a never ending road - clifford chance... · 2020-05-18 · a never ending road 7 investment...

A never ending roadNew aspects in the regulation of securitisation

A year ago, things were looking very uncertain and concerning for the world of securitisation andstructured debt. The proposed new Basel and EU Solvency II capital rules looked like they were set tosignificantly increase capital charges for banks and insurers investing in securitisations. Moreover, CRA3was introducing yet more disclosure requirements that appeared likely to be difficult to comply with andEU risk retention rules were changing yet again, with much of the flexibility in Article 122a and theCEBS Guidelines (later the EBA Guidelines) removed. Looking across the Atlantic, the markets werecoming to grips with the Volcker Rule and what it was likely to mean for structured debt both in the USand elsewhere. Against this, there was improved mood music from policymakers and regulators aboutthe importance of securitisation, but this was not being reflected in concrete regulatory response.

The picture this year is brighter, if still mixed. A range of official bodies have made clear theirenthusiasm for the idea of “high quality” or “qualifying” securitisation as a building block for making themarkets more hospitable to new securitisation issuance. The European Commission’s flagship CapitalMarkets Union initiative includes the promotion of simple, transparent and standardised securitisationas a main policy objective in support of jobs, growth and the real economy. The new Baselsecuritisation framework is finalised and capital charges are increasing, but it looks like “qualifying”securitisation may reduce the impact of that blow. CRA3 disclosure obligations are onerous, but atleast they are (so far as many public transactions are concerned) certain and manageable (albeit withsome significant issues for a number of asset classes).

There is still a long list of developments in progress, though. Will ideas of qualifying securitisation beadjusted to allow inclusion of key product areas like ABCP conduits, typical CMBS and synthetics? Willcapital rules create a level enough playing field for qualifying securitisation investments against otherkinds of exposures to lure investors back into the markets? How will CRA3 disclosure obligations affectprivate transactions and asset classes where the nature of disclosure under CRA3 is misconceived?Will risk retention rules be adjusted to allow for mutual recognition and substituted compliance?

While the road of regulation on which securitisation market participants travel no longer seems quite sosteep, it is still a winding and seemingly never ending one. We hope this latest publication in our NewBeginnings series helps you to consider your journey along that road and to be properly equipped forthe adventure!

Introduction

Kevin IngramPartner, On behalf of the International Structured Debt Group

Andrew E. BryanSenior Associate PSL –Structured Debt

1. Capital Markets Union – the next big thing? .................................................................... 4

2. Qualifying securitisation – the way forward? .................................................................... 10

3. Basel Securitisation Framework – reloaded ..................................................................... 18

4. Risk retention – spot the difference ................................................................................. 22

5. US risk retention – go your own way .............................................................................. 28

6. CRA3 disclosure requirements – the worst yet to come? ................................................ 34

7. US disclosure rules for ABS – an embarrassment of riches ............................................. 38

8. Bank recovery and resolution – A narrow escape ............................................................ 44

9. Volcker Rule implementation – challenges for structured finance underwriters .................. 48

10. Securitisation swaps – recent regulatory developments and challenges ahead................. 54

Clifford Chance contacts (London) ......................................................................................... 61

Clifford Chance contacts (Global) ........................................................................................... 62

Other contributors.................................................................................................................. 64

Acknowledgements................................................................................................................ 64

Contents

1. Capital Markets Union –the next big thing?

© Clifford Chance, June 2015

A never ending road 5

What is the CMU and whatare its main objectives?Capital Markets Union is a flagship initiativeof the European Commission that aims tocreate a single capital market. This wouldrepresent a significant step forward in thepractical implementation of a long standingobjective of the European Union: the freemovement of capital. The CMU project isalso a key part of the overall drive by theEuropean Commission to boost jobsand growth.

The CMU initiatives are designed tostrengthen cross-border capital flows,improve access to finance for businessesand infrastructure projects across Europeand diversify sources of credit. Thesecomponent elements aim to reduce thecost of raising capital, particularly forSMEs, and lessen Europe’s heavydependence on the banking system infavour of a larger role for the capitalmarkets in channelling financing to thereal economy.

The European Commission’s publicconsultations invited contributions from abroad spectrum of stakeholders as to thechallenges facing the CMU project andhow best to overcome them.

Submissions were due by 13 May 2015and the European Commission iscurrently in the process of preparing anAction Plan expected to be ready later in2015, setting out the actions to becarried out over the next five years. Acopy of Clifford Chance’s response to theGreen Paper is available on our website.

Key obstacles and areasof improvementSection 2 of the Green Paper provides apreliminary analysis of some of theobstacles to the integration anddevelopment of the EU capital marketsand identifies three key areas where it isnecessary to overcome challenges:

n access to finance, including to riskcapital, notably for SMEs

n the flow of institutional and retailinvestment into capital markets; and

n effectiveness of markets;

1. Access to finance,including to risk capital,notably for SMEsWell-functioning equity and bond marketsare among the fundamental objectives of

the CMU project. In that context, theGreen Paper discusses some of thebarriers that have impeded access tocapital markets, such as insufficient creditinformation in respect of SMEs, the costof accessing public capital markets (e.g.the cost of preparing a prospectus,performing due diligence/verification andother complying with regulatoryrequirements), “short termism” on thepart of investors and regulatory barrierswhich are common in new infrastructureinvestments.

To address the problems faced by SMEsrelating to availability of credit information,the Green Paper suggests that banksshould be encouraged to provide betterfeedback to SMEs whose creditapplications are declined and to raiseawareness of the alternative sources offunding that might be available. Anothersuggestion is to develop a simplified,common accounting standard, tailored tocompanies listed on markets such asmultilateral trading facilities, which generallyhave less onerous listing and disclosurerequirements than regulated markets.

The Green Paper further highlights theimportance of establishing common

On 18 February 2015, the European Commission unveiled its long-expected plan toboost funding and growth across Europe by creating a Capital Markets Union (CMU) –a true single market for capital across the 28 EU member states.

The Commission’s Green Paper on Building a Capital Markets Union aims to stimulatedebate on the measures needed to identify and remove the many obstacles standingin the way of a deep and integrated single European capital market.

Two technical consultations, on “simple, transparent and standardised securitisation”and on the Prospectus Directive, were launched alongside the Green Paper. All threeconsultations closed on 13 May 2015 and the Commission is expected to moveforward quickly, with concrete proposals to be published in the coming months.

6 A never ending road

standards and a common set of marketrules, transparency on productfeatures and consistent supervisionand enforcement.

Finally, specific mention is made in theGreen Paper of peer-to-peer lending andcrowdfunding as a way of diversifying thesources of finance available within Europe.In this respect, feedback is sought onwhether there are barriers to thedevelopment of appropriately regulatedcrowdfunding or peer-to-peer platforms,including on a cross-border basis.

2. The flow of institutionaland retail investment intocapital marketsThe European Commission begins itsreview of this area by acknowledging theimportance of attracting moreinstitutional, retail and internationalinvestors to promote the diversification offunding sources.

The Green Paper analyses the role to beplayed by institutional investors – assetmanagers, pension funds and insurancecompanies, private equity and venturecapital funds – and discusses some ofthe barriers that might be impedinginvestment from these institutions.

For asset managers, one such barrier iscompliance costs, including the costs of

setting up funds, becoming an authorisedmanager and selling across borders.

On the pensions front, the Green Paperconsiders whether the introduction of astandardised personal pension productacross the EU, or removing barriers tocross-border access, would strengthenthe single market in pension provision.

In response to calls for tailored treatmentfor infrastructure investments, the GreenPaper seeks views on whether thisshould be included in future reviews ofSolvency II and the CRD/CRR regime.

Private equity and venture capital fundsare noted as providing valuable sourcesof funding, although significant barriers,such as the absence of an equity


Implementation TimelineEstimated Timing

CMU Green Paper Consultation

Securitisation Consultation

Prospectus Directive Consultation

Consultation Period

Conference on CMU to be held

“Summer 2015”

Commission to launch Capital Markets Action

Plan “later in 2015”

Building Blocks

for Capital Markets Union to be in place

May Summer 2015 Aug Sept Later in 2015 2019

13 May 2015 Deadline for Submitting

Response to Green Paper

Other Initiatives in 2015

The Commission to consult on EU covered bond

frameworks

The Commission to issue a report on

cross-border transfer of claims and order

of priority

The Commission to evaluate its 2014

“Recommendation on a new approach to

business failure and insolvency”

The Commission to hold workshops

on SME credit information


investment culture, lack of credit andfinancial information, a fragmentedmarket, and high costs mean that suchmarkets often lack scale.

Furthermore, the Green Paper soughtviews on how private equity and venturecapital might be further developed asalternative sources of finance. Moreparticularly, the Commission wished toknow whether changes are needed to therecently introduced EuVECA (EuropeanVenture Capital Funds Regulation) andEuSEF (European Social EntrepreneurshipFund) Regulations.

Finally, acknowledging the impact of newtechnology and business models, theCommission sought views on whetherthere are any significant barriers to entryfor bank and non-bank direct lenderswho often provide funding to start-upsand SMEs.

3. Effectiveness of marketsIn order to achieve a larger, moreintegrated and deeper capital market it isnecessary to overcome the barriers thatare fragmenting European markets andholding back the development of variousmarket segments. This is an extremelybroad objective and the barriers arediverse, covering areas of company,insolvency and securities laws, anddiverging tax treatments. As theEuropean Commission acknowledges,tackling these issues will not be easy. Wehave already seen the degree of difficultyEuropean authorities have encountered inattempting to harmonise insolvency lawwith the example of the EU InsolvencyRegulation. Indeed, this first attempt atcoordinating a European approach toinsolvency acknowledges explicitly inRecital 11 that “as a result of widelydiffering substantive laws it is notpractical to introduce insolvency

proceedings with universal scope in theentire Community”. Recital 11 goes on toacknowledge “widely differing laws onsecurity interests” and differentapproaches to preferential creditors ashurdles. This may explain in part why theCommission’s Green Paper says that“further analysis is needed to identify thescale of the challenge in each area andthe appropriate solutions and degree ofprioritisation”. Taking on all of these areaswill be challenging, to say the least.

Single rulebookThe single rulebook, developed overrecent years through a number of keyreforms, is seen as a major step forward,by creating a harmonised regulatoryframework for European capital markets.However, it is noted that the practice ofintroducing superequivalent standards atnational level, or “gold-plating”, anddivergent interpretation of the rules atnational level persists and prevents manyof the single rulebook’s benefits frombeing fully realised. In this respect, theCommission proposes to work withMember States and the ESAs to ensurethat financial regulation is correctly andconsistently implemented and enforced.

Competition and barriers to entryTo support more efficient and well-functioning capital markets, theCommission aims to remove barriers toentry and assure access to financialmarket infrastructure. To this end, theCommission says it will continue toensure that competition law is rigorouslyapplied to avoid restrictions or distortionsof competition.

Supervisory convergenceThe Commission will review thefunctioning and operation of the ESAswith a view to improving regulatoryconvergence, seen as vital to establishingharmonised regulatory frameworks for

capital markets. Accordingly, the GreenPaper seeks views on whether the ESAs’current powers to ensure consistentsupervision are sufficient and raises thequestion of whether they should be givenadditional powers if national regulatoryregimes result in differing levels ofinvestor protection, barriers tocross-border operation being erected orcompanies being discouraged fromseeking finance in other Member States.

Data and reportingThe Green Paper goes on to discuss howthe development of common data andreporting across the EU would assist theCapital Markets Union. It makes clear thatif market-led efforts fail to deliver aconsolidated tape which is easilyaccessible to market participants on areasonable commercial basis, other optionsmay be considered, including “entrustingthe operation of a consolidated tape to acommercial entity”.

Market infrastructure, collateral andsecurities lawThe Green Paper refers to existing work inrespect of the regulatory frameworkapplying to market infrastructures.Collateral is mentioned as an area forimprovement because the Commissionbelieves that the fluidity of collateral in theEU is currently restricted. The Green Papersought views on whether steps should beundertaken to facilitate an appropriatelyregulated flow of collateral throughout theEU and whether work should beundertaken to improve the legalenforceability of collateral and close-outnetting arrangements cross-border.

On the securities law side, the Green Paperqueries whether changes should be madeto the laws relating to securities ownership,noting that legislation relating to investors’rights in securities differs across memberstates. The Green Paper investigated the



feasibility of targeted changes to securitiesownership rules that could materiallycontribute to more integrated capitalmarkets, making it easier for investors tocompare and assess the risks inherent intheir investments.

