1. The "open market CLO" option requires the lead underwriter of corporate loans to hold at least five percent of the face amount of the term loan tranche purchased by the "open market CLO."
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.