The New EU Securitisation Regulation

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1 A step in the right direction, but many unanswered questions BRIEFING OCTOBER 2015 On 30 September 2015, the European Commission published a proposal for a securitisation regulation (the Securitisation Regulation ): 1. harmonising and reforming existing rules on due diligence, risk retention and disclosure, which will apply in a uniform way to all securitisations and all types of regulated institutional investors; and 2. creating a new framework for simple, transparent and standardised long-term securitisations and asset-backed commercial paper programmes (collectively, STS ), investors in which will benefit from favourable regulatory capital treatment. Together with the Securitisation Regulation, the European Commission published its action plan on building a capital markets union and a proposal amending the capital requirements regulation ( CRR ) so that credit institutions investing in securitisations benefit from a more risk-sensitive prudential treatment. A similar proposal, amending the prudential treatment for insurers investing in securitisations, will follow at a later stage, via amendments to the Solvency II Delegated Act. These proposals represent the most significant reform of securitisation regulation in the EU for many years. They are the result of a debate concerning how securitisation should be regulated that has involved market participants, industry bodies, central banks, national and European regulators, global standards setters for securities and a plethora of official sector consultations. The European Commission intends that the proposed reforms restart securitisation markets in Europe on a sustainable basis, contributing to job creation and economic growth in the EU. Next steps Even though the Securitisation Regulation is still only a proposal, securitisation market participants will need to consider its implications and how to structure and document transactions to comply with it immediately. The proposal will follow the ordinary legislative procedure which requires consent of the European Council and the European Parliament. However, because of the huge political capital invested in the success of the capital markets union and Key considerations for securitising parties and investors Securitising parties will have a direct obligation to retain risk. Existing approaches to risk retention representations, undertakings and remedies should be revisited. Entities established for the sole purpose of securitising exposures will not qualify as originators for risk retention purposes. However, this sole purpose test may not be a bright line test given the broader business purpose requirement. Securitising parties will have to make onerous disclosure to ESMA and investors, via a website. It is unclear how public this will be. The STS criteria are vague and there is therefore a risk that regulators will interpret them in a different way from securitising parties. For example, how homogenous does a portfolio of assets have to be to meet the homogeneity criteria? Market participants will want potentially eligible existing and new securitisations to benefit from the STS regime. Documenting this will be particularly tricky before the text of the proposed Securitisation Regulation is final. Securitising parties will have to take responsibility for STS notifications, but it is uncertain how much reliance investors will be able to place on these.

2 because securitisation reforms mark the first substantial legislative element to the capital markets union, it may be expected that agreement will be sought at the first reading stage, if necessary involving trialogues between the Commission, Parliament and Council to reach consensus on the text. The Securitisation Regulation may therefore be in force as early as the second half of 2016, and as a regulation it will be directly effective in all member states. RISK RETENTION THE DIRECT APPROACH Existing risk retention requirements laid down in different pieces of sectoral legislation (CRR, Solvency II Directive and the alternative investment fund managers directive ( AIFMD )) will be repealed and replaced by a single article providing for a new direct obligation on originators, sponsors and original lenders to retain risk (the so-called direct approach ). The direct approach is intended to complement the existing requirement on institutional investors to check before investing whether or not the originator, sponsor or original lender has retained risk (the so-called indirect approach ), which is maintained. It will mean that EU securitisers will be required to retain risk even if the only investors are located outside the EU or are not regulated institutional investors. In complex transactions it may be that numerous entities (which may not be related) potentially fall within the definitions of originator, sponsor or original lender and responsibility for risk retention compliance (and potential related liability) will need to be agreed among them. The existing five structural methods for retaining risk have been largely left untouched, though the detail of these will be set out in regulatory technical standards ( RTS ) to be developed by the EBA. The grandfathering provisions envisage that existing securitisations structured to comply with existing risk retention requirement should not be impacted by the Securitisation Regulation, which will only apply revised risk retention obligations prospectively. The direct obligation on securitising parties to retain risk will apply to new securitisations entered into on or after the date that the Securitisation Regulation enters into force, though the existing RTS will continue to apply until the new RTS have been adopted. Originators, sponsors and original