Credit Risk Retention Under the Dodd-Frank Act what do EU firms need to know?

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1 CLIENT BRIEFING Credit Risk Retention in the U.S. Credit Risk Retention Under the Dodd-Frank Act what do EU firms need to know? This client briefing gives an overview of the proposed U.S. risk retention rule and highlights the issues for non-u.s. originators and investors in ABS transactions and some key differences between the recently implemented EU retention requirements (Article 122a of the CRD) and the proposed U.S. equivalent. 30 March 2011, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the FDIC, the Securities and Exchange Commission (the SEC ) and the Federal Housing Finance Authority (referred to here as the Agencies ), jointly proposed a set of rules to implement the securitisation credit risk retention requirements of Section 15G of the Securities Exchange Act of 1934 (the Exchange Act ), which was added by Section 941 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act ). The proposed risk retention rules would apply to securitizers in securitisations that involve the issuance of asset-backed securities as defined in section 3(a)(77) of the Exchange Act. The Exchange Act defines an asset-backed security to mean a fixed-income or other security collateralized by any type of self-liquidating financial asset (including a loan, lease, mortgage, or other secured or unsecured receivable) that allows the holder of the security to receive payments that depend primarily on cash flow from the asset. The new section 15G of the Exchange Act does not distinguish between transactions that are registered with the SEC under the Securities Act of 1933 and those that are exempt from registration under the Securities Act. In addition, the statutory definition of assetbacked security is broader than the definition of asset-backed security in the Commission s Regulation AB, which governs the disclosure requirements for ABS offerings that are registered under the Securities Act. The proposed rules further apply the risk retention requirements to the securitizer in each securitization transaction, which is defined as a transaction involving the offer and sale of ABS by an issuing entity. Applying the risk retention requirements to the securitizer of each issuance of ABS ensures that the requirements apply to all ABS issued by an issuing entity that issues ABS periodically. Under the proposed U.S. rules, the retention obligation falls on the sponsor or securitiser rather than the investor Anne Tanney Associate Director, Banking & Capital Markets T: +44 (0) anne.tanney@blplaw.com Dina Chowdhury Associate, Banking & Capital Markets T: +44 (0) dina.chowdhury@blplaw.com

2 02 The EU rules (Article 122a of the Capital Requirements Directive), in contrast, require retention in any securitisation transaction, as defined in the Capital Requirements Directive. As described in our client briefing on Article 122a, this definition potentially includes transactions which have not traditionally been thought of as securitisation transactions. The U.S. rule requires the issuance of ABS, and the definition of assetbacked securities, as it requires the securities to be collateralised by the assets, does not cover synthetic securitisation, whilst the EU rules do. Who retains the interest? Under the risk retention requirements of Section 15G of the Exchange Act, a sponsor or securitiser must retain the credit risk. A sponsor or securitiser is defined by reference to the DoddFrank Act as either (1) an issuer of an asset-backed security, or (2) a person who organises and initiates an asset-backed securities transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the issuer. Note that whilst the equivalent EU requirements fall on the investor in the transaction, the U.S. requirements place direct obligations on the issuer or arranger of the deal. The retention may be split between the sponsor and the originator only in certain circumstances (whereas in the EU, the retention can be held by the originator in all cases.) For multiple sponsors, the credit risk can be retained by one of the sponsors, but each sponsor remains responsible for ensuring that at least one of the sponsors complies with the risk retention requirements. 03 Generally the proposed rules require a sponsor of a securitisation (including both publicly placed securitisations and private placements) to retain at least 5% credit risk retention related to the securitisation. As is the case with the EU rules, there would be a prohibition on the transfer or hedging of that risk, but the granting of a pledge of the assets or instruments which comprise the retained risk is acceptable provided that the obligation is full recourse to the sponsor. Certain transactions are exempt from risk retention requirements (see below). Although there is a proposed safe harbour for non-u.s. transactions, this does not automatically exempt transactions placed in reliance on Rule 144A. Although there is a proposed safe harbour for non-u.s. transactions, this does not automatically exempt transactions placed in reliance on Rule 144A. Method of retention The sponsor required to retain the minimum 5% of the credit risk of the securitisation may retain the credit risk in the form of any of five generally applicable risk retention options, which are: (i) vertical risk retention, (ii) horizontal risk retention, (iii) L-shaped risk retention, (iv) seller s interest (i.e. for revolving asset master trusts), (v) representative sample, or by falling within specific treatment set out for CMBS and ABCP transactions (see below). Transactions based on assets of government-sponsored enterprises (such as mortgage- backed securities issued by Fannie Mae and Freddie Mac) are deemed automatically to fulfil the retention requirements provided that they operate according to certain conditions. As such enterprises must retain the required risk, their ability to buy portfolio insurance will be limited going forward. There have been calls by the industry for a mutual recognition process between regulators in different jurisdictions It is worth noting that, as in the EU, these options do not provide a clear retention method for managed CLO transactions as the asset manager will often be thinly capitalised and unable to hold 5% of each transaction it manages. The CEBS (now EBA) guidelines on the EU rules included an express extension of the seller interest option for revolving assets, so that it can be used for transactions based on revolving pools (such as mortgage master trusts). This flexibility currently does not appear in the U.S. proposed rule, although the U.S. rule includes an L-shaped risk retention option (i.e. retention of both a vertical and horizontal slice) which is not an option in the EU rules. Premium capture cash reserve account If the securitisation has interest-only tranches or bonds which are issued at a premium, a sponsor who is subject to the risk retention requirements must also establish and fund a premium capture cash reserve account. Amounts in this account will be held by a trustee for the transaction and would be required to be available to cover losses on the underlying assets. Client ClientBrief Briefing ing

