CLOs & European Risk Retention: Changes Proposed In The New Securitisation Regulation

On 30 September2015, following two separate unauthorised "leaks" to the financial press of early drafts, the European Commission published its official draft proposal for the new Securitisation Regulation1.

Once finalised and in force (see below for further detail), the Securitisation Regulation is intended to replace and consolidate in a single regulation the existing European risk retention regime that is currently scattered acrossseveraldifferent pieces of legislation. From a substantive perspective, most aspects of the risk retention regime will remain the same. However, as we highlight below, there are some crucial differences which will impact the European CLO market(and the US CLO market with respect to transactions that aim to be compliant with the Existing Rules and the Securitisation Regulation) if the Securitisation Regulation is implemented in its current draft form.

EXISTING POSITION

Currently the regulatory framework for risk retention in Europe is implemented by four different pieces of primary legislation (together, the "Existing Rules")2 which require that an entity3, other than when acting as an originator, a sponsor or original lender, shall be exposed to the credit risk of a securitisation position only if the originator, sponsor or original lender has explicitly disclosed thatit will retain, on an ongoing basis, a material net economic interest which, in any event, shall not be less than 5% (the "Retention Requirement").

The Existing Rules impose what is known as an "indirect" compliance obligation, as it is investors who arerequired to comply, rather than the entity that actually holds the 5% retention (the "Retention Holder"), in contrast to the US risk retention rules which become effective in December 2016. Consequently, most focus under the Existing Rules has been on confirming whether, and exactly how, any particular Retention Holder is eligible to act in such capacity. In addition, the Existing Rules also impose significant diligence obligations on investors4.

BACKGROUND TO THE CHANGES

The European Commission recognises that securitisation is an important element of well-functioning capital markets, necessary for diversifying funding sources and allocating risk efficiently within the EU financial system5. It also observes that post-crisis European securitisation markets have remained subdued when compared to the United States, notwithstanding significantly lower default rates6. The Securitisation Regulation is part of the European Commission's attempt to restart the securitisation markets on a sustainable basis7.

The Securitisation Regulation also introduces certain amendments in light of the recommendations made by the European Banking Authority (the "EBA") in its report on risk retention published 22 December, 2014 (the "2014 Report")8. In the 2014 Report, the EBA in particular recommended that the European Commission revisit the definition of an "originator" in order to reduce a perceived misuse of the rules by virtue of a supposed "legal loophole", as well as revisiting disclosure and due-diligence requirements and, finally, to look at a move to direct application of the Retention Requirement.

DESCRIPTION OF PRINCIPAL CHANGES

(a)The move to direct application The Securitisation Regulation contemplates a move to "direct" application of the Retention Requirement, in that Article 4(1) requires the originator, sponsor or original lender of a securitisation to retain a 5% interest on an ongoing basis.

As noted above, by contrast the Existing Rules apply "indirectly" by requiring that the investor exposed to the credit risk of a securitisation may only hold a securitisation position where the relevant Retention Holder has explicitly disclosed to such investor that it will retain a 5% interest on an ongoing basis. The rationale for the...

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