lenders will be required to disclose to investors information about the risk retained within investor reports and, for the first time, if they breach their risk retention obligations they will be subject to administrative sanctions and potentially also criminal sanctions, to be formulated by local competent authorities. The consolidation of risk retention requirements for all regulated institutional investors into a single article is to be welcomed as it clarifies and streamlines the existing law. A move towards the direct approach also moves the EU position closer to the US risk retention framework, which should facilitate transatlantic transactions. The sole purpose test and the originator loophole The revised risk retention requirements also seek to address the EBA s recommendation to close the so-called originator loophole whereby, taking advantage of the wide definition of originator in the CRR, an originator SPE is established solely for buying a third party s exposures which it securitises. In its December 2014 report on risk retention, the EBA opined that these types of structures were non-compliant with the spirit of the risk retention requirements and suggested that the definition of originator in the CRR be narrowed. The proposed Securitisation Regulation has not amended the definition of originator, but has instead stated that an entity shall not be considered to be an originator where the entity has been established or operates for the sole purpose of securitising exposures. There is no further guidance within the text of the proposed Securitisation Regulation on how to interpret sole purpose, but the explanatory memorandum states: an entity established as a dedicated shelf for the sole purpose of securitising exposures and without a broad business purpose cannot be considered as an originator. For instance, the entity retaining the economic interest has to have the capacity to meet a payment obligation from resources not related to the exposures being securitised. The test in the explanatory memorandum appears more 02

3 onerous than the test in the operative text (and it should be noted that an explanatory memorandum is an authoritative interpretative aid to the construction of the operative text). The position might be further fleshed out in the RTS. The extension of the originator interest retention method (option (b)) to include revolving securitisations and not just revolving exposures will provide certainty for synthetic securitisations (which customarily include replenishment provisions) to continue to allow originators to hold the requisite 5% material interest in the form of assets outside the reference portfolio. Who is on the hook if the risk retention structuring goes wrong? The European Commission expresses the hope that the direct approach will enhance legal certainty for investors, who should be able to rely on risk retention disclosure by the securitising parties. However, while investors may continue to take comfort that their regulatory capital position will not be penalised if they invest in a securitisation (after having verified that it is risk retention compliant) which subsequently proves not to be risk retention compliant, their investment may nevertheless fall in value or become illiquid, as subsequent secondary market regulated investors in the EU will no longer be able to invest. Investors who invested in reliance on incorrect risk retention disclosure may be able to sue one of the securitising parties for loss (for example under FSMA issuer liability for published information). For a cross-border transaction, questions as to which securitising party they sue and which laws, courts and measures of loss apply (in the absence of any direct contractual recourse) could be extremely complex. One consequence of the direct approach is that the drafting of risk retention representations and undertakings in contractual documentation and related risk factors in offering documents may well change: it will be more difficult for securitising parties to argue that they should not bear the risk of structuring a transaction that turns out not to be risk retention compliant or making inadequate disclosure. Risk factors and disclosure statements that seek to limit liability towards investors on this basis will need to be reconsidered. There is some uncertainty within the current proposal over the time that the investor is required to check that the securitisation is risk retention compliant: the due diligence obligations indicate that this is before the investor becomes exposed, by checking the disclosure made by the securitising parties. However, the obligations of the securitising parties to disclose do not take effect until after closing. Hopefully this uncertainty will be ironed out in the final text. DUE DILIGENCE REQUIREMENTS FOR INSTITUTIONAL INVESTORS Existing due diligence requirements laid down in different pieces of sectoral legislation (the CRR, the Solvency II Delegated Act and AIFMD) will be repealed and replaced by a single article providing that all types of regulated institutional investors engaging in business in or through the EU must undertake identical due diligence processes, both before becoming exposed to a securitisation and on an on-going basis as long as they are exposed. The majority of the proposed due diligence requirements are substantially similar to existing due diligence requirements, though some have been clarified and others have been removed. They will apply from the date of entry into force of the Securitisation Regulation to all securitisations currently subject to due diligence requirements (i.e. those issued on or after 1 January 2011, or older securitisations where new exposures have been added or substituted after 31 December 2014). The proposal includes requirements on institutional investors to: i. make certain verifications before becoming exposed to a securitisation, including that the structure is risk retention compliant and that the originator, sponsor and securitisation special purpose entity ( SSPE ) comply with their disclosure obligations; 03

