Demystifying the Securitisation Regulations

Background

The speciality finance market covers a range of non-bank speciality lenders including pay¬day lending, auto-finance, various types of real-estate backed financing, asset finance and development finance.

Speciality finance funding structures can be varied and complex. Drivers for the diversity of corporate and capital structures include lender of record considerations, servicing arrangements, senior/mezzanine funding requirements, equity injection, and insolvency remote structuring, amongst others.

The recently introduced Securitisation Regulation (Regulation (EU) 2017/2402 of the European Parliament and of the Council of 12 December 2017) has meant there is a renewed focus on whether transaction structures are caught by European regulations applicable to securitisations; indeed this is a consideration across a wide range of financings, crossing funds finance, non-performing loans, and through to fintech and more. The nature of speciality finance funding structures, and their close structural similarities to warehouses or private securitisations mean that the focus is even more pertinent in this market. In this note, we outline the context and highlight some of the considerations that both borrowers and funders may be wise to hold uppermost in their minds as they set out to structure their new financings.

Ashurst’s speciality finance practice works closely with its international securitisation practice, giving us a unique and market leading understanding of the risks, mitigants and legal framework.

Specialist Finance Structures

A common (simplified) speciality finance funding structure may look similar to the below:

You may quickly note that the above structure looks similar in many respects to a securitisation. Whilst it may be the case that this similarity is accidental, with these types of structures suiting the commercial purposes of the parties involved, in other instances it may be deliberate. For example, in scenarios where structures are put in place at an early stage to ease the transition into an asset-backed warehouse and/or ultimately a public securitisation. The key point, however, is that if the transaction is determined to be a securitisation pursuant to the Securitisation Regulation there are certain regulatory consequences for the transaction and the parties thereto.

The Regulatory Context

The Securitisation Regulation (which came into force on 1 January 2019) provides the framework for securitisation transactions. Most pertinently, “Tranche” and “first loss tranche” are both defined very widely (see Article 2(6) and (18) of the Securitisation Regulation).

In most cases, if payments in respect of the Senior/Mezzanine Debt can be said to be dependent on the performance of the portfolio of assets held by the borrowing entity (see Article 2(1) of the Securitisation Regulation), the inclusion of junior debt in the form of an intra group loan alongside Senior/Mezzanine Debt will constitute the structure being considered as “tranched”, as each of the Senior, Mezzanine and junior debt will likely comprise “a contractually established segment of credit risk” associated with such portfolio of assets. This could lead to characterisation of a structure as a securitisation pursuant to the Securitisation Regulation.

Final draft Regulatory Technical Standards (RTS) on the requirements for originators, sponsors and original lenders relating to risk retention were published on 31 July 2018. These includes matters such as the measurement of the level of retention, the conditions for retention by an originator group (i.e. the speciality finance company accessing the funding) on a consolidated basis and the prohibition of hedging or selling the retained interest.

The retention rate (5%) and retention methods set out in the Securitisation Regulation (Article 6) and the abovementioned RTS (including the “first loss” method typically adopted in the speciality finance space) actually remain the same as under the pre 1 January 2019 securitisation framework. However, the rules impose risk retention requirements directly on the originator, sponsor or original lender to fulfil the retention requirement (as opposed to being an indirect obligation per the pre January 1 2019 framework). This results in EU borrowers needing to satisfy the requirements even where there is no requirement on the funders to do so (for example when those funders are non-EU entities).

On this point, it is worth noting that under the “sole purpose test” established under the current framework, an entity that has been established for the sole purpose of receiving funding and holding the exposures is not an originator for retention purposes, thus frustrating any attempt to achieve compliance by way of aesthetic structuring rather than substantive risk ownership. The RTS includes guidelines for compliance with this point.

The Securitisation Regulation also sets out direct transparency obligations on the originator (see Article 7 of the Securitisation Regulation), and EU regulated investors in any securitisation are required to diligence information that broadly mirrors what an originator is required to disclose (see Article 5 of the Securitisation Regulation). This includes full transaction documentation and a deal summary (on closing) and Loan Level Data and Investor Reports (on a quarterly basis).

So what should we be alive To ?

At a very basic level, when parties set out on the path to a new financing, they would do well to bear in mind that any structure which has tranched debt funding a borrower, the repayment of which is dependent on the repayment of underlying debt obligations, may be caught by the securitisation regulations; and when you consider that (i) tranched debt may include shareholder loans (and depending how it is documented within the transaction other funding more typically described as “equity”), and (ii) the repayment of all debt in speciality finance transactions will be, to some extent, dependant on the repayment of an underlying debt obligation, you will soon come to the realisation that a high proportion of speciality finance transactions will require analysis as to whether they could be deemed to be securitisations under the Securitisation Regulation.

There are differing views in the market as to whether shareholder loans and certain types of “equity” should be regarded as tranched debt for regulatory purposes, but the existence (or not) of tranching in respect of any spec fin transaction should be considered on its own facts along with the other determinants of whether a transaction is a securitisation pursuant to Article 2(1) of the Securitisation Regulation. We suggest some potential mitigants below.

Fresh Issuance

The Securitisation Regulation is not retrospective, that is any transaction completed prior to 1 January 2019 will be ‘grandfathered’ and will fall under the old regime. That said, if any new notes are issued or funding line increased after 1 January 2019, that grandfathering may be open to challenge, and the transaction could be considered to fall under the new regime. Advice should be sought in these instances.

Potential Repercussions

Failure to interrogate the types of structures we are discussing in the context of the Securitisation Regulation have a few potentially serious repercussions for the unwary, and the characterisation of a speciality finance funding structure as a securitisation now has potential consequences for both a funder (or investor) (see Article 5 of the Securitisation Regulations) as well as the borrower (or issuer). Those consequences could include:

1. for the funder:
   
   (A) ring-fencing implications and having to enter the transaction through an entity which is separated from “ring-fenced” operations (e.g. retail banking);
   
   (B) compliance with diligence obligations; and
   
   (C) liability to sanctions, penalties and fines imposed by the FCA;
2. for the borrower:
   
   (A) compliance with the risk retention rules set out in the Securitisation Regulation;
   
   (B) compliance with detailed disclosure and transparency obligations; and
   
   (C) liability to sanctions, penalties and fines imposed by the FCA.

What to do

It is important to stress that individual, expert, assessment will need to be carried out in relation to each financing structure, and there is no panacea. There are, however, structural mitigants which could point to a speciality finance structure not falling within the Securitisation Regulation:

1. the corporate entity with whom the underlying debt obligation sits is an operating business; and
2. the corporate entity with whom the underlying debt obligation sits is the beneficiary of an unlimited guarantee from another group company (usually its parent).

Alternatively, it may be advantages to embrace the benefits of the Securitisation Regulation, and we can help you build a first loss risk retention mechanism. There are a number of methods open to the parties, with varying degrees of complexity, but all should be viewed with expertise on call.

Our offering

Ashurst offers a full service to the speciality finance market. From structured finance products (borrowing base facilities, variable funding notes, forward flow agreements), securitisation and warehouses (public and private), M&A expertise, through to regulatory capability, and GDPR advice, we are ideally positioned to talk you through the risks and opportunities that lie ahead, wherever you sit in the speciality finance landscape. We would welcome the opportunity to discuss how we can help you, either with regard to any of the topics raised in this note, or more generally in the speciality finance market.