The Commission has particularlyprioritised achieving greater legal certaintyin cross-border transfer of claims andtheir order of priority and plans to issue areport on this before the end of 2015.They hope that this will help to develop apan-European market in securitisationand financial collateral arrangements andalso facilitate other financial activities,such as factoring.

Company law and corporategovernanceThe Commission believes that furtherreforms to company law might be helpful inovercoming barriers to cross-borderestablishment and operation of companies.Accordingly, it discusses several obstaclesarising from company law in the GreenPaper, including those relating to corporategovernance, protection of minorityshareholders, cross-border mobility,restructurings and divergent nationalconflict-of-laws rules. The Green Papersought views on these and other obstaclesincluding possible solutions theCommission might implement.

InsolvencyDespite the challenges, the Commissionwishes to revisit this area as it believesreducing divergences in nationalinsolvency frameworks could contributeto the emergence of a pan-Europeanequity and debt market by reducinguncertainty for investors. In 2014, theCommission adopted a recommendationon a new approach to business failure inwhich it urges member states to put inplace early restructuring procedures and“second chance” provisions and to

consider applying the principles toconsumer over-indebtedness andbankruptcy. An evaluation of thatrecommendation is planned for 2015.

TaxationThe Green Paper solicited suggestions asto what tax-related barriers should beexamined as a priority. A number ofbarriers are discussed in the GreenPaper, including obstacles tocross-border investments such aspensions and life assurance products,due to distortions caused by different taxregimes across member states (e.g. todifferent types of market participants andto different types of financings). Theeffective use of incentives, such as R&Dexpenditure for innovative companies, isalso discussed.

TechnologyFinally the Green Paper notes thatEuropean and national company law hasnot kept pace with technologicaldevelopments and that use of moderntechnology, e.g. electronic voting forshareholders and European-wide on-lineregistration of companies, could helpreduce costs, ease administrativeburdens and make cross-bordercommunication more efficient. TheCommission is interested in how the EUcan best support the development ofnew technologies to benefit integratedand efficient capital markets.

Priorities for early action –quick winsWhile the creation of the CMU is a longterm project, requiring sustained effortover many years, the EuropeanCommission has identified some areaswhere progress could be made in theshort term. The Green Paper outlines fivepriority actions, some of which were also

identified in the “Investment Plan forEurope”, published in November 2014.

These are: (i) helping small firms to raisefunding and reach investors cross-borderthrough a review of the current prospectusregime; (ii) widening the investor base forSMEs by improving the availability of creditinformation; (iii) encouraging directinvestment in smaller businesses bysupporting industry-led work to develop apan European private placement regime;(iv) attracting investment in infrastructureand other long term projects by supportingthe take up of new European long terminvestment funds (ELTIFs); and(v) promoting high quality securitisation andfreeing up bank balance sheets to lend.

What is the role ofsecuritisation in the CMU?Securitisation features prominently in theCMU project.

Alongside the Green Paper, the EuropeanCommission launched a specificconsultation on securitisation, seeking todevelop an EU market for simple,transparent and standardisedsecuritisation, which is an initiative thatfollows innovations from industrysubsequently taken forward by the Bankof England, the ECB, the EuropeanBanking Authority and the BCBS-IOSCOTaskforce on Securitisation Markets. Itaims to revive the securitisation marketswhile leaving behind the elements ofunpredictability and opacity thatcontributed to the financial crisis.

Indeed, the consultation acknowledgesthe ongoing negative effect of thefinancial crisis on securitisation, withissuance in Europe amounting to €216billion (most of which was retained) in2014, compared with €594 billion in 2007(most of which was placed) and notes




that the US securitisation markets haverecovered much more quickly that theEuropean ones. Since the Commissiondoes not plan to replicate the levels ofofficial support for the securitisationmarkets that exist in the US, theconsultation paper seeks other methodsof encouraging their return.

The Commission is, however eager toemphasise that this “is not a return to thebad old days of the subprime market.Securitisation can help free up banks’balance sheets, allowing them to increasetheir lending to businesses andhouseholds” in the words of CommissionerJonathan Hill, who has responsibility forFinancial Stability, Financial Services andCapital Markets Union.

The idea is to formulate a set of genericrules to ensure simplicity, transparencyand standardisation of securitisationinstruments. Such a standardised systemwould create the conditions to encouragethe new products and promote theavailability of high quality information inrelation to them. EU authorities are,however, likely to be extremely prudentbecause of the perceived rolesecuritisation played in the crisis.

Securitisations that meet this new set ofrules will likely benefit from more benignregulatory treatment, probably includingmore lenient risk weightings forsecuritisation assets held in the bankingbook.

Benefits for banksAlthough one of the principal aims of theCMU is to diversify sources of finance toinclude nonbank sources of funding, theEuropean Commission has been keen toemphasise that “Capital Markets Unionis about complementing the role ofbanks, not about displacing them.

Europe’s banking system will obviouslycontinue to play a pivotal role inEurope’s economy: it is very importantto local communities; and it is at theheart of capital markets themselves”.

As banks are lenders to a significantproportion of the economy and act asintermediaries in capital markets, thehope is that they would benefit from adeeper integration of the single market forcapital as this would mean fewer barriersto cross-border investments and anincrease in the number and the amountsof transactions, both domestically andacross the European Union. In addition,the European Commission believes thatmeasures such as a framework forsimple, transparent and standardisedsecuritisations could provide scope forbanks to lend more to the extent thatthey are able to transfer risks safely offtheir balance sheets.

The Commission is now acknowledgingthat, soundly structured, securitisationcan be an important channel fordiversifying funding sources andenabling a broader distribution of risk byremoving part of the risk from thebanks’ balance sheets.

Securitisation can also provide additionalinvestment opportunities by allowingbanks to transfer assets to institutionalinvestors to meet those investors’ assetdiversification, return and maturity needs.

Next stepsReponses to the Green Paper and tothe consultations on Securitisation andthe Prospectus Directive were due on13 May 2015.

A conference will be organised for thesummer of 2015 and, taking into accountthe feedback from to the consultations,

the European Commission will launch aCapital Markets Action Plan later in 2015.

In addition, work on a number of otherinitiatives, relating to various aspects ofthe Capital Markets Union project, arescheduled to take place in 2015. TheEuropean Commission plans to:

n hold workshops on SMEcredit information ;

n consult on the merits and potentialshape of an EU covered bondframework and subsequently topresent policy options;

n issue a report identifying the problemsand possible solutions in relation tocross-border transfer of claims andthe order of priority in cases such asinsolvency; and

n evaluate their recommendation toMember States on a new approach tobusiness failure and insolvency, whichwas issued in 2014.

The target is to have the building blocks ofCapital Markets Union in place by 2019.

2. Qualifying securitisation –the way forward?



General backgroundParticipants in the securitisation marketsare well aware of the seriousconsequences the financial crisis of2007-08 had on those markets.Issuance dropped off precipitously for avariety of reasons and certain productssuch as arbitrage synthetic CLOs, CDO-squared and SIVs have never comeback, and at this stage it looks unlikelythey ever will – often for good reasons.It has not helped the recovery of themarkets that wave after wave of newregulation has been brought in thatgenerally make securitisation a lessattractive product for all involved, evenwhere well-intentioned. Bank, insurerand fund investors have all had riskretention and regulatory due diligencerequirements imposed. Bank andinsurance capital requirements inrelation to securitisation investments arenow being raised to levels so high it is aserious disincentive to investment. Onthe sell side, regulatory recognition ofsignificant risk transfer has become verydifficult to achieve and a plethora ofoften overlapping disclosurerequirements have been introduced

requiring publication of extremelydetailed information in a variety offormats, at a variety of frequencies andin a variety of places. In addition, anumber of legislative initiatives that arenot particularly aimed at securitisationwill nonetheless affect it, again generallymaking it more difficult, including bankrecovery and resolution initiatives andnew derivatives rules.

In that context it is not surprising thatrecovery of the securitisation markets hasbeen slow. According to the Associationfor Financial Markets in Europe, annualsecuritisation issuance placed in theEuropean markets was a laggardly €77.6billion in 2014, compared to the pre-crisispeak of €477.6 billion. This is despite thefact that it was only a small number ofsecuritisation products that hadperformed badly through the crisis.European RMBS, credit cards and otherconsumer ABS (which make up themajority of the European securitisationmarkets) all had default rates under 0.2%for the period from mid 2007 to the endof Q2 2014. SME securitisations had avery respectable default rate of 0.55% forthe same period. CMBS, due largely to

their maturity transformation features, hada default rate of 10.66% and made upjust under 10% of the market. CDOs ofABS, on the other hand, had acatastrophic 41.08% default rate, butrepresented only 1.7% of thesecuritisation markets.

The fallout from the financial crisis causedsecuritisation to become something of atoxic brand as a whole, even though itwas a small number of products,representing a very small proportion ofthe market, that were truly problematic.

As a result, industry considered the ideaof trying to differentiate the market. Byseparating the universe of securitisationproducts into those that met certainstandards (such as transparency,simplicity and standardisation) and therest, the hope was that those productsthat had performed well could be revived.This idea originally manifested itself in theform of the Prime Collateralised Securitiesinitiative, which assigned its first label inlate 2012. PCS was established andremains an industry-led, not-for-profitscheme to certify that securities metcertain criteria of “quality, transparency,

A large number of regulatory initiatives affecting securitisation have come out in the lastseveral years, most of which increase the regulatory burdens associated withsecuritisation transactions, generate uncertainty for transaction parties, or both. It is withsome relief, then, that market participants have greeted proposals from policymakersand regulators to differentiate the securitisation markets by creating a class of “qualifyingsecuritisations” that would benefit from a more benign regulatory environment and agenerally more level playing field with other comparable forms of investment.

In this article, we explore the background to these proposals, the likely benefits andwhat kinds of transactions are likely to fall into the “qualifying” category. We also explorethe situation of ABCP conduits, typical CMBS and synthetics, which are unlikely toqualify under current proposals but which might in future “come in from the cold”.


simplicity and liquidity” and is restricted tocertain asset classes.

Perhaps as a reaction to the generallyslow pace of economic recovery followingthe crisis, various central banks,governments, and supranational andinternational authorities have recognisedthat anaemic issuance of securitisationinstruments might be one of the brakeson growth and have become interested inreviving the securitisation markets.The Bank of England (BoE), the EuropeanCentral Bank (ECB), the EuropeanBanking Authority (EBA), the EuropeanCommission (EC), the Basel Committeeon Banking Supervision (BCBS) and theInternational Organisation of SecuritiesCommissions (IOSCO) have all consultedon some variation of a set of standards todifferentiate the market.

Official sector expressions of interest in thistopic started out referring to “high quality”securitisation with asset class-baseddistinctions, but have increasingly movedtoward the idea that distinctions should bedrawn along more neutral lines that are notasset class specific and don’t suggest aspecific limitation of risk or a particular levelof credit quality. At this stage, a consensusbetween the official sector and marketparticipants appears to be emergingaround the idea of “qualifyingsecuritisation” that meets standards ofsimplicity, transparency andstandardisation or comparability.Essentially, the idea is that “qualifyingsecuritisation” should represent a beliefthat the risks of the transaction can beproperly understood and accuratelymodelled based on the information madeavailable to investors or prospectiveinvestors in the transaction. It should notbe taken as an indication that thetransaction is low or no risk. To dootherwise would be to eliminate the role ofinvestors in assessing risk, deciding

whether they are prepared to take it on,and at what price.

Why should I care?All this is very interesting, but thequestion on most market participants’minds will, of course, be “Why do I care?”What does one get out of being a“qualifying securitisation” besides somevery vague, general kudos?

Unfortunately, the answer at this stage isnot clear. In today’s market environment,taking into account the “toxic brand” ofsecuritisation, of course, imprecise,general kudos are not to be sniffed at. Ageneral positive attitude towardsecuritisation products would in itself behelpful in regenerating the market, but it’sunlikely to be enough on its own.

The most likely outcome is that there willbe more favourable regulatory treatmentof qualifying securitisation. Again, preciseanswers are hard to come by at thisearly stage, but a number of possibilitieslook likely.