4 ii. carry out a due diligence assessment commensurate with the risks involved before becoming exposed to a securitisation, both in relation to the exposures underlying the securitisation and the structural features of the securitisation, and, for a securitisation that is designated STS, as to whether it meets the STS criteria; and iii. on an on-going basis during the life of the securitisation, establish written procedures to monitor the performance of the securitisation, perform stress tests, ensure there is an adequate level of internal reporting and be able to demonstrate to authorities that they have a comprehensive and thorough understanding of their securitisation position and its underlying exposures. Is the administrative burden on investors too high? The rationalisation of due diligence requirements for all regulated institutional investors into a single article is to be welcomed as it clarifies and streamlines the existing law and places institutional investors wanting to invest in securitisations on a level playing field with each other. However, many market participants will consider that the reform has not gone far enough and that regulatory due diligence requirements represent an unnecessary burden on investors, particularly those in the secondary market, without any corresponding benefit. Given that it is investors who suffer losses from any poor investments, they are already incentivised to undertake due diligence prior to investing: arguably it should be for them to decide the nature of that due diligence. Moreover, institutional investors are not systematically required to undertake similar due diligence exercises in relation to other capital markets instruments, such as equities, plain vanilla debt or covered bonds, though these are not inherently less risky than securitisations. Granular and detailed due diligence requirements on securitisations may therefore act as a disincentive to invest in securitisations, which (whilst better than the present rules) might undermine the policy objective of the Securitisation Regulation. The penalties for investors who breach their due diligence obligations have not been included within the proposed Securitisation Regulation and these remain in sectoral legislation and include the ability of competent authorities to impose additional risk weights on investors who breach their due diligence requirements. TRANSPARENCY REQUIREMENTS FOR ORIGINATORS, SPONSORS AND SSPES Existing transparency requirements for securitising parties set out in the CRR will be repealed and replaced by a single article, requiring that the originator, sponsor and SSPE disclose to holders of a securitisation position and competent authorities information relating to the securitisation, both on closing and on an on-going basis during the life of the transaction. The general duty to disclose all materially relevant data currently contained within Article 409 of the CRR has been removed; instead the proposed transparency requirements are substantially similar to the granular disclosure obligations currently contained in the CRA III Delegated Act, including requirements to disclose: i. loan level data, through standardised disclosure templates (without delay after closing and on a quarterly basis, no later than one month after the interest payment date); ii. transaction documentation, including any offering document or prospectus and a detailed description of the priority of payments (without delay after closing); iii. where there is no prospectus, an overview of the main features of the securitisation (without delay after closing); iv. in the case of STS securitisations, the STS notification (without delay after closing); 04

5 v. investor reports, covering the credit quality and performance of the underlying exposures, data on cashflows and liabilities and risk retention compliance (on a quarterly basis, no later than one month after the interest payment date); and vi. inside information disclosure, following either the Market Abuse Regulation (where it applies) or a similar regime (where it does not apply). Originators, sponsors and SSPEs may designate one entity among themselves to fulfil this requirement and must disclose the information by means of a website (though the right to delegate disclosure to a third party contained within the CRA III Delegated Act has been removed). The reporting entity must be specified within the securitisation documentation. ESMA is required to develop RTS to specify standardised templates for loan level data, the STS notification and the requirements to be met by the website. This proposed disclosure obligation will not apply to existing securitisations and will apply to new securitisations entered into on or after the date of entry into force of the Securitisation Regulation (though securitising parties may use the templates contained in the CRA III Delegated Act until the new RTS covering loan level data take effect). Existing securitisations that are subject to disclosure obligations under the CRA III delegated act will continue to be subject to those obligations. Securitising parties who breach the proposed disclosure obligations will be subject to administrative sanctions and potentially also criminal sanctions, to be formulated by local competent authorities. How public is securitisation disclosure? There is an open question as to the extent to which securitising parties will be required to make this disclosure publicly. The text of the regulation, which provides an obligation to disclose to