​Brexit for CLOs

Britain has voted to leave the European Union, an historic decision that will have many macro-economic consequences for the CLO market generally. But what are the likely legal consequences for UK-based CLO managers attempting to comply with EU risk retention requirements in order to sell to EU investors?

Britain has voted to leave the European Union, an historic decision that will have many macro-economic consequences for the CLO market generally. But what are the likely legal consequences for UK-based CLO managers attempting to comply with EU risk retention requirements in order to sell to EU investors?

Investors and market participants will know that UK-based managers have favoured relying on the "sponsor" route for compliance with risk retention. In order to qualify as a sponsor under the EU Capital Requirements Regulation (CRR) managers need to obtain authorisation under the Markets in Financial Instruments Directive (MiFID) from their national regulator. In the case of UK-based managers, this regulator is the FCA. During the withdrawal negotiations, and while the UK is still part of the EU, FCA authorisation will continue to be valid for retention purposes as sponsor and existing authorisations will not be affected.

However, there is a risk that existing transactions using a sponsor as retaining party will become non-compliant on the effective date of the UK's withdrawal from the EU. This is because UK-based managers will no longer be authorised under MiFID, absent an equivalence decision or a bilateral agreement, as only EU entities will qualify for authorisation under MiFID.

In the case of transactions which have closed prior to the effective withdrawal date, it is unlikely that investors would be penalised for non-compliance where retention is held by a UK-based manager. This is because investors are only subject to capital penalties in the event of their own negligence or omission. If investors discharged their obligation to ensure that the sponsor did, at the time of investment, undertake to retain the required risk, it would be difficult for a regulator to establish the requisite negligence or omission. However, any investor that acquires a non-compliant securitisation position following the withdrawal date is likely to be penalised. Existing investors may therefore find that liquidity of their CLO positions in the secondary market is vastly reduced.

So is it possible to structure a transaction today that will remain compliant after the official withdrawal? One solution might be to establish a sponsor entity in another EU country which would be the named collateral manager for new CLOs. In that case, managers will need to carefully consider the substance, tax and corporate governance implications of such an internal reorganisation. Another possible solution is to consider including provision in the CLO documentation to allow the manager to move operations to another entity in order to ensure compliance. However, the risk retention rules have thus far not provided certainty that such a move would be capable of ensuring that a transaction remains compliant.

A third option could point to favouring the originator/manager structure, in which the manager originates a portion of the portfolio and holds credit and market risk of the assets for a seasoning period. The use of an originator/manager does not depend on pan-EU licensing under MiFID and is currently favoured by the majority of US-based CLO managers that have sought to satisfy the EU risk retention requirements. These transactions should not, on the basis of the current risk retention requirements, become non-compliant upon the effective withdrawal date. However it should be noted that the EU Parliament is currently considering the upcoming changes to the EU securitisation rules and has proposed a provision that would require all originators to be regulated entities. Non-EU originator/managers (which would include the UK upon withdrawal) would not be capable of being so regulated. As such, the originator/manager structure may be a viable option in the short term but may yet fail if the EU Parliament's proposals are adopted in their current form.

Finally, it should be noted that following withdrawal, the UK could choose to amend (or even in theory discard) the retention requirements in relation to a class of assets or a type of securitisation structure (such as a CLO). But even if that were to occur, the sale of CLO paper to investors within the rest of Europe would remain possible only if the EU retention requirements are also met.