Capital treatmentThe first is better capital treatment. This isalready the case for insurance andreinsurance undertakings under Solvency II.An early version of the qualifyingsecuritisation idea has been incorporated inthe Solvency II Delegated Act, whereinvestments in “Type 1” securitisations (thatmeet certain criteria) are subject to lowercapital charges than “Type 2” securitisation(that do not). A similar approach looks likelyto be set out for banks once Europeancriteria for qualifying securitisation areadopted. The hope is that the criteria forinsurance undertakings would then berevisited and harmonised with the generalcriteria adopted for securitisations by theEuropean legislative authorities.

It is not clear the extent to which capitalrelief would be granted to banks forinvestments in securitisations, but theEBA consultation suggested that “thecapital treatment proposed for the‘qualifying’ framework should aim atlimiting the extent of non-neutrality ofcapital charges.” This suggests that thecapital treatment for holding asecuritisation exposure is unlikely to beidentical to the capital treatment on theunderlying loan, but that it may be quiteclose, and certainly closer than itcurrently is proposed to be under theBasel III Securitisation Framework (as towhich, see the separate article in thiscollection). Given that high capitalcharges compared to other debtproducts are seen as one of the majorimpediments to a recovery of theEuropean securitisation markets, thiswould be a significant help on its own.

There would, of course, be a questionabout how to square any changes incapital charges to Europe’s Baselcommitments, but this is by no meansan unsolvable problem. For one thing,the BCBS has indicated that it plans toassess how the qualifying securitisationframework can be built into the Baselcapital rules, which would mean theremight be no need to deviate from theBasel commitments at all. In any case,both the EBA and the EC havesuggested they may be willing to adopt aEurope-specific approach to bank capitalthat takes into account the improvedunderstanding of risk associated with aninvestment in a qualifying securitisation.

Broader regulatory benefitsImproved capital treatment is probablythe most important prospective regulatorybenefit of being a qualifying securitisation,but it is by no means the only one.




It has been suggested that the rules forqualifying as a Level 2B securitisation forpurposes of the liquidity coveragerequirement (LCR) – which alreadydifferentiate between types ofsecuritisations – should be revisited andharmonised with the qualifyingsecuritisation criteria. Accordingly, being a“qualifying securitisation” should mean asecuritisation also qualifies for inclusionas a Level 2B high quality liquid asset forLCR purposes – possibly with additional“add-on” requirements also being set toreflect liquid assets requirements.

Likewise, certain modifications to the riskretention rules have been suggested thatwould only apply to qualifyingsecuritisations. These would take theregulatory risk of non-compliance off ofinvestors and thereby make it easier toinvest in qualifying securitisationinstruments. There may also be someform of alleviated regulatory due diligencefor alternative investment fund managers,for example, who are subject to riskretention rules but do not have regulatorycapital requirements (and accordinglycannot have capital penalties forbreaches of risk retention requirements inthe way that banks and insurers have).

What does a “qualifyingsecuritisation” look like?As mentioned above, a number ofconsultations have taken place on variousincarnations of “qualifying securitisation”.The BoE and ECB consulted jointly,followed by a consultation by the EBA, ajoint consultation by the BCBS andIOSCO and most recently the ECconfirmed that a framework for “simple,transparent and standardised”securitisation was a key part of itsheadline Capital Market Union project.These consultations have each beendifferent, notably as to the level of detail

in the criteria, but the general themes andcategories of criteria are very similar.

Broadly, the proposals have suggestedthat any criteria eventually adoptedshould be modular in nature. Asdescribed above, regulators andlegislators are intending (with the supportof industry) to use the concept ofqualifying securitisation for multiplepurposes. Accordingly, while criteriashould be harmonised, it isacknowledged that slightly differentcriteria will be appropriate for differentapplications. A securitisation instrumentthat is very high credit quality may beappropriate for a lower capital charge, forexample, but liquidity will be morerelevant for inclusion in the LCR liquiditybuffer. It is therefore broadly intended tocome up with a list of “core” criteria thatall qualifying securitisation instruments willhave to meet, but then acknowledge thatthere may be other “add-on” criteriaimposed for specific purposes. Differentproposals have approached this issue indifferent ways, and there is so far no clearconsensus on which criteria would becore criteria on which would be add-on.

The categories of criteria have thus farbeen separated into simplicity,transparency andstandardisation/comparability.

SimplicityThis category of criteria focuses onensuring that deals are not so highlystructured as to make it unreasonablydifficult to model the risk being taken byan investor in the transaction. Accordingly,it includes the following types of criteria:

n Exclusion of resecuritisations: It isfairly obvious that piling onesecuritisation on top of anothermakes transactions more complexand makes it more difficult toaccurately model the risk being taken

by an investor in the resecuritisation.This criterion has been universal anduncontroversial in the consultationsthus far. It is also reflective of theextremely poor historical performanceof CDOs of ABS.

n True sale: The inclusion of “true sale”as a requirement has been consistent,but perhaps not very well articulated.It largely reflects a concern to ensurethat the originator’s credit is not afactor in assessing the securitisationinstruments, which is universallyaccepted. That, however, could beachieved by an “asset isolation”requirement that might be met, e.g.by a synthetic securitisation withnotes that are fully cash collateralised.The specific choice of “true sale” as arequirement probably reflects asuspicion of synthetic securitisations(discussed further below) and aconcern to ensure that investors can“get their hands on the assets” in theevent of an enforcement.

n Asset homogeneity: The precisecontent of this requirement varies,but the general theme is that onlyone “kind” of asset should beincluded in a transaction. One shouldnot have to be an expert in multiplemarkets and the potential forcorrelation of risks between thosemarkets in order to properly riskmodel a securitisation. To the extentthat this relates to asset class, it isuncontroversial. Nobody issuggesting that residential mortgagesand credit card receivables should besecuritised in the same pool. But tothe extent that homogeneity extendsto currency or jurisdiction, it is lessclear that this is appropriate.Currency risks can be hedged(indeed, another criterion requiresthat they be hedged), and somejurisdictions and asset classes might


not be able to build up large enoughpools to justify a securitisation if theyhad to stay within a singlejurisdiction. In addition, a requirementfor homogeneity of jurisdiction, atleast within the EU, would seem tobe contrary to the broader themes ofthe CMU project. It is also notjustified based on the historicalperformance of, e.g. UK RMBS,(which routinely include both Englishand Scottish loans) or European SMEloan securitisations (which often haveloans in more than one jurisdiction toprovide sufficient scale).

n Exclusion of defaulted assets andcredit-impaired obligors: Theprinciple behind this criterion is a goodone, and the broad idea is widelyaccepted. It is much more complicatedto assess the likely cash flows wherethe asset is already defaulted or wherethe obligor has a bad credit historythan where the assets and obligors arein good standing. However, differentindustries and different jurisdictionshave different ways of assessing theconcept of “credit-impaired” anddeciding when assets are “defaulted”.Securitised credit card portfoliosroutinely include loans that are 90 daysor more overdue as they are part of theover all bank (card issuer) portfolio andonly exclude them from the portfoliowhen they are “charged off”. Not so forresidential mortgages or auto loans,where such loans are excluded fromthe portfolio being securitised.Likewise, it is easy to imagine anobligor being “credit-impaired” when itcomes to a large residential mortgageloan, but being perfectly good credit fora comparatively small auto loan or alow-limit credit card. The devil, then, willbe in the detail, and it will be importantfor the authorities to recognise thesedifferences and allow sufficient flexibilitywhen formulating the criteria.

n Exclusion of refinancing risk: Mostproposed sets of criteria also containan exclusion of securitisations thatcontain a significant element ofmaturity transformation and/orrefinancing risk. This, of course,would exclude the structuredinvestment vehicles popular inpre-crisis days, but also excludesmany European CMBS transactions,which are typically backed by loansthat have large balloon payments thatwill need to be refinanced at maturity.

TransparencyThis category of criteria focuses onensuring that enough information isprovided to investors to ensure that theywill be able to make an informedassessment of their (prospective)investments. The requirementsbroadly include:

n Compliance with disclosurerequirements: Given the category,this is the most fundamental of therequirements. It is nonethelesssomewhat controversial, largelybecause of questions aroundsubstituted compliance (whichdisclosure requirements needcomplying with) and because of thebroad and intrusive nature of somedisclosure requirements, includingArticle 8b of the EU’s Credit RatingAgencies Regulation (as to which seethe separate article on CRA3disclosure requirements in thiscollection). This particularly affectsprivate securitisation arrangements andthose at the fringes of what one wouldnormally think of as securitisation, butnonetheless falls within the regulatorydefinition of that term.

n Investor access to transactiondocuments: This is broadlyuncontroversial and comes partly as areaction to the difficulty some investors

had when seeking to enforce theirrights during the financial crisisbecause they could not lay hands onthe documents under which their rightsarose. The only real area ofcontroversy in this respect is thespecific stage at which documents aremade available. In a European context,it will be quite difficult for transactionparties to make documents availableprior to the date of issuance, as theseare often being negotiated right up tothat point. Conversely, some proposalssuggest documents should beavailable during marketing of thetransaction, which is closer to thecurrent US market practice.

n Listing: Some proposals include arequirement that the transactioncomply with the Prospectus Directiveand/or have a public listing. This iscontroversial because it wouldeffectively exclude all privatearrangements, including asset-backed commercial paper. It alsoseems unnecessary as a “core”criterion in the light of othertransparency-related criteria.

n External verification of underlyingassets: This requirement wouldeffectively formalise the existing marketpractice of having auditors or anotherindependent party verify the pool tapeagainst a sample of underlying loans toprovide comfort as to the disclosuremade to investors in any formal offeringdocument. Market participants arebroadly happy with this, though itwould be awkward to apply in privatescenarios where there would notnecessarily be a formal offeringdocument and, even if there was, itmight not include asset-level disclosure.

n Availability of loan-by-loan data:This has been articulated in a numberof ways and the underlying substanceis broadly uncontroversial.




Loan-by-loan data requirements havebeen imposed a number of ways overthe last several years, and originatorsare used to complying with them.There is, however, an objection toimposing the same requirementseparately in addition to a generalrequirement to comply with allapplicable disclosure requirements.At least one of those disclosurerequirements will normally be arequirement to provide loan-by-loandata. Where there is no suchrequirement this will normallyrepresent a deliberate policy choice(e.g. because investors have directaccess to the data or are not relyingprimarily on the underlying assets forrepayment) and that policy choiceshould not be effectively displaced bya qualifying securitisation regime.

Standardisation/ComparabilityThe third and final category is in someways a bit of a catch-all for other criteria,but is notionally supposed to make iteasier to compare between securitisationtransactions. These include:

n Compliance with risk retentionrules: This is designed to help ensure alevel playing field betweensecuritisations and is broadlyuncontroversial. Some issues arise,however, in respect of mutualrecognition and substitutedcompliance. Despite the fact that theyare designed to achieve broadly thesame policy objectives, the US riskretention rules that will shortly becomeeffective (as to which, see the separatearticle in this collection) are significantlydifferent from the EU risk retention rulesthat have been in place for a number ofyears. The result of this is that it will notbe straightforward for transactions tocomply with both. Industry hassuggested that compliance with any

applicable set of risk retention rulesought to be sufficient for the purposesof being a qualifying securitisation, butit is not clear that recognition of third-country regimes will be adopted.

n Restriction to standard/commonlyencountered rates: This is arequirement that interest rates used todetermine payments in thesecuritisation should be based oncommonly encountered marketinterest rates. This presumablyfacilitates comparison of ratesbecause experienced investors will beused to modelling differentcommonly-encountered interest rates,and often the same underlying indexwill be used. This is broadlyuncontentious, though it does raisethe issue, especially for RMBS, ofwhether the originator’s own standardvariable rate (which underlies manymortgage loan interest rates) will beacceptable for these purposes. If not,then a large number of RMBStransactions would not be able toqualify – an outcome we understandthe relevant regulators do not intend.

n Hedging requirement: Mostproposals have a requirement thatany interest rate and currency risksshould be hedged or otherwiseappropriately mitigated. This is pairedwith a requirement that derivativesshould be used only for “genuinehedging” purposes. There arediverging views on whether thelimitation of derivatives to “genuinehedging” would exclude syntheticsecuritisations, but the true salerequirement is obviously the biggerobstacle to synthetics qualifying.

n Clear articulation of serviceproviders’ roles: This is a somewhatvague requirement but it largelyrelates to ensuring investors will knowwhat the various service providers

(e.g. swap counterparty, servicer,trustee) are responsible for doing andproviding, so far as possible, thatthose roles will always be filledappropriately. This means investorswill be aware of any differences inroles and can largely ignore the risksassociated with one or more serviceproviders failing to carry out their role.