3 04 05 Additional risk retention options for certain products As well as the five options above, there are specific risk retention options available for certain types of structured finance transaction. ABCP The proposed rules provide a risk retention option available only for short-term ABCP collateralised by pools of assets and supported by 100% liquidity coverage. This allows for satisfaction of the risk retention requirement through retention by the originator-seller of each underlying transaction, rather than by the sponsor of the ABCP program, of an interest meeting the horizontal risk retention requirements. This option is available only to single-seller or multi-seller ABCP conduits if the following conditions are satisfied, (i) the ABCP conduit is bankruptcy remote, (ii) the ABS issued by an intermediate SPV to the issuing entity is collateralized solely by assets originated by a single originatorseller, (iii) all the interests issued by an intermediate SPV are transferred to one or more ABCP conduits or retained by the originator-seller and (iv) a regulated liquidity provider provides 100% liquidity coverage to all the ABCP issued by the issuing entity. Sponsors relying on this option are required to maintain policies and procedures to monitor originator-sellers compliance with the risk retention option and notify the ABCP investors of any noncompliance. Further, sponsors are required to disclose to investors, the bank regulator and the SEC prior to the sale of any ABCP, the name of the each originator-seller retaining the risk in the transaction and the form and amount of such risk retention. Note that in the EU, the retention requirement in the case of ABCP transactions can, under the Guidelines issued by CEBS (now the EBA) on 31st December 2010, be met by programme-wide letters of credit, or by liquidity facilities which cover credit risk of the assets. This addressed industry concerns that retention by the underlying sellers may not always be available to satisfy the requirement at CP level. These methods of meeting the retention requirement are not available in the U.S. under the current proposed rule. Thus, the U.S. rule may give clear guidance that seller-retention satisfies the requirements at CP level, but this does not necessarily assist EU regulated investors in U.S. ABCP as they are subject to the EU regulations. CMBS For CMBS transactions, the risk retention obligations can be met by a qualified third party B piece buyer holding the horizontal firstloss position in a CMBS. Typically a B-piece buyer purchases the most subordinate tranche in the capital structure at a discount to face value. In order to manage its risk, the B-piece buyer is often involved early in the securitisation process and has significant influence over the selection of pool assets. If a securitiser wishes to use this retention option, the following criteria must be met: (i) commercial real estate loans must constitute at least 95% of the unpaid principal balance of the securitised assets, (ii) the interest acquired by the third-party purchaser must be the most junior interest in the capital structure and must be subject to the same restrictions on hedging, etc. as would apply if the interest were held by the sponsor, (iii) the third-party purchaser must pay for the first-loss interest in cash at the closing of the securitisation without financing being provided by any other person that is a party to the securitisation (other than an investor), (iv) the purchaser must carry out the required due diligence, (v) the purchaser must not be affiliated with any other party to the transaction other than investors or have controlling rights in the securitisation (including acting as servicer or special servicer) that are not collectively shared by all other investors (unless an independent operating advisor is appointed), and (vi) the sponsor must provide potential purchasers with certain information concerning the thirdparty purchaser. In the EU, a third party investor would not currently qualify as retention-holder for a securitisation (although there has been some discussion with regulators about the possibility of an equity investor holding the retention in the context of a managed CLO). However, due to the strict conditions attached, it is not clear as yet whether this option will be practical for issuers in the U.S. The U.S. rule includes an L-shaped risk retention option (i.e. retention of both a vertical and horizontal slice) which is not an option in the EU rules. Exemptions for certain transactions and for certain foreign transactions Unlike the equivalent EU rules, there are exemptions for qualifying residential mortgages which meet certain LTV and other tests, and also for commercial loans, commercial real estate loans, auto loans and residential mortgages (which are not qualifying residential mortgages), which meet stringent underwriting standards designed to ensure very low credit risk on the assets. As the rule is currently a proposal, it is unclear how far these exemptions will be used in practice. The underwriting standards are so stringent that it appears many assets will not qualify. However, the EU has no analogous exemptions. There is therefore, a further discrepancy between the U.S. rules and the EU rules and the potential for U.S. transactions to be exempt from the U.S. retention requirements, whilst EU investors in those transactions will still require the retention requirement to be satisfied for the purposes of the EU rules. The introduction of a Premium Capture Cash Reserve Account for structures which monetise excess spread could mean that features such as interest-only strips are a thing of the past. As mentioned above, the proposed rule includes a safe harbour which is intended to exempt predominantly foreign transactions from the retention requirements. The safe harbour may be used if certain conditions are met, including; (i) the securitisation transaction is not required to be and is not registered under the Securities Act, (ii) no more than 10 percent of the dollar value (or equivalent) of all classes of ABS sold in the transaction are sold to U.S. persons or for the benefit of U.S. persons, (iii) neither the sponsor nor the issuer of the securitisation is chartered, incorporated, or organized under the laws of the U.S, and (iv) no more than 25% (of the unpaid principal balance) of the underlying assets were acquired by the sponsor or issuing entity from a consolidated affiliate that is a U.S. entity. Whilst transactions which fall within Regulation S are expected to fall squarely within this safe harbour, there is no clear exemption for private placements which are made under the safe harbours in SEC rule 144A or Regulation D. The limit of 10% on ABS sold to U.S. persons may easily be exceeded by 144A tranches and there is currently no special treatment for such tranches in the proposed rule, nor any express clarification of whether the 10% limit applies only to the initial issue or to secondary market transactions (although we would expect the limit to be read as applying to initial issue only). What s next? There have been calls by the industry for a mutual recognition process between regulators in different jurisdictions so that the differing requirements in the U.S. and the EU (and indeed other jurisdictions) do not result in operational difficulties which make it impractical for investors and issuers to transact across jurisdictional borders. These calls have not yet been acted upon, however the FSA in the UK has, in its consultation paper CP11/0, on the implementation of CRD2 and CRD3, allowed the possibility of a waiver in circumstances in which a firm which finds itself having to comply with both EU and non-eu rules, may be excused from compliance with article 122a if the compliance burden would be too great and if equivalent rules are in place in the non-eu jurisdiction. This is at least some relief for EU institutions investing in the U.S., however there is no indication as yet of how easily the FSA will grant such a waiver and which rules if will consider to be equivalent. Client Briefing