holders of a securitisation position and to the competent authorities appears significantly narrower than the current position within CRA III which refers to publish information and might be an indication that loan level data, investor reports and transaction documents should not be publically available. However, prospective investors will be required to do due diligence in respect of this information before becoming exposed and it is hard to see how, from an operational perspective, a website will be able to make information available to prospective investors without it being in practical terms publicly available. It is also not clear if there is an intention for there to be a different disclosure regime for private and bilateral transactions, which are not referred to at all in the proposed Securitisation Regulation and which do not sit well within a public disclosure regime. Industry participants will hope that ESMA clarifies this within its RTS in due course, especially given that some information contained within loan level data and investor reports may be commercially sensitive. Is the administrative burden on securitisers too high? Once more, the rationalisation of disclosure requirements into a single article is to be welcomed. However, some market commentators have suggested that disclosure standards for securitisations within the EU are already sufficient for investors and that lack of sufficient disclosure was not a significant cause of the financial crisis in the EU. To the extent that this is true, there is a risk that granular disclosure requirements will place a burden on securitising parties without giving investors a proportionate benefit and thereby act as an unnecessary disincentive to issuance. The administrative and potentially criminal sanctions (which include fines and bans on individuals) may mean that the level of internal compliance and verification that securitising parties go through will have to increase. The proposed disclosure requirements for securitisations go well beyond disclosure requirements for other capital markets instruments, which are typically subject to the general duty of disclosure standard under the Prospectus Directive, which is widely understood. 05

6 SIMPLE, TRANSPARENT AND STANDARDISED LONG-TERM SECURITISATIONS AND ABCP The second part of the Securitisation Regulation contains a new framework for the regulation of: i. simple, transparent and standardised term securitisations; and ii. simple, transparent and standardised asset-backed commercial paper ( ABCP ), which will apply to all types of regulated institutional investors, eligible asset classes and transaction structures. Related existing provisions which give favourable prudential treatment to certain securitisations in sectoral legislation, such as the LCR Delegated Act and the Solvency II Delegated Act will be repealed. The proposed STS framework contains eligibility criteria for STS securitisations, provisions for notifications by securitising parties and reliance and due diligence by investors as well as supervision mechanisms. The European Commission believes that, by differentiating simple, transparent and standardised securitisations from highly complex, opaque and risky securitisations and incentivising investment in the former over the latter through recalibrated prudential frameworks for all institutional investors, European securitisation markets will be restarted on a more sustainable basis. As a policy decision, the European Commission has deliberately excluded from the STS framework securitisations with managed portfolios of assets, CMBS (which would seem unlikely to comply with homogeneity criteria), re-securitisations and synthetic securitisations, though the European Commission has indicated that it envisages creating an STS framework for synthetic securitisations in due course. It is hard to predict the consequences of a bifurcated securitisation regime, though it is likely that there will be unintended consequences as well as intended consequences. In its explanatory memorandum, the European Commission was at pains to stress that, because the STS criteria relate to structure rather than asset quality, non-sts securitisations would continue to be issued and continue to be good investments, though it remains to be seen if there will be a market appetite for them. One unfortunate consequence of a clearly bifurcated regime is that those securitisations that cannot meet just one of the criteria will have no regulatory incentive to meet any of the criteria. THE STS CRITERIA The proposed STS criteria, which are separated into 57 different items organised into three categories of requirements relating to simplicity, standardisation and transparency, relate to the process by which the transaction is structured rather than the underlying credit quality of the assets involved. There is thus no implication that an STS securitisation is free of risks, but rather that a prudent and diligent investor will better be able to analyse and price the risk involved. The criteria are to a large extent based on existing requirements in the LCR delegated act and the Solvency II delegated act and also advice from the EBA and BCBS-IOSCO, both published in July. The criteria for long-term securitisations and ABCP are to a large extent the same, with some specific adjustments to reflect the structural features of these two market segments. The criteria include requirements relating to the asset sale, asset homogeneity, origination standards, creditworthiness of the underlying debtors, risk retention compliance, interest rate and currency risk mitigation, documentation contents and clarity, external verification of underlying exposures, provision of a liability cash-flow model, provision of documents to potential investors prior to pricing and so forth. Interpreting the STS criteria Unfortunately many of the criteria are vague (some extremely so) and therefore potentially open to different interpretations. (For example, are mortgages governed by English and Scots law homogenous? If so, how about English and French law?) The explanatory memorandum to the proposal indicates that the European supervisory 06

