On 17 December 2013, the European Banking Authority (EBA) published its Final Draft Regulatory Technical Standards and Implementing Technical Standards (together, Technical Standards) in respect of Article 404-410 of the Capital Requirements Regulation (CRR) (formerly Article 122a).
The Technical Standards follow the publication of a draft version (the Consultation Draft) in May of 2013. The Regulatory Technical Standards have been approved by the European Commission with little substantive change from the EBA's draft. The Technical Standards are now subject to a period during which the European Parliament or the Council may object to their content. If there is no such objection, they will be published in the Official Journal and come into force 20 days later.
What is the effect of the Technical Standards on existing guidelines?
The Technical Standards will be binding in all EU Member States, unlike the preceding Guidelines on Article 122a of the existing Capital Requirements Directive issued by CEBS in December 2010 (CEBS Guidelines), and cannot be disapplied or varied by home regulators. When CRR came into force, Articles 404-410 replaced Article 122a of the existing Capital Requirements Directive, and the CEBS Guidelines fell away, along with the related Q&As issued by CEBS in September 2011.
Have there been any changes since the Consultation Draft regarding who can hold the retention in a CLO?
No. The Technical Standards confirmed that, in accordance with the CRR, the retaining entity must be an originator, sponsor or original lender.
Is there any relaxation of the requirements for sponsors holding the retention which may make it easier for CLO managers to comply?
As we discussed in our briefing on the Consultation Draft in May 2013, the CRR amends the definition of a "sponsor" so that a sponsor no longer has to be a credit institution but can be an investment firm as long as it has certain MiFID authorisations (a CRR Investment Firm). While acknowledging this will exclude some managers, the EBA remains of the view that to extend this definition through the Technical Standards would cut across the language in CRR itself.
The difficulty with this is that to be a CRR Investment Firm, a portfolio manager must be MiFID-regulated and authorised to conduct certain regulated activities which include holding of client money or provision of custody services and/or dealing on own account, underwriting financial instruments or placing on a firm commitment basis. Managers without one of these authorisations would not be CRR Investment Firms, and thus would not fall within the definition of sponsor, without obtaining additional authorisations.
Perhaps more problematically, CRR investment firms also do not include non-EU investment managers and advisers or alternative investment fund managers regulated under the AIFMD. As a result, non-MiFID regulated managers and other non-EU regulated managers cannot fulfil the retention requirements as set out in CRR, and the EBA has closed the door on the additional flexibility needed to allow this.
However, the Technical Standards have allowed some flexibility around sponsors holding the retention. Where there is more than one sponsor of the transaction, the retention can be held either by the sponsor whose economic interest is most appropriately aligned with investors, or by each sponsor pro rata in relation to the number of sponsors. This may allow some scope for co-managers to hold smaller retention pieces, as long as they both meet the definition of sponsor and have the correct authorisations. The Commission-approved version of the Technical Standards set out some objective criteria on which multiple sponsors should allocate their portion of the retention such as fee structure and level of involvement in management.
Can consolidated entities hold the retention?
No. The CEBS guidelines had contained useful flexibility for the retention to be held by any member of a consolidated accounting group. This allowed CLO managers without the requisite capital to fund the retention through an affiliate, but in the absence of express provision in the Technical Standards this flexibility has gone. The feedback document which accompanied the EBA's draft of the Technical Standards explains that the EBA did not consider it had the scope to allow this flexibility in the absence of provision in the CRR itself.
While CRR itself allows retention to be held on a consolidated basis, this only applies where the securitised exposures are those of regulated entities within the consolidated supervision group of the retaining entity, and is thus of limited benefit to CLO managers.
Is any flexibility allowed for pre-2011 transactions which substitute exposures?
There is no express provision in the Technical Standards for grandfathering of transactions which make substitutions after 31 December 2014, although there is a comment in the background paper which states that the CEBS Guidelines will remain relevant to the question of allowing the substitution of underlying exposures after 31 December 2014 for transactions issued prior to 1 January 2011. There is also confirmation of that approach in the feedback document, specifically in relation to CLOs which substitute assets.
The CEBS Guidelines allowed some asset substitution after 31 December 2014 for a securitisation which existed prior to 2011 without the transaction losing the benefit of grandfathering as long as the substitution was pursuant to the pre-defined contractual terms of the transaction. When the Consultation Draft was published, this concession had been lost, leaving a significant number of pre-2011 CLOs potentially having to comply with Articles 404-410.
In conversations Ashurst had with the EBA during the consultation period, the EBA had no objection to allowing substitutions which complied with the CEBS Guidelines, and suggested it could be dealt with in any future Q&A document. We are pleased to see this approach confirmed in the background paper and feedback document, however as these documents do not form part of the Regulation adopted by the Commission, we will be following this up with the EBA in the hope that it is addressed in any future Q&A process.
Have the Technical Standards addressed the possibility of a change in manager holding the retention?
No. The Technical Standards are silent as to what happens in circumstances in which a CLO manager is acting as retention-holder and is replaced or resigns. As requiring the replacement manager to hold the retention as sponsor could cause difficulties finding a replacement, the industry had argued for the option of allowing the original manager to continue to retain or the replacement manager to retain. This will remain a question of interpretation of the provisions of Articles 404-410, unless it is dealt with in future Q&As.
Are there any other changes to the retention requirement?
Yes. While the CEBS Guidelines allowed the retention to be held on a contingent or synthetic basis, such as through the use of derivatives, the Technical Standards provide that if the retaining party is not a credit institution, any interest held on a synthetic or contingent basis must be fully cash-collateralised and held in a segregated client account. Retaining CLO managers will therefore need to fund the retention up front.
The Technical Standards do confirm that the retention can be used for secured financing purposes provided the credit risk is not transferred to third parties. What is unclear is how this interacts with the limitations on synthetic or contingent retention.
Do the Technical Standards make any express provision for grandfathering?
The Consultation Draft was silent on the issue of grandfathering, leaving uncertainty surrounding transactions which complied with the existing CEBS Guidelines once CRR comes into force, and possibly requiring those transactions to be reassessed against the final Technical Standards once in effect.
The Technical Standards do not provide express grandfathering, but do provide that in assessing whether an institution has failed to meet the requirements in Article 404-410 in relation to transactions issued between 1 January 2011 and 1 January 2014, and in relation to imposing any additional risk weighting, competent authorities may consider whether the requirements of Article 122a and the guidance made under it were and continue to be met.
We would hope that this means that existing investors in CLOs which complied with the CEBS Guidelines will not incur an increased capital charge, but it falls short of a clear message to that effect. The possibility that such transactions will be found by regulators to be non-compliant could still affect the liquidity of existing CLO notes, particularly as it is unlikely that an investor who has invested in such a CLO after 1 January 2014 will be able to rely on the CEBS Guidelines.
What is the impact of these proposed changes for CLOs?
In the Consultation Draft, the EBA stated that "The changes could potentially translate in the long term modification of the currently existing managed CLO model". To date, we have not seen significant change to the model, but investors have primarily wanted simple retention structures with a MiFID-authorised manager holding the retention. It is unfortunate that no clear path has been drawn for non-MiFID-regulated managers to hold the retention.
Continued engagement with the EBA is likely to be required through the Q&A process. However, our view is that the Technical Standards will not make a significant difference to the market which has emerged following the publication of the Consultation Draft.
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