CLO 1.0 vs. 2.0: Part III Of A Series: The Risk Retention Factor

1. INTRODUCTION

   This is the third in a series of our U.S. collateralized loan obligation ("CLO") client alerts examining important distinguishing features of post-credit crisis CLOs ("CLO 2.0"). Risk retention rules that originally took effect in Europe in January 2011, and that were revised in May 2013 for implementation from January 1, 2014, have had a profound impact on the structure of and market for CLO 2.0 transactions that target European credit institution investors. One result has been that relatively few CLO 2.0 transactions are being structured to be compliant with the EU risk retention regime.1 Just as CLO market participants have begun to adjust to the new European rules, U.S. federal regulators have recently taken a step closer to implementing U.S. risk retention rules. There is unfortunately little overlap between the European regime and the U.S. regime as currently proposed.

2. THE U.S. RULES AS RE-PROPOSED

   On August 28, 2013, the Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Department of Housing and Urban Development, Federal Housing Finance Agency, Office of the Comptroller of the Currency, and Securities and Exchange Commission (collectively, the "Agencies") re-proposed rules (the "Modified Proposals") for implementing the requirements of Section 941 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"), the comment period for which expired on October 30, 2013. The Modified Proposals take into consideration comments received on the rules originally proposed in April 2011 (the "Original Proposals").

   In general, Section 15G of the Securities Exchange Act of 1934, as added by Section 941(b) of the Dodd-Frank Act, requires the Agencies to prescribe regulations that (1) require "securitizers"2 to retain at least 5 percent of the credit risk of any securitized assets (the "Retention Requirement") and (2) prohibit a securitizer from directly or indirectly hedging or otherwise transferring the credit risk required to be retained.3 The Retention Requirement is intended to provide an incentive for the securitizer to actively monitor the quality of the assets that are being securitized and, thereby, align the interests of the securitizer with the interests of investors.

   The Modified Proposals make the controversial assertion that in a CLO, the CLO manager is a securitizer because it "indirectly transfers the underlying assets to the CLO issuing entity typically by selecting the assets and directing the CLO issuing entity to purchase and sell those assets"4. Industry trade groups have submitted comment letters vigorously disputing this statutory interpretation, arguing that in CLOs that are not balance sheet transactions, the CLO manager should not be considered a securitizer because it neither sells nor transfers assets to the CLO. If the Modified Proposals are implemented as proposed, the CLO manager (or its majority-owned affiliate)5 will be the only participant in a CLO that can satisfy the Retention Requirement.

3. METHODS OF RISK RETENTION

   The Original Proposals would have allowed sponsors to satisfy the Retention Requirement by vertical risk retention, horizontal risk retention or L-shaped risk retention. Under the Modified Proposals, the Agencies have consolidated these options into a "combined standard risk retention option that would permit a sponsor to satisfy its risk retention obligation by retaining an 'eligible vertical interest,'6 an 'eligible horizontal residual interest,'7 or any combination thereof, in a total amount equal to no less than 5 percent of the fair value of all ABS interests in the issuing entity that are issued as part of the securitization transaction"8. The horizontal option can also be satisfied by the implementation of a reserve account into which cash equivalent to the 5 percent requirement is deposited.

   The Modified Proposals introduce a new problematic requirement for CLO sponsors that elect to comply using the horizontal...