7 agencies could interpret the criteria by means of a Q&A, though this idea is not included in the substantive provisions. The vagueness of some of the criteria and the unduly specific nature of others (for example, the prohibition on the portfolio including exposures in default or to credit-impaired obligors in relation to credit card securitisations) may adversely affect their workability in practice and make securitising parties reluctant to confirm that a securitisation meets them, especially as they may be subject to criminal liability were a regulator to disagree with their interpretation. There is also a risk that a granular list of prescriptive criteria may stultify market practice at a particular point in time and inhibit market innovation (for example, if a new product line were to contain features which meant it would not be homogenous in the context of existing products, it may be less attractive to originate). For crossborder transactions, there are likely to be a number of competent authorities and supervisory agencies with regulatory oversight who may reach different interpretations in relation to the criteria. The proposed Securitisation Regulation does attempt to deal with this by establishing a co-operation procedure, but this could be very time-consuming. STS NOTIFICATION AND DISCLOSURE Originators, sponsors and SSPEs are required to jointly notify ESMA, national competent authorities and investors that a securitisation meets the STS criteria, by means of a standardised template to be developed by ESMA, and designate among themselves a contact point for investors and competent authorities. If a securitisation no longer meets the STS criteria, the originator, sponsor and SSPE are required to immediately notify ESMA and competent authorities. While there is no explicit obligation to notify investors of this, it is likely that investors would have to be notified under the general disclosure obligations. ESMA will maintain a list of STS securitisations on its website. Securitising parties who breach their STS obligations will be subject to administrative sanctions and potentially also criminal sanctions, to be formulated by local competent authorities. The proposal indicates that the STS notification should be made available without delay after the closing of the transaction, though presumably investors will require certainty prior to pricing. How much reliance can investors place on the STS notification? There is an open question as to the level of reliance an investor may place on the STS notification. The text of the proposal states that: Institutional investors may place appropriate reliance on the STS notification and on the information disclosed by the originator, sponsor and SSPE on the compliance with the STS requirements. Because this text appears in the context of the requirement for an investor to do a due diligence assessment rather than a mere verification and because the text does not refer simply to the STS notification but also to other information (which could include the transaction documents, offering document and underlying loan level data), it is likely that investors will feel compelled to check that the STS notification is consistent with the other information, which will increase costs and may impact secondary market liquidity. The recitals to the proposed Securitisation Regulation state both that originators, sponsors and SSPEs take responsibility for their claim that the securitisation is STS but also that it is essential that investors make their own assessment [and] take responsibility for their investment decisions. While the proposal does not include any specific penalties for an investor who invests in a securitisation in reliance on an STS notification without having undertaken an appropriate due diligence exercise, it is possible that such an investor may not be able to recover the full value of any loss incurred from the securitising parties and would also be subject to additional risk weights on their investments from competent authorities under sectoral legislation. There is also an open question in relation to securitisations that cease being STS in circumstances where neither the securitising parties nor the investors are at fault. For example, interest rate and currency risk may no longer be mitigated if a hedge counterparty is downgraded or otherwise stops operating. In this circumstance, investors may suffer significant losses as the price of their investment falls to reflect the investment no longer benefitting from prudential advantages, leaving the question of whether the investor has an action against the securitising parties uncertain. 07