Who’s in and who’s out?The criteria for qualifying securitisationsare, of course, not asset class based. It isnonetheless possible to compare thecriteria proposed with the asset class inthe market and the transaction structuresgenerally adopted in respect of them.Doing that exercise yields the result thatresidential mortgages, auto loans, creditcard receivables and other forms ofconsumer lending should broadly be ableto qualify (excluding sub-prime portfoliosor portfolios including non-performingloans in all cases). In each case there arehurdles to qualification, but these varydepending on the asset class and thespecific formulation of the proposals.Cash securitisations of SME loans aretheoretically in the same category, butsynthetic securitisations of SME loans aremore common than cash securitisationsat present so it remains to be seen howpractically useful that will be.

It is equally clear that CDOs, re-securitisations, managed CLOs,and some others will be excluded.

It is therefore more interesting to focuson ABCP and conduits, CMBS andsynthetic securitisations, which have allbeen excluded, but may in future be in aposition to be included.

ABCP and conduitsABCP and conduit transactions areunfortunately excluded from the proposed


criteria. It is simply not possible for thesearrangements to meet the kinds of criteriathat are appropriate for termsecuritisations. What’s more, anAssociation for Financial Markets inEurope survey suggests that applying thekind of transparency requirementsimposed by the criteria would lead to adramatic reduction in the use of thesemarkets – the opposite of the outcomethe authorities are hoping for. Theproblem is particularly acute from theauthorities’ perspective because thesekinds of arrangements are a crucial toolfor financing exactly the kind of creditthey are hoping to encourage –tradereceivables in particular.

Since the early proposals, authorities havestarted to acknowledge both theimportance of ABCP conduits and thetrade-related transactions they undertake,and that the criteria as proposed areinappropriate for them. There are earlyindications that the authorities intend topropose a solution (presumably in the formof separate, appropriate criteria), but notimeline has yet been proposed for that.

CMBSCMBS is an interesting asset class fromthe perspective of qualifying securitisationbecause it is broadly capable of meetingthe criteria set out in most of theproposals. It is also very much a “realeconomy” asset class that seems on itsface to be consistent with the kind offinance that European authorities wish toencourage in that CMBS transactionsfinance real estate for use by businesses.Offices, hotels and shopping centres arecommon assets to be financed via CMBS.

That said, it has been excluded from the“good” side of the differentiation of themarket right from the beginning. In theoriginal PCS criteria, CMBS was

excluded as an asset class and it still istoday. The criterion that appears mostfrequently in proposals that wouldexclude CMBS is the prohibition onrefinancing risk. Some US CMBS (thatinclude more loans and that stagger theirrepayment profiles to a greater extent)might qualify based on the criteria asproposed by the BCBS-IOSCOconsultation, but European CMBS (thathave fewer loans and contain closelyaligned repayment dates) would not.

At this stage, it’s looking unlikely that mostCMBS will be in a position to qualify in theshort term. Certainly this asset class facesa difficult uphill battle with regulators. This ispartly true because CMBS had a muchhigher default rate than most asset classesthat look likely to qualify (10.66% from mid2007 to the end of Q2 2014, where allothers were 0.55% or below), and this isbroadly understood to be due in part to therefinancing risk inherent in these structures.

Synthetic securitisationsWhile this is a securitisation technique,rather than an asset class, it is veryclearly excluded by the criterion requiringtrue sale, which is universally included inthe proposals. It is not, however, clearwhy all synthetic securitisations should beexcluded. They are capable of meetingthe vast majority of the proposed criteriain all of the proposals thus far. Theregulators’ justifiable reluctance to beseen to endorse a return of syntheticarbitrage CLOs could easily be addressedby a criterion requiring that syntheticCLOs be designed to assist with theoriginator’s capital management.Concerns regarding isolation of theassets from the credit of the originatorcan be (and routinely are) addressed bycollateralising the notes. Concernsrelating to the investors being able to “gettheir hands on” the assets in an

enforcement situation are equallyobviated by collateralising the notes.

What is perhaps more important is thatsynthetic securitisation is a usefultechnique for securitising assets that aresometimes difficult to securitise viatraditional techniques. Whether this isbecause of transfer restrictions on theunderlying loans, costs or other reasons,many securitisations (of SME loans, forexample) would be much more difficult(and perhaps even impossible in somecases) without the use of syntheticsecuritisation techniques. If theauthorities’ goal in establishing thequalifying securitisation framework is torevive the market in SME loansecuritisations (among others), they mayfind they have come in wide of the markuntil synthetic securitisations are allowedto qualify as well.




ConclusionThe move towards differentiating the market in a manner that provides certainregulatory advantages to qualifying securitisations is a major and excitingdevelopment for the securitisation markets. It represents a sea change in officialattitudes to securitisation. It may well help remove the “toxic brand” stigmaassociated with securitisation and spur the revival of markets that have been in thedoldrums for the best part of a decade. Inevitably, some product areas will notqualify, and the impact of failing to qualify will likely vary depending on the specificcircumstances. Synthetic securitisations, for example, may carry on (albeit at alower level) because investors in synthetic securitisations largely do not haveregulatory capital concerns. In other areas, investor bases may change, oralternative techniques for funding the same assets will be found.

Whatever the case, if the large amount of work that has already been done is tobear fruit, it must be implemented swiftly. In particular policymakers and regulatorsneed to clarify in the very short term what caplital consequences will be associatedwith being “in” or being “out”. Already the general level of securitisation expertise inthe industry has begun to diminish as both investors and originators reduce theresources allocated to the product area in favour of other options that are lowercost, less stigmatised and subject to fewer regulatory burdens.

3. Basel Securitisation Framework –reloaded



Background and purposeOn 11 December 2014, the BaselCommittee published the final Basel IIIDocument on the revisions to thesecuritisation framework, which governsbanks’ calculations of credit risk capitalrequirements for exposures insecuritisation transactions. The finalframework follows the two consultativedocuments from December 2012 and2013, and contains the text of the revisedframework that will replace the frameworkin Basel II (as amended) fromJanuary 2018.

The revised framework forms part of theCommittee’s broader Basel III agenda toreform regulatory standards for banks inresponse to the global financial crisis. Inparticular, the revised framework aims toreduce mechanistic reliance on externalratings, increase risk weights forhighly-rated securitisation exposures andreduce risk weights for lower-rated seniorsecuritisation exposures, thereby reducingthe cliff effects inherent in the currentsecuritisation framework. It also aims toenhance the risk sensitivity of the capitalcharges imposed by the framework.

The final framework largely follows thesecond consultative document fromDecember 2013 in overall approach.However, in response to concerns raisedby a number of market participants, theCommittee has made a number ofrevisions and amendments in the finalframework. These changes are discussedbelow along with the main elements ofthe revised framework.

Hierarchy of approachesOne of the most notable proposals of theCommittee is to introduce a hierarchy ofapproaches for assigning capitalrequirements to securitisation exposures.This has been introduced to reduce the

reliance on external ratings as well as tosimplify and limit the number ofapproaches. No significant changes weremade to the hierarchy of approaches ascompared with the proposals containedin the second consultative document.

Approaches are organised in order ofdescending risk sensitivity (and thereforeincreasingly punitive nature). The idea isthat the approach at the top of thehierarchy requires a large amount ofinformation and gives credit to the bank(in the form of a lower capital charge) tothe extent possible based on its detailedknowledge of the assets. Conversely, theapproach at the bottom of the hierarchyrequires very little information in order toassign a risk weight, but penalises thebank (in the form of a higher capitalcharge) for assuming risks it doesn’tunderstand as well.

Wherever possible, therefore, bankswould apply the Internal Ratings-BasedApproach. Where that is not possible,they would apply the ExternalRatings-Based Approach. Where bankshave insufficient information to applyeither of those approaches, they wouldapply the Standardised Approach.

Use of the Internal Ratings-BasedApproach would be required wherebanks have a suitable IRB model andsufficient information to estimate the IRBcapital charge for the underlying pool if ithad not been securitised. The use of theIRBA may, however be denied by thenational supervisor where they lackconfidence that this approach reflects therisk of the transactions. For example, thismay be the case due to the structuralfeatures of the securitisation. The IRBAwould reduce mechanistic reliance onexternal credit ratings and insteaddepend upon the transaction’s creditenhancement level, tranche thickness,

maturity and the calculation of expectedlosses. The explicit intention is for thisapproach to result in a lower capitalrequirement than the other approachesfurther down the hierarchy.

The External Ratings-Based Approachwould be applied where the bank couldnot, for whatever reason, use the IRBA,and it is accordingly designed to produceslightly higher capital charges. The ERBAwould require the bank to know theexternal or inferred credit rating of thetranche, its seniority in the capitalstructure, the thickness of non-seniortranches and the maturity of the tranche.Only one rating would be required inorder to use this approach as opposed tothe two required by the currentframework. Finally, the Committee hasreduced the risk weights forlonger-maturity tranches assigned underthe ERBA relative to those proposed inthe second consultative document, amodification introduced to addressconcerns of potentially overstatingmaturity effects.

The Standardised Approach is intendedto produce capital requirements that areslightly higher than under the IRBA butcomparable to the ERBA, and iscalculated on the basis of the weightedaverage capital charge for the underlyingexposures in the pool with an uplift toreflect any deterioration in theunderlying pool.

Where none of the above approachescan be used, a punitive risk weight of1,250% is required to be assigned tothe exposure.

Unfortunately, despite the BaselCommittee’s efforts, the capital changesfor a given exposure do not alwaysincrease as you go down the hierarchy ofapproaches. This means that in some



cases, it will actually be advantageousfrom a capital point of view for a bank tohave less information and to avoidseeking permission to use the IRBA. Thisconcern was identified by industry duringthe 2-year consultation process but neverfully addressed.

Separately, an Internal AssessmentApproach may also be used in the caseof unrated exposures to ABCPprogrammes only. The Basel Committeeon Banking Supervision may wish toconsider allowing this approach to beapplied to unrated securitisationexposures which are not funded throughan ABCP conduit.

Mixed poolsAs compared to the second consultativedocument, the final framework has beenfurther developed in the context of mixedpools (where a bank is able to calculateIRB parameters for some but not allunderlying exposures in a securitisation).A bank will only be able to use the IRBAwhere it is able to calculate the IRBinputs for at least 95% of the underlyingexposures. Where a bank is unable to doso, it must use the other approacheslower in the hierarchy.

MaturityWith regard to exposures with longermaturities, the Committee continues toapply increased risk weights. TheCommittee intends that the tranchematurity input for the IRBA and ERBAapproaches should have a five-year capand a one year floor, and for this purposehas regard to the contractual or legalmaturity.

In response to the second consultativedocument, a number of marketparticipants commented that they viewthe use of legal maturity as too

conservative an approach (as opposedto, for example the weighted average lifeof the assets). As a result, the Committeehas agreed to apply a haircut in order tosmooth the impact of maturity on capitalcharges where legal maturity is used. Asopposed to being equal to legal finalmaturity, tranche maturity will equal oneyear plus 80% of the excess of legal finalmaturity over one year.

Maximum capitalrequirementThe Committee acknowledged in thesecond consultative document that thecapital charges for a securitisation shouldbe broadly consistent with the capitalcharges for the underlying pool, inparticular senior tranches.

As such, the replacement text of therevised framework states that a bankusing the IRBA for a senior securitisationexposure may apply a maximum capitalrequirement for the senior securitisationexposures it holds equal to the IRBcapital requirement that would have beenassessed against the underlyingexposures had they not been securitisedand assessed under the IRB framework.Similarly, in the context of the ERBA andStandardised Approach, the bank mayapply a maximum capital requirement forthe senior securitisation exposures itholds equal to the capital requirementthat would have been assessed againstthe underlying exposures had they notbeen securitised.

In line with the above, the Committee hasalso confirmed that a bank should not becompelled to hold more capital after asecuritisation than before.