4 06 Overview of key points only securitisations involving the issuance of asset-backed securities are caught synthetic securitisations are not caught the retention obligation falls on the sponsor or securitiser rather than the investor there is a proposed safe harbour for non-u.s. transactions provided all the following conditions are satisfied (note this does not automatically exempt transactions placed in reliance on Rule 144A) the transaction is not Securities Act registered/registrable no more than 10% of all classes are sold to/for account of U.S. persons neither the sponsor nor the issuer are U.S. entities no more than 25% (of the unpaid principal balance) of the underlying assets were acquired by the sponsor or issuing entity from a consolidated affiliate that is a U.S. entity Overview of timeline Proposed rules published on 30 March 2011 Comments on the proposed rules are due by June Final rules were required to be adopted by 270 Days following the date of enactment (i.e. by 17 April 2011) but are now expected in the final quarter of 2011 Sponsors of RMBS must comply with the final rules one year after the date of their publication in the Federal Register Sponsors of other ABS must comply with the final rules two years after the date of their publication in the Federal Register About BLP Today s world demands clear, pragmatic legal advice that is grounded in commercial objectives. Our clients benefit not just from our excellence in technical quality, but also from our close understanding of the business realities and imperatives that they face. Our people are prized for their legal talent and renowned for being personally committed to helping clients succeed. It s a distinct BLP quality. This award winning approach is redefining the way legal services are delivered. With experience stretching across more than 20 industry sectors and over 100 countries worldwide, you will get the expertise and business insight you need, wherever you need it. Expertise Commercial, Outsourcing, Technology, Media and Telecoms Competition, EU and Trade Corporate Finance Dispute Resolution Employment, Pensions and Incentives Finance Funds and Financial Services Intellectual Property Projects Real Estate Regulatory and Compliance Restructuring and Insolvency Tax

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