8 There is also an open question about the extent to which third parties may verify that a securitisation meets the STS criteria. The recitals state that: The involvement of third parties in helping to check compliance of a securitisation with the STS requirements may be useful for investors, originators, sponsors and SSPEs and could contribute to increase confidence in the market for STS securitisations. However, there are no operative provisions shedding further light on this and it also seems to run counter to the requirement that securitising parties and investors take responsibility. It may be that third party providers can add value by giving additional comfort to originators, credibility to sponsors and assist with a due diligence defence for investors. IMPLICATIONS OF THE STS CRITERIA FOR TRANSACTIONS STS transactions will benefit from an advantageous prudential framework relative to non-sts transactions and market participants should consider the following practical changes: i. Existing securitisations that have already been issued can theoretically benefit from the STS label. However, given the very detailed and prescriptive nature of the criteria, it is unlikely that many existing securitisations will (absent transitional or grandfathering provisions within the RTS) in practice be able to benefit. Even if it were practicable to amend documentation and for originators to buy back non-compliant assets, it will not be possible to meet criteria related to transparency prior to pricing if they were not met at the time the securitisation was issued. ii. New securitisations that will be issued before the final text of the Securitisation Regulation is certain could be structured and documented so as to meet the STS criteria, though these criteria might change. It would be possible to try to future-proof for any changes, for example by giving the trustee a power to amend documentation (perhaps via an investor negative consent process) and by giving the originator the obligation to buy back non-compliant assets. iii. Consideration should be given to the asset criteria at the origination stage to ensure that the pool of assets meet STS criteria as to quality and homogeneity. Third party purchasers of asset portfolios which they intend to securitise should be particularly mindful of these criteria and consider whether it is possible to seek representations from the seller in this regard. iv. In order for new issuances under master trust structures and programmes to be STS compliant, the entire structure may need to be amended. It may make sense to time updates to these transactions to coincide with the finalisation of the proposed Securitisation Regulation. CONCLUSION It is extremely welcome that the European Commission, by proposing the Securitisation Regulation and making it the initial pillar of the capital markets union, has explicitly recognised the importance of securitisation within financial markets and the wider economy. The rationalisation of various piecemeal legislative provisions into a single text will also provide some clarity and certainty to the securitisation regulatory framework. However, further work is required in order to make some of the more administratively cumbersome obligations workable allowing securitisation market participants to restart markets. European legislative institutions should therefore take advantage of this opportunity to listen to market participants and improve the final text: the political desire for a speedy outcome should not override the economic necessity for an efficient and effective regime. 08

9 IMPLEMENTATION AND GRANDFATHERING Legislative developments Risk retention Disclosure for securitisers Due diligence for investors STS securitisations 30 September 2015 European Commission publishes proposed Securitisation Regulation Investors investing in existing securitisations to continue to check risk retention compliance on the basis of existing sectoral legislation Securitisers to continue to make disclosure on existing securitisations on the basis of CRR Investors investing in existing securitisations 1 to continue to comply with due diligence obligations in existing sectoral legislation Securitisations wanting to benefit from STS designation in the future should be structured and documented to comply with STS From 30 September 2015 EU ordinary legislative procedure on Securitisation Regulation begins 1 January 2017 CRA III delegated act applies Securitisers to make disclosure on securitisations issued on or after 26 January 2015 on the basis of the CRA III Delegated Act 2016/2017 (depending on legislative process), Securitisation Regulation adopted, entering into force 20 days after publication in the OJEU Securitisers have a direct obligation to retain risk in relation to all new securitisations. Investors have an obligation to check risk retention compliance in relation to existing securitisations and new securitisations Securitisers to make disclosure on new securitisations on the basis of new disclosure requirements, though using loan level data templates annexed to CRA III delegated act All institutional investors to comply with new due diligence standards, in relation to existing securitisations 1 as well as new securitisations Risk retention methods on the basis of existing RTS Six months after entry into force, EBA to prepare risk retention RTS Risk retention methods on the basis of new RTS One year after entry into force, ESMA to prepare disclosure RTS and STS notification RTS Securitisers to use loan level data templates in new RTS Existing and new securitisations complying with STS criteria may use STS designation 1 I.e. those securitisations issued on or after 1 January 2011, or where new underlying exposures have been added or substituted after 31 December Slaughter and May 2015 This material is for general information only and is not intended to provide legal advice. For further information, please speak to your usual Slaughter and May contact. OSM _v04

10 For further information on the matters highlighted in this briefing, please contact one of the following or your usual Slaughter and May contact. SANJEV WARNA-KULA-SURIYA T E sanjevwks@slaughterandmay.com GUY O KEEFE T E guy.okeefe@slaughterandmay.com RICHARD JONES T E richard.jones@slaughterandmay.com TOLEK PETCH T E tolek.petch@slaughterandmay.com OLIVER WICKER T E oliver.wicker@slaughterandmay.com OLIVER STOREY T E oliver.storey@slaughterandmay.com SARAH ELLICOTT T E sarah.ellicott@slaughterandmay.com HARRY BACON T E harry.bacon@slaughterandmay.com ERIC PHILLIPS T E eric.phillips@slaughterandmay.com 10