Risk weight floorConsistent with the second consultativedocument, no matter which approach is

used, any securitisation exposure will havea risk weight floor of 15%. The originalproposed floor was 20% before theCommittee revised this downwards.A number of market participants hadsuggested a 10% floor, commenting thatthe 15% floor may still be too high as it stillrepresents a substantial increase on the7% floor under the current framework.Despite this, the floor remains at 15% inthe final framework. Although where anymaximum capital requirement in thecontext of senior tranches (as discussedabove) is lower than the 15% floor rate dueto applying a look through approach to theunderlying exposures, the lower maximumcapital requirement rate will apply.

Early amortisationprovisionsAs with the second consultativedocument, an originator or seller ofassets into a securitisation which hasearly amortisation provisions will beunable to apply the securitisationframework to the sold assets wherespecific operational requirements are notmet. This would mean that such assetswould be assessed as if they were“on-balance sheet” for regulatory capitalpurposes. Where the operationalrequirements are met, the bank mayexclude the exposures associated fromthe calculation of risk-weighted assets,but must still hold regulatory capitalagainst securitisation exposures retainedin connection with this transaction.

ResecuritisationsA resecuritisation exposure is asecuritisation exposure in which the riskassociated with the underlying pool ofexposures is tranched and at least one ofthe underlying exposures is asecuritisation exposure. As a result of theCommittee’s view that resecuritisations



are inherently difficult to model, only anadjusted version of the StandardisedApproach can be used forresecuritisations. The adjusted versionprovides that resecuritisation exposureswill be subject to a risk weight floor of100% and risk weight and capitalrequirements caps will not apply.

Further, in response to previous commentsfrom market participants, the revisedwording provides that an exposureresulting from retranching of a securitisationexposure is not a resecuritisation if thebank is able to demonstrate that the cashflows to and from the bank could bereplicated in all circumstances andconditions by an exposure to the

securitisation of a pool of assets thatcontains no securitisation exposures.

Next stepsThe revised framework will come intoeffect in January 2018. Concurrent withthe revised framework, a number ofconsultations have been undertaken byvarious regulatory bodies, including theInternational Organization ofSecurities Commissions (IOSCO), theEuropean Banking Authority and theBank of England.

In particular, further work is beingconducted jointly between the BaselCommittee and IOSCO on establishing

“Criteria for identifying simple, transparentand comparable securitisations” with aview to promoting the development ofsustainable securitisation markets (as towhich, see the separate article onqualifying securitisation in this collection).A consultative document with theproposed criteria has been issued, andthe Basel Committee will consider how toincorporate such criteria into the revisedframework over the course of 2015.These consultations will provide marketparticipants with opportunities fordialogue with regulatory bodies on theinterpretation and implementation of therevised framework.

4. Risk retention – spot the difference



AIFMR and Solvency II –divergence from CRR andundertakingsA key area of divergence between thetext of the CRR, AIFMR and Solvency IIis the ability to consolidate risk retentionwithin a supervisory group. Article405(2) of the CRR allows the riskretention requirement to be satisfied onthe basis of the consolidated situationof a parent credit institution, EU financialholding company or EU mixed financialholding company where it or one of itssubsidiaries, as sponsor or originator(the definition of which includes anentity which is indirectly involved in theoriginal agreement which created theexposure being securitised) securitisesexposures from several creditinstitutions, investment firms or otherfinancial institutions included in thescope of regulatory supervision of theparent or holding company. However,

no equivalent consolidation provision iscontained in either AIFMR or SolvencyII. Although Article 56 of AIFMRprovides that the provisions of Articles50 to 55 shall be interpreted in amanner consistent with the“corresponding provisions” of the CRR,this is unlikely to provide sufficientscope to incorporate a new operatingprovision into AIFMR where there is no“corresponding provision”. In our view,Article 56 is limited to aiding theinterpretation of existing operatingprovisions only. The position underSolvency II is clear and generally evenmore inflexible as there is no provisionauthorising retention on a consolidatedbasis and no clause requiringinterpretation consistent with either CRRor AIFMR.

This issue and other minor textualdifferences between the three regimesbring into focus the more general

question as to the extent to which it isappropriate for the retaining entity onsecuritisation transactions to makecovenants and representations as tocompliance with AIFMR and Solvency IIin addition to the CRR, particularly giventhe distinct possibility of furtherdivergence between the three regimesin future, especially Solvency II. Thearguments in favour of retaining entitiesagreeing to covenants to comply withthe CRR are much stronger than forAIFMR and Solvency II. The CRRapplies to EU regulated creditinstitutions and investment firms and ingeneral will apply directly (not only inrelation to risk retention) to the majorityof originators on securitisationtransactions in Europe. The retainingentity should therefore be familiar withthe application of the detailedrequirements of the CRR and havedirect knowledge of the EBA as theEuropean bank regulator. The retaining

Articles 404-410 of the Capital Requirements Regulation (EU) No 575/2013 and therelated regulatory technical standards (the “CRR”) prohibit EU regulated creditinstitutions and investment firms from being exposed to the credit risk of asecuritisation position unless certain risk retention and disclosure requirements aresatisfied. Similar provisions now also apply to EU regulated alternative investment fundmanagers under Articles 50-56 of EU Regulation 231/2013 (“AIFMR”) and in respectof EU regulated insurers and reinsurers under Articles 254-257 of Regulation (EU)2015/35 (“Solvency II”).

Despite some indication from regulators that the intention is for the three regulatoryregimes to be interpreted consistently, certain differences have become apparent,particularly when contrasting Solvency II, which is administered by EIOPA, with theCRR and AIFMR, which are administered by the EBA and ESMA respectively and aremore textually closely aligned. In this article we explore some of these differences andthe approaches taken by originators in practice. We also consider other recent trendsaround risk retention that may be of interest to the market.



entity therefore has detailed knowledgeand expertise as to the application ofthe CRR. It is well placed to determinewhat it needs to do to comply with theCRR and should be comfortable givingcovenants as to compliance in thetransaction documents.

Although the argument can be madethat investors that are alternativeinvestment funds “AIFs” or insurance orreinsurance undertakings (collectively,“insurers”) should benefit from anequivalent level of comfort in respect oftheir own regulatory regimes, this has tobe considered in the wider context. Inthese situations, it is the investor, notthe retaining entity, that has the greatestinsight into the workings of theregulatory regime (whether AIFMR orSolvency II) and the relationship with therelevant regulatory authority.Accordingly, although the retaining entitymust be clear as to the retention anddisclosure obligations it is prepared toundertake, in many cases, it can beargued that it should be for the investor,not the retaining entity, to determinewhether the retention and disclosureundertakings in the documentation,provided in the context of the CRR oron a generic basis, are sufficient for thepurposes of AIFMR and Solvency II. Italso seems reasonable for the relevantinvestor to take the risk of any changein approach between the CRR and itsown regulatory regime, rather thanplacing this risk on the retaining entity,who is not regulated by that regulatoryregime and has no control or bargainingpower when it comes to consultationsfor future amendments or guidance.

Under current law, for the large majorityof transactions, retention and disclosureobligations which comply with the CRRwill be sufficient to comply with theretention requirements under AIFMR

and Solvency II as well. Retainingentities will argue that the covenant tocomply with the terms of the CRRshould provide sufficient comfort toinvestors that are AIFs and insurers aswell. We have, however, seen examplesof retaining entities that are prepared togive covenants on compliance withAIFMR and Solvency II as well, inparticular where the covenants arelimited to the position under current law.In some instances, originators haveundertaken to retain in accordance withthe requirements of Solvency II (giventhe methods of retention aresubstantially similar to those in CRR andAIFMR) but that undertaking has notextended to other requirements, suchas ongoing disclosure.

Parent company asoriginator – when can aparent be acquiring assets‘for its own account’?A parent company may be the retainingentity by virtue of being an ‘originator’ inits own right rather than by takingadvantage of the consolidation provisionsin the CRR. The definition of originator inthe CRR (which also applies to AIFMRunder Article 56 and Solvency II under itsdefinitions provision) includes both: (i) anentity that is involved, directly or indirectly,in the original agreement which createdthe exposure; and (ii) an entity thatpurchases a third party’s exposures for itsown account and then securitises them.The first limb provides a significantdegree of flexibility for a parent or holdingcompany to be designated as theretaining entity provided that entity issufficiently involved in the originationprocess. The second limb of thisdefinition requires further considerationparticularly as to the meaning of thephrase ‘for its own account’. Thought hasto be given as to whether the words ‘for

its own account’ should be interpretednarrowly such as to preclude anythingother than legal or beneficial title to theassets, or if a wider interpretation whichcould include a parent entity sometimesmay be appropriate.

A key consideration on any portfolioacquisition will be the entity throughwhich the portfolio will be acquired. Onmany transactions a special purposevehicle will be established for thespecific purpose of holding legal title tothe assets. This may be preferable for avariety of legal, regulatory oradministrative reasons at the time of thesale, these might include, for example,the requirements of local law pertainingto the assets and whether the portfoliois being acquired by a fund or via aREIT. Although it may be necessary ordesirable for legal title to be held by aspecific entity established for thatpurpose, different considerations mayapply to risk retention, particularly if, forexample, there may be a desire in futureto reorganise the corporate group of thepurchaser. Whether or not it can beargued that the parent company ispurchasing the exposures ‘for its ownaccount’ in such situations thenbecomes of relevance.

There is very little guidance on themeaning of the phrase ‘for its ownaccount’. In our view, it is capable ofextending beyond the holding of legal orbeneficial title provided it can be shownthat the true purchaser of the assets isthe parent company. Whether or not theparent can be considered to be thepurchaser of the assets would need tobe determined on a case by case basis,however, we can identify certain keyfactors that are likely to be influential:(i) the degree of involvement of theparent entity in negotiating andexecuting the acquisition; (ii) whether it is



strongly desirable or even necessary thattitle be held by a subsidiary for legal,regulatory or administrative purposes,for example, pursuant to the local lawapplicable to the underlying exposuresor rules relating to the management andoperation of the purchaser; (iii) whetherthe parent can be said to be merely‘booking’ the trade through a subsidiary.

Establishing a strong nexus betweendefaults on the underlying portfolio andthe economic impact on the parent willalso be important. If the subsidiary thatholds title to the assets beingsecuritised is directly and wholly ownedby the parent and does not carry on anybusiness other than holding the assetsthere will be a clear, direct link betweenthe performance of the assets and thevalue of the shares held by the parent inthe subsidiary, such that any default onthe assets will economically be‘passed-through’ to the parent. Thisarrangement would need to besupported by covenants in thedocumentation as to ongoing ownershiparrangements and business activities ifit was to be relied on to support theparent company as retaining entity. Thenexus between the holder of the assetsand the parent would be much moredifficult to establish if ownership wasindirect (unless the intermediarycompanies were themselves shellentities) or if the subsidiary conductedother business which would dilute theotherwise pass-through nature of anydefaults. To the extent there are anyother arrangements in place betweenthe parent and subsidiary that have theeffect of placing the risk of default ontothe parent these will also be relevant,for example, a limited recourse loanbetween parent and subsidiarydependent on the cashflows receivedby the subsidiary under the assets or

some form of credit default swaparrangement. These arrangements areonly likely to be helpful in support of theargument that the parent is the truepurchaser of the assets if they are inplace at the time of acquisition.

Where the parent is the retaining entityfor the purposes of the regulation itmay, in some situations, be possible forthe parent to be the ‘retaining entity’ butfor the retained assets to be held byits subsidiary as part of thepurchase arrangements.

Method C: retention ofrandomly selectedexposuresThe CRR, AIFMR and Solvency II allprovide for retention in the form ofrandomly selected exposures equivalentto no less than 5% of the nominal valueof the securitised exposures, where suchexposures would otherwise have beensecuritised in the securitisation, providedthat the number of potentially securitisedexposures is no less than 100 atorigination. This method of retention isused relatively rarely on securitisationtransactions compared to the retention ofthe first loss tranche or a vertical slice ofthe exposures, which are much morecommon. It is therefore worth spendingsome time considering how the retentionof randomly selected exposures wouldwork in practice.

In our experience, where the portfolio ofsecuritised exposures is being selectedfrom a larger portfolio of eligible assets,originators have tended to randomlyselect the receivables to be securitisedfrom the larger pool in an aggregateamount equal to 100 per cent. of theexpected funding, as opposed torandomly selecting exposures equal to

approximately 105.263 per cent. (beingthe number required to produce 100 percent. of the expected funding afterremoving 5 per cent.) of the expectedfunding and then randomly de-selecting5 per cent. of those to then provide100 per cent. of the expected funding.From a risk and economic perspectivethe approaches deliver the same resultand the former approach is simpler toexplain from a disclosure perspective inthe prospectus. A more significant issuethat has arisen, however, is at what pointin time the 5 per cent. retention will besized, bearing in mind that this particularmethod of retention is only tested at theoutset of the transaction.

It is common practice on securitisationtransactions for a cut-off date to beestablished in respect of the portfolio asat which point the final pool is selectedand the purchase price for the portfoliocalculated based on the principal amountoutstanding at that time. We shall call thisdate the ‘final selection date’. The finalselection date can range from being acouple of weeks to a few days prior tothe closing date and either this date or anearlier (provisional) date will form thebasis of the portfolio information in theprospectus. This approach is a sensibleone in practice for a number of reasons:(i) it reflects the fact that there will alwaysbe a slight time lag in the systems of theservicer to process recent paymentsunder the exposures or other actionstaken in relation to the portfolio;(ii) to ensure certainty of execution - theselection of the pool needs to beestablished in advance to form the basisof the sizing and pricing of thesubscription by investors and anyretained piece; and (iii) the requirementthat the retained exposures should notamortise any more quickly than thesecuritised loans means that after the



final selection date the naturalamortisation profile will be applicableto the retained as well as thesecuritised loans.

The practice of pricing and sizing the dealbased on the size of the pool on the finalselection date raises timing issues if themethod of retention being used is the‘randomly selected exposures’ method.One line of argument is that the 5%retention should be estimated in advancewith the final calculation being determinedon the closing date, taking into accountthe payment rate on both the securitisedand retained exposures between the finalselection date and the closing date of thetransaction. This interpretation would,however, lead to uncertainty with regardsto the assets being sold to the issuer andfunded by investors. To cater for thepossibility that the payment rate on theretained exposures may be slightly higherthan on the securitised exposures, theretaining entity would either need to beprepared to incorporate a degree ofheadroom when calculating the size ofthe retention or some form of adjustmentin the documentation to take place on, orshortly after, the closing date to removeor reassign back to the originator certainof the securitised exposures. This wouldappear to be unduly onerous and causea significant degree of uncertainty giventhe unlikelihood of there being anymaterial divergence in the performance ofsecuritised and retained exposures duringthe relevant period.

In our view, it can be argued thatcalculating the size of the retention as atthe final selection date would not only bemore workable in practice but in mostcases would also sit more comfortablywithin the spirit of the CRR. In making thisassertion, we note that on the majority ofsecuritisation transactions the issuer willtake the risk of defaults on the securitisedexposures and the benefit of anycollections from the final selection date,not the closing date. Accordingly, from aneconomic and risk perspective, assumingthe transaction closes, it is as if the assetswere transferred on the final selection dateand therefore appropriate that the size ofthe retention is also calculated on thisdate. To the extent there is any variation inthe payment rate under the securitisedexposures and retained exposures theissuer will take the benefit or risk of suchvariations accordingly.

This is an example of how the method ofretention that is selected can impact onthe size of the retention. We havehighlighted this in other contexts in thepast, particularly where the assets arebeing transferred at a discount, whereretention of the nominal value of thesecuritised exposures under method (a)or (d) will require an increased amount ofretention than retention by way of avertical slice of each tranche of notessold to investors. It is important to bearthese differences in mind whenconsidering the method of retention thatwill be used on the transaction.

ConclusionWe demonstrate above thatalthough risk retention requirementshave applied to securitisations for anumber of years, new issuescontinue to arise and need to beexplored. There is still a degree ofuncertainty as to the application ofthese rules, particularly in thecontext of AIFMR and Solvency IIand the risk that there will be furtherdivergence between the threeregimes is of general concern to themarket. We would hope, however,that relevant authorities andinvestors will continue to worktogether to promote consistencyand clear guidance on theapplication of each of the regimesin future.

5. US risk retention – go yourown way



Compliance obligationsCompliance with US risk retentionrequirements will be required as of 24December 2015 for residential mortgagebacked securities (RMBS) and one yearlater (24 December 2016) for all othertypes of ABS, unless an exemption isavailable. Any ABS issued before theapplicable compliance date are notsubject to these risk retentionrequirements. In contrast to the EU riskretention regulations, the US rules will notrequire a second layer of credit riskretention for pass-throughre-securitisation transactions involvingABS for which credit risk has beenretained in compliance with applicable UScredit risk retention requirements.

While European risk retentionrequirements generally place thecompliance burden on regulated ABS

investors, US credit risk retentionrequirements are mandatory requirementsof the securities laws which will applydirectly to the sponsor of a securitisationand will need to be covered by standardno-contravention of law opinions. Theserequirements will apply to privateplacements in the United States as wellas public offerings.

Retention by affiliates andthird partiesA sponsor may elect to retain therequired amount of credit risk indirectlythrough a consolidated, wholly-ownedaffiliate. In limited cases, a sponsor mayalso be able to meet its risk retentionobligation by arranging for a third-partypurchaser to retain the required amountof credit risk. Even when such risk isretained by a third party, however, thesponsor will remain responsible for

ongoing compliance with the riskretention requirements.

Restrictions on hedging andrisk transfersRetained credit risk may not be hedgedor otherwise transferred until theexpiration of the relevant transfer andhedging restrictions. For all types of ABSother than RMBS, transfer and hedgingrestrictions will expire on the latest of:

n two years after the closing date ofthe securitisation;

n the date on which the total unpaidprincipal balance of the securitisedassets that collateralise thesecuritisation is reduced to 33% ofthe original unpaid principal balance;

n the date on which the total unpaidprincipal obligations under the ABSinterests issued in the securitisation is

Enacted in 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act(the “Dodd-Frank Act”) generally requires securitisers to retain at least five percent ofthe credit risk of any asset pool that is securitised and prohibits hedging or otherwisetransferring such retained risk. The policy purpose of risk retention is to align theinterests of those who originate assets that will be securitised and those whosecuritise those assets with the interests of investors in the resulting asset-backedsecurities (ABS). This risk retention requirement was not immediately effective whenenacted in 2010, however, because Section 941 of the Dodd-Frank Act delegates theresponsibility for implementing these risk retention requirements to a group of USfederal regulators. This section also grants federal regulators discretion to craftexemptions for securitisations involving high-quality assets and specify permittedforms of risk retention.

US federal regulators released an initial proposal to implement credit risk retention inearly 2011. During the public comment process, significant concerns were raisedregarding the proposal’s potential impact on lending activity. Revised implementingrules were proposed in August 2013 and final rules were adopted in October 2014.



reduced to 33% of the original unpaidprincipal obligations.

For RMBS, the transfer and hedgingrestrictions will expire on the later of: (1)five years after the closing date for thesecuritisation; and (2) the date on whichthe total unpaid principal balance of thesecuritised assets is reduced to 25% ofthe original unpaid principal balance, butnot later than seven years after theclosing date. A limited exception tothese transfer restrictions is available forCMBS risk retention involving eligiblethird-party purchasers.

Permitted forms ofrisk retentionStandard risk retention optionsUS risk retention requirements allow asponsor to satisfy its risk retentionobligation by retaining an eligible verticalinterest, an eligible horizontal residualinterest, or any combination thereof aslong as the amount of the eligible verticalinterest and the amount of the eligiblehorizontal residual interest combined isno less than five percent. The amount ofthe eligible vertical interest is equal to thepercentage of each class of ABS interestsissued in the securitisation transactionheld by the sponsor as eligible verticalrisk retention. The amount of eligiblehorizontal residual interest is equal to thefair value of the eligible horizontal residualinterest divided by the fair value of allABS interests issued in thesecuritisation transaction.

Any fair value determinations made inconnection with the horizontal riskretention option would need to be madein accordance with US GAAP. Sponsorswould be required to disclose keyinformation about the methodologies andassumptions that they use to calculatethe amount of their eligible horizontal

residual interests in accordance with fairvalue standards. After consideringcomments, the federal regulatorsdeclined to modify the final rule to allowfor calculation of fair value using the fairvalue measurement framework underlocal GAAP or IFRS for securitisationtransactions where the sponsor isestablished outside the United States.The federal regulators believe the benefitsto investors of being able to easilycompare the fair value of risk retention intwo separate issuances of ABS interests(regardless of where the sponsors areestablished) outweigh their estimate ofthe burden imposed on the sponsors bythe requirement to use US GAAPmethodology to determine fair value.

Alternative risk retention options forcertain asset classesThe federal regulators have adoptedtailored alternative risk retention optionsfor specific types of asset classes. Thesealternatives, however, do not include anyrepresentative sample method similar toMethod C of the EU risk retention rules.Commenters voiced concerns that thelack of a representative sample optioncould make it more difficult for globalofferings of asset-backed securitiesoriginated outside the United States to besold to investors in the United States.

It has been common in CMBStransactions for third-party purchasers tospecifically negotiate the purchase of afirst-loss position. In recognition of thismarket practice, the Dodd-Frank Actgave federal regulators authority to createthird-party risk retention for CMBStransactions. As adopted in the finalrules, either one or two (but no more thantwo) third-party purchasers are permittedto satisfy the risk retention requirementthrough the purchase of an eligiblehorizontal residual interest. If there aretwo third-party purchasers, neither third-

party purchaser’s losses may besubordinate to the other’s losses.

In recognition of typical connectionsbetween third-party purchasers andspecial servicing rights in CMBStransactions, the final rules require theappointment of an Operating Advisor(“OA”) for CMBS transactions that rely onthe third-party risk retention option. TheOA requirement provides a check onthird-party purchasers by limiting theirability to manipulate cash flows throughthe exercise of the special servicingrights. The OA is required to beindependent and will have the authority torecommend and call a vote for removal ofthe special servicer under certainconditions. In addition, the OA will berequired to periodically report to investorsand the issuer whether the specialservicer is operating in compliance withany standards specified in the applicabletransaction documents.

Exemptions from US creditrisk retention requirementsSafe harbour for non-US transactions In implementing the risk retentionprovisions of the Dodd-Frank Act, thefederal agencies adopted a “safeharbour” provision for qualifying non-UStransactions. Specifically, this provisionexcludes from US risk retentionrequirements transactions for which:

n neither the sponsor nor the issuingentity is chartered, incorporated orestablished under US law;

n no more than 10% of the value of allclasses of ABS interests in thesecuritisation transaction are sold ortransferred to US persons or for theaccount or benefit of US persons; and

n no more than 25% of the underlyingassets underlying the ABS issue wereacquired from a majority owned



affiliates of the sponsor or issuingentity that is chartered, incorporatedor organised under US law or from anunincorporated branch or office of theissuing entity that is located in theUnited States.

Some uncertainty remains about how thissafe harbour will be applied in practice. Inthe near term, it would be prudent formarket participants to seek adviceregarding the availability of this safeharbour for Regulation S transactions thatcontemplate offshore offers to US persons.

This non-US transaction safe harbour isnarrowly tailored to capture only thosetransactions in which the effects on USinterests are sufficiently remote so as notto significantly impact US underwritingstandards and risk managementpractices or the interests of US investors.The relatively narrow scope of the foreignsafe harbour provision may have negativeeffect on non-US sponsors that seek USinvestors because they may need tosatisfy risk retention requirements of twojurisdictions (their home country and theUnited States).

Qualified commercial loans CLOs are subject to US risk retentionrequirements and CLO managers areconsidered to be the securitisers. Thefinal rules provide an exemption for CLOsbacked by qualifying commercial loan(QCLs). To qualify, the originator mustdetermine that the borrower has satisfiedthe following numerical requirements forits two most recent fiscal years and isexpected satisfy them in the next twofiscal years as well, based onreasonable projections:

n total liabilities ratio of 50% or less;calculated as the borrower’s totalliabilities divided by the sum of theborrower’s total liabilities and equity,less the borrower’s intangible assets;

n leverage ratio of 3.0:1.0 or less; and

n debt service coverage ratio (“DSCR”)of 1.5 or greater; calculated as theborrower’s EBITDA, as of the mostrecently completed fiscal year, dividedby the sum of the borrower’s annualpayments for principal and interest onany debt obligation.

Calculation of each component of theseQCL metrics must be made inaccordance with US GAAP. A QCL willalso need to meet the following criteria:

n a straight-line amortising payment;

n a fixed interest rate;

n a maximum five-year, fully amortisingloan term;

n representations and warrantiesprohibiting additionalindebtedness; and

n additional standards for QCLs that arebacked by collateral, including lienperfection and collateral inspection.

Under the final rules, junior liens maycollateralise a QCL. QCLs are alsosubject to certain evaluation, certificationand repurchase conditions under thefinal rules.

Qualified commercial realestate loansUnder the final rules, the following criteriaare required for a qualified commercialmortgage loan, referred to as a qualifiedcommercial real estate (“QCRE”) loan,which may be included in a CMBStransaction exempt from Dodd-Frank riskretention requirements:

n a 1.25 DSCR for loans made withrespect to multifamily properties;

n for loans other than multifamilyproperty loans, a 1.5 DSCR for leasedQCRE loans; and

n a 1.7 DSCR for all other QCRE loans.

n The analysis of whether a loan is aQCRE loan is made with respect to theborrower and not limited to theunderlying property. Loans with respectto properties with less than two yearsof operating history are, however, noteligible for QCRE loan status.

QCRE loans must also have thefollowing characteristics:

n first-lien loan;

n ten-year minimum maturity;

n maximum LTV ratio of 65% with up toa 70% combined LTV ratio;

n a fixed interest rate (or convertible intoa fixed rate via a specified derivative).

Interest-only loans or interest-only periodloans will not qualify as QCRE loans.These loans are also subject toevaluation, certification andrepurchase requirements.

Qualified residential mortgages The Dodd-Frank Act generally providesfor a qualified residential mortgage(“QRM”) exemption for securitisationsinvolving high-quality residentialmortgages. While the statute requiredfederal regulators to define this term aspart of the implementation process, itprovided that the QRM definition could beno broader than the definition of qualifiedmortgage (“QM”) as defined in Section129C of the US Truth in Lending Act(“TILA”). This means that regulators hadthe option to adopt a definition narrowerthan the QM definition. The final rulesreflect a regulatory decision to insteadexactly align the QRM definition with theQM definition (by cross-reference) tominimise the potential for future conflictsbetween the QRM standards for riskretention purposes and the QMstandards adopted under TILA. In



declining to grant a commenter’s requestto allow non-US originated transactionsto benefit from the QRM exemption, theagencies noted that the application of thisdefinition of QM to non-US originatedtransactions is limited by the statutoryreference to the QM definition under TILA.While other categories of non-USoriginated loans may have troublequalifying for potentially relevant riskretention exceptions as a practical matter,QRMs are the only category of qualifyingloan exception for which federalregulators have indicated that theirstatutory authority to implement anexception is implicitly restricted to US-originated assets.

Qualifying re-securitisationsAn exemption from US risk retentionrequirements will be available for qualifyingre-securitisations if:

n the resulting ABS interests consistonly of a single class and provides fora pass through of all principal andinterest payments received on theunderlying ABS interests (net of issuerexpenses); and

n the underlying ABS interests wereissued in compliance with US creditrisk retention requirements or anapplicable exemption.

Seasoned loansThe implementing rules also provide anexemption from risk retention forsecuritisations collateralized solely byservicing assets and seasoned loans thathave not been modified since theirorigination or been delinquent for 30 daysor more. For purposes of this exception,“seasoned loans” includes:

n residential mortgage loans that havebeen outstanding and performing foreither: (1) the longer of five years orthe period until the outstanding

balance of the loan has been reducedto 25% of the original principalbalance or (2) at least sevenyears; and

n any loan that is not a residentialmortgage loan and that has beenoutstanding and performing for thelonger of either: (1) two years; or(2) the period until the outstandingprincipal balance of the loan has beenreduced to 33% of the originalprincipal balance.

Qualified auto loans Under the final rules, qualified auto loans(“QALs”) included in an auto loan ABStransaction would be exempt from UScredit risk retention requirements. To beconsidered a QAL, the followingconditions must be met:

n a DTI ratio not in excess of 36% of aborrower’s monthly gross income;

n a fixed interest rate and fixedinterest payments;

n level monthly payments that fullyamortise the loan over its term;

n compliance with applicable law forrecording a lien on the title; and

n term that is the lesser of: (a) six yearsor (b) ten years less the vehicle’s age.

Loans related to recreational vehicles,business vehicles and automobileleases are not eligible as QALs. QALsare also subject to evaluation,certification and repurchaserequirements under the final rules.

Agency RMBSUS credit risk retention requirements willnot apply to securitisations of residentialmortgages underwritten by USgovernment sponsored entities (GSEs)Fannie Mae and Freddie Mac. Suchmortgages are fully guaranteed by these

entities and backed by the full faith andcredit of the US government. Noequivalent exemption is available forRMBS involving residential mortgagesbacked by the full faith and credit of anynon-US government.

Substituted compliancewith non-US risk retentionrequirements not availableUS federal regulators consideredcomments that requested establishmentof a mutual recognition framework thatwould permit substituted compliance forABS that complied with a comparablenon-US risk retention regime. In decliningto permit substituted compliance, theseregulators noted that other non-USjurisdictions with risk retentionrequirements had generally not adoptedmutual recognition frameworks. Inaddition, some non-US risk retentionregimes recognise unfunded forms of riskretention, such as standby letters ofcredit, which US regulators do not believeprovide sufficient alignment of incentivesand have rejected as eligible forms of riskretention under the US framework.

ConclusionThe federal regulators designed theUS credit risk retention requirementsto incorporate sufficient flexibility withrespect to forms of eligible riskretention to permit non-US sponsorsseeking a significant US investorbase to retain risk in a format thatcould satisfy applicable non-US andUS regulatory requirements.Compliance with more than one setof risk retention requirements,especially in light of materialdifferences, is likely to drive structuralchanges to securitisations bothwithin and outside the United Statesand, in both cases, may requiresignificant additional resources.

6. CRA3 disclosure requirements –the worst yet to come?



Background Participants in the structured debt marketswill by now be aware of the amendments(collectively known as CRA3) to the CreditRating Agencies Regulation that came intoeffect in June 2013. In addition to the dualrating obligation and the obligation toconsider appointing a smaller credit ratingagency that industry has been living withfor almost two years, CRA3 alsointroduced broad disclosure obligations inrelation to structured finance instruments(being, broadly, a financial instrument orother asset resulting from a securitisation)(“SFI”). From 1 January 2017, where any ofthe issuer, originator or sponsor the SFI isestablished in the European Union,information will have to be disclosed via apublicly-accessible website to beestablished by ESMA (the “SFIs website”).

The new disclosure obligations imposedunder Article 8b have been the subject ofmuch discussion since 2013 when theenabling legislation came into force, andin June 2014 the European Securities andMarkets Authority (“ESMA”) published itsfinal draft regulatory technical standards(the “RTS”) further elaborating on theprecise nature of the disclosureobligations in respect of Article 8b forSFIs, backed by residential mortgages,commercial mortgages, loans to SMEs,

auto loans, loans to consumers, creditcard loans and leases to individuals orbusinesses. SFIs issued from 26 January2015 which remain outstanding on1 January 2017 will be caught by thedisclosure requirements under the RTS.SFIs backed by other asset classes, bymixed pools or resulting from private andbilateral transactions are exempt fromreporting obligations for the moment. Thenature of any grandfathering in respect ofthese transactions remains uncertain.

Information and data to bereported under the RTSThe information to be reported under theRTS consists of:

n Loan level data, reported by way of thereporting templates for the relevantasset classes (residential mortgages,commercial mortgages, loans to SMEs,auto loans, loans to consumers, creditcard loans and leases to individuals orbusinesses). This data is very similar tothat already reported to EuropeanDataWarehouse for ECB eligible assetsbut is not identical.

n Where applicable, the final offeringdocument or prospectus andtransaction documents, including adetailed description of the waterfall of

payments of the SFI and any otherunderlying documentation that isessential for the understanding ofthe transaction.

n Where a prospectus has not beendrawn up in compliance with theProspectus Directive, a transactionsummary or overview of the mainfeatures of the SFI, including, amongstother things, the deal structure, theasset characteristics, cash flows, creditenhancement and liquidity supportfeatures, noteholder voting rights andthe inter-relationship between securedcreditors in a transaction.

n Investor reports, containing detailedinformation on, amongst other things,asset performance, cash flowallocation, a list of all triggers and theirstatus, a list of all counterpartiesinvolved in a transaction, their roleand their credit ratings and details ofcash injected into the transaction bythe originator/sponsor or utilisation ofany liquidity or credit support andsupport provided by a third party.

Loan level data and investor reports are tobe made available on a quarterly basis, ineach case no later than one monthfollowing an interest payment date on therelevant SFI. The prospectus (or transaction

The disclosure requirements under CRA3 have been hotly debated between marketparticipants and regulators ever since the introduction of Article 8b, the provisionsunder which the requirements were introduced, in 2013. In that time, regulatorytechnical standards have come out that give form and substance to the disclosureobligations as they apply to certain asset classes in public transactions. The situationfor other asset classes, and for private transactions, remains unclear and certainrecent developments suggest that the worst may be yet to come.

In this article, we describe the disclosure obligations under CRA3 that have alreadybeen clarified, and provide an update on recent developments that give an indicationof what may still be in store for the securitisation markets.



summary where applicable) and relevanttransaction documents must be madeavailable “without delay” after the issuanceof an SFI.

SFIs websiteCRA3 specifies that the informationrequired to be disclosed on SFIs (asdetailed above) will be published on theSFIs website once set up by ESMA.

The RTS state that the technical reportinginstructions concerning, among others,the transmission and the format of thefiles to be submitted by issuers,originators and sponsors will becommunicated by ESMA on its website.These technical instructions are requiredto be published no later than 1 July 2016.This deadline is designed to ensure thatissuers, originators and sponsors havesufficient time before reporting begins on1 January 2017 to allow them to adaptand to develop adequate systems andprocedures to ensure compliance.

Responsibility for provisionof dataResponsibility for reporting data underCRA3 lies with the issuer, originator andsponsor, as applicable, on eachtransaction. However, the RTS is clearthat one or more of them (and/or somethird party) can be designated as thereporting entity (or reporting entities) toupload the required information to theSFIs website on behalf of all parties. TheRTS clarifies however that responsibilityfor the reporting would remain with theissuer, originator and sponsor regardlessof any such designation. The relevantdesignated entity must also be notified toESMA “without undue delay” once thereporting obligations become live.

The relevant reporting entity is requiredunder the RTS to store the files uploadedto the SFIs website in electronic form forat least five years. Where the reporting

entity or any of the issuer, the originatoror the sponsor (if different) identifiesfactual errors in the data that have beenprovided to the SFIs website there is arequirement that this corrected withoutundue delay. There are, interestingly, nodispute resolution provisions in the eventthese parties have a factual disagreementabout the data required to be provided.

Implications forsecuritisation documentationAlthough the market is still adapting tothe (still evolving) disclosure obligationsunder CRA3, certain provisions havestarted to be included in underlyingtransaction documents for issuances ofSFIs falling within the asset classesspecified in the RTS.

As stated above, issuers, originators and/orsponsors on a particular transaction areable to designate one or more reportingentities for the purposes of CRA3, andthere is an emerging practice to appoint theservicer (who is often also the originatingentity) for that role. This is a sensibleapproach given the nature of some of theinformation to be reported such as loanlevel data which would normally beacquired during the loan origination processand will anyway be needed for the ongoingservicing of the assets.

Arrangers and managers have also, insome cases, begun requesting comfortthat CRA3 disclosure obligations will beproperly managed. As a result, there is anemerging practice on some transactionsto include such comfort in thesubscription agreement, in a standaloneletter or in some other document,depending on the specific circumstances.

Recent developmentsESMA consultation andindustry responseNow that the requirements of the RTS havebecome relatively clear (subject to the

technical reporting instructions beingpublished next year), ESMA has turned itsattention to the SFI that are outside thescope of the RTS, and in particular thoseresulting from private and bilateraltransactions. ESMA launched aconsultation in March 2015 with twoobjectives: first to inform ESMA as itdefines the terms “private” and “bilateral”which are as yet undefined in the RTS; andsecond to allow ESMA to assess whetherthe disclosure requirements currentlycontained in the RTS could be sensiblyapplied to SFIs of a private or bilateralnature or whether they should be adapted.Responses to the call for evidence issuedas part of the ESMA consultation were dueon 20 May 2015 and ESMA intends totake these into consideration when revisingthe RTS to cover private and bilateral SFIs.

Industry was naturally very interested in thiscall for evidence, given that a significantproportion of “securitisations” (as defined inthe Capital Requirements Regulation) arenon-public transactions that have thereforebeen subject to very limited (if any) publicdisclosure requirements to date. Thepotential requirement for public disclosureof detailed information relating tofundamentally private transactions has longbeen an area of concern for industry inrespect of Article 8b. The broad thrust ofindustry’s response to the ESMA call forevidence, therefore, was as follows:

n Private and/or bilateral transactionsrepresent an important segment ofthe market and raise additional andheightened considerations from adisclosure perspective.

n Private transactions should be definedto mean transactions in respect ofwhich no obligation arises under theEU Prospectus Directive to publisha prospectus.

n Private transactions should be furthersub-divided into: private andsupported, private and bilateral, privateand intra-group, and private only.



n Private and supported transactionswould, broadly, be those that aresupported in full or in part by creditenhancement or liquidity facilitiesprovided by the sponsor or another EU-regulated institution. In respect of suchtransactions, industry has suggestedthat there should be a principles-baseddisclosure requirement, as well asspecific requirements to entrenchcertain existing practices, including aninformation memorandum thatdescribes the programme’s legalstructure and operative documents, andinvestor reports (on at least a monthlybasis) setting out information about thetransaction, the liquidity and creditsupport providers and the underlyingtransactions (consistent with establishedmarket practice).

n Private and bilateral transactions wouldbe broadly defined as transactions withsophisticated institutional investors,where identification of investors will bepossible throughout the life of thetransaction and where there is nounderwriting by an arranger. In respectof such transactions, industry hassuggested that the disclosurerequirements outlined in the RTSshould not apply and instead aprinciples-based requirement shouldbe implemented requiring that theissuer, originator and sponsor jointlyshould ensure that investors haveaccess to “all materially relevant data”on the items referred to in CRA3. Thisapproach would align the CRA3requirements with the disclosureobligation which applies to creditinstitution and investment firmoriginators and sponsors under article409 of the CRR.

n Private and intra-group transactionswould be those where each of theinvestors is in the same group as anoriginator or sponsor of thesecuritisation, from either anaccounting or prudential perspective.

By definition these arrangements willnot involve third party investors. Forthat reason, industry has suggestedthat a complete exemption should beprovided, failing which aprinciples-based requirement (on thesame basis as suggested above forprivate and bilateral transactions)should be adopted to providesufficient flexibility.

n Private only transactions would bethose that meet the definition ofprivate but do not fall into any of thethree more specific categoriesoutlined above. In respect of suchtransactions, industry has requestedthat only the transaction documentsand investor report requirements ofthe existing RTS should be applied,and the obligation to publicly disclosethis information via the SFIs websiteshould be disapplied. In addition, thegeneral CRA3 disclosure obligation toprovide investors with “all materiallyrelevant data” should apply.

Although it is not yet clear to what extentfeedback from the consultation process(and particularly the comments of industrysummarised above) will inform the eventualposition, it is hoped that a more limiteddisclosure obligation will apply in respect ofprivate and/or bilateral SFIs. ESMA hasacknowledged the confidential nature ofmany private or bilateral arrangements(referring in its consultation paper to “tradesecrets” as an example), however itremains to be seen whether there will beany protection of the commercially sensitiveelements of these transactions in the finaldetailed requirements.

Report of the Joint Committee of theEuropean Supervisory AuthoritiesThe latest development of note is theJoint Committee of the EuropeanSupervisory Authorities report publishedon 12 May 2015 (the “Joint CommitteeReport”). The Joint Committee Report isintended to be a wide-ranging review of

the existing legislative and regulatoryframework relating to securitisation (ofwhich CRA3 is a part) with a specificfocus on the consistency of due diligenceand disclosure requirements. A number ofrecommendations are put forward in theJoint Committee Report, some of whichwould, if implemented, directly impact thedisclosure obligations under CRA3.

In the industry response to ESMA’s callfor evidence on the subject of private andbilateral transactions, industry rightly setout some concerns with respect to anumber of the recommendations set outin the Joint Committee Report. The reportappears to single out securitisation and, ifimplemented, its recommendations couldhinder the recovery of Europe’ssecuritisation markets. This seemsparticularly unexpected in the context ofthe Capital Markets Union initiative of theEuropean Commission, one of the mainelements of which is a drive to reviveEuropean securitisation markets. Whileindustry fully supports greaterharmonisation and consistency, especiallyacross different types of investors, thereis a legitimate concern that securitisationmarket participants have not beenconsulted regarding the practicalimplementation of the Joint CommitteeReport’s recommendations.

The Joint Committee Report seems themore unusual in that it comes so closely onthe heels of the final RTS and that itrecommends introducing further disclosurerequirements that go beyond what weunderstand to be both the information thatcan be reasonably expected to beprovided by an issuer or originator andbeyond that which is reasonably requiredby investors. It is not yet clear whetherthese recommendations will beimplemented (and if so in what form), but itis to be hoped that proper consultation willbe conducted and the legitimate concernsraised by industry will be addressed beforeany further action is taken.

7. US disclosure rules for ABS – anembarrassment of riches



Regulation AB IIRegulation AB II is an expansion andcontinuation of Regulation AB, the primaryregulatory disclosure framework for SEC-registered ABS in the U.S., which the SECoriginally adopted in December 2004.Regulation AB II implements provisions ofthe Dodd-Frank Wall Street Reform andConsumer Protection Act of 2010 (the“Dodd-Frank Act”), introduces newdisclosure requirements, most prominentlya requirement to provide detailedasset-level data varying by the asset typeunderlying the ABS, and contains formsand schedules geared towardstandardising and expanding the

information provided to investors aboutunderlying assets in ABS. Issuers ofSEC-registered ABS will be required tocomply with these new requirements,which include ABS-specific registrationforms (Form SF-1 and SF-3), beginningon 23 November 2015, except for therequirement to provide asset-levelinformation, which will begin on23 November 2016.

Asset-level disclosureRegulation AB II will require asset-leveldisclosures for ABS registered with theSEC that is backed by:

n residential mortgage loans (“RMBS”);

n commercial mortgage loans (“CMBS”);

n auto loans and leases;

n debt securities; and

n resecuritisations of ABS.

No asset-level disclosure requirementshave been adopted for ABS backed byequipment loans or leases, student loans,credit cards or floorplan loans, and anexemption is provided forresecuritisations of ABS issued prior tothe compliance date.

Asset-level information will need to beprovided in a standardised, tagged data

During the fall of 2014, the U.S. Securities and Exchange Commission (the “SEC”)adopted a number of rule amendments that affect the disclosure obligations of issuersoffering asset-backed securities (“ABS”) to U.S. investors. Specifically, the SECadopted (1) Regulation AB II, a series of amendments to the disclosure-based rulescontained in Regulation AB, the most prominent of which is the addition of detailedasset-level data to the disclosure requirements for SEC-registered ABS, (2) Rule15Ga-2, which imposes requirements on issuers and underwriters of ABS to disclosethe findings and conclusions of third party diligence reports and (3) Rule 17g-10,which requires third party due diligence service providers, such as accounting firms, tomake certain representations to Nationally Recognised Statistical Rating Organisations(“NRSRO”) regarding their due diligence reports. While issuers offering and sellingABS pursuant to transactions exempt from the registration requirements of theSecurities Act of 1933, as amended (the “Securities Act”) are not required to complywith the disclosure requirements of Regulation AB II, beginning 15 June 2015, allissuers and underwriters that offer ABS to U.S. investors will be required to complywith Rule 15Ga-2 and their due diligence service providers will be required to complywith Rule 17g-10. Non-U.S. issuers that privately place ABS into the U.S., while notrequired to strictly comply with Regulation AB or Regulation AB II, should neverthelessview the disclosure requirements contained therein as helpful guidance as to themateriality of specific asset-level disclosure data points.



format (eXtensible Mark-up Language, orXML). Schedule AL specifies the contentof a required asset data file for eachasset class to which asset-leveldisclosure applies. Although specific datarequirements vary by asset class (forexample, the SEC requires the disclosureof only 72 data points for auto loans whileit requires 152 data points for CMBS), thenew asset-level disclosures generally willinclude information about:

n the credit quality of obligors;

n the collateral related to each asset; and

n the cash flows related to a particularasset, such as the terms, expectedpayment amounts, and whether andhow payment terms change over time.

Prospectus disclosure requirementsIn addition, the SEC recently adoptedamendments related to prospectusdisclosure requirements for ABSofferings, including:

n expanded disclosure about transactionparties, including disclosure about asponsor’s retained economic interest inan ABS transaction and financialinformation about parties obligated torepurchase assets;

n statistical information regardingwhether pool assets were originatedin conformity with (or as exceptionsto) disclosed underwriting/originationcriteria, or modified after origination;

n a description of the provisions in thetransaction agreements aboutmodification of the terms of theunderlying assets; and

n a requirement to file the transactiondocuments in connection with shelftakedowns by the date of thefinal prospectus.

Applicability of Regulation AB II tounregistered offeringsRegulation AB II in its original proposedform would have applied to both publicand private offerings of ABS into the U.S.Although, as adopted, Regulation AB IIdoes not apply to unregistered offerings,market participants generally regarddisclosure regulation promulgated by theSEC, including Regulation AB, asimportant guidance for the preparation ofoffering memoranda for private offeringsof securities, including offerings of ABS.U.S. federal securities law imposessignificant disclosure obligations andpotential liabilities on an issuer and otherparties involved in offerings of securitiesto U.S. investors, whether offered andsold publicly or privately. Pursuant toSection 10(b) of the U.S. SecuritiesExchange Act of 1934, as amended (the“Exchange Act”), and Rule 10b-5promulgated thereunder, U.S. federalsecurities law imposes civil liability onissuers and other distribution participantsfor material misstatements and omissionscontained in any offering documentcirculated to prospective investors orotherwise made (orally or in writing) inconnection with any securities offering.

In its adopting release for RegulationAB II, the SEC expressed the view thatinvestors needed access to more robustand standardised information aboutassets underlying particular ABS in orderto make informed decisions. In the samerelease, however, the SEC also notedthat many issuers of CMBS, RMBS andABS backed by other assets types arealready providing asset-level disclosurein compliance with disclosureframeworks developed by industrygroups or, in the case of foreign issuersof ABS, disclosure regulations issued bydomestic regulators.

While acknowledging that different assettypes call for different disclosure,Regulation AB II reflects the SEC’s viewthat investors would gain significant valuefrom asset-level disclosure that’sstandardised by asset type. In light of thestrongly held view of Mary Jo White, thechairwoman of the SEC, that thedisclosure requirements of RegulationAB II address core issues related to thefinancial crisis, issuers of ABS into theU.S. that already provide asset-leveldisclosure in their offering documentsshould consider carefully the materiality ofany specific data points that are called forby Regulation AB II’s asset-leveldisclosure framework but not currentlyincluded in their offering documents.Issuers that do not currently provideasset-level disclosure should alsoconsider carefully the materiality of suchdisclosure to their investors in light of theworldwide industry and regulatory trendscalling for asset-level disclosure.

Disclosure requirementsregarding third party duediligence reportsEffective 15 June 2015, Rule 15Ga-2 willrequire any issuer or underwriter ofregistered or unregistered ABS, asdefined in the Exchange Act (“ExchangeAct-ABS”), rated by a NRSRO to publiclyfile a Form ABS-15G on EDGAR, theSEC’s electronic document retrievalsystem, in connection with any third partydue diligence reports an issuer orunderwriter obtains, which discloses thefindings and conclusions of any suchthird-party due diligence report. Inpractice, this effective date means thatthe Form ABS-15G filing requirement willapply to relevant transactions that priceon or after 12 June 2015. Form ABS-15Gmust be filed on EDGAR at least fivebusiness days prior to the first sale in theoffering, but it need only be provided with



respect to the initial rating of ABS(i.e., not necessary in connection withsubsequent rating activities). While thisrule contemplates that a Form ABS-15Gwould be filed by either an issuer or anunderwriter, we anticipate that it willbecome market practice for underwritersto expect issuers to bear theresponsibility for filing these forms.

The Form ABS-15G disclosure may notmerely summarise the third-party duediligence report; it must contain the actualfindings and conclusions expressedtherein. If the disclosure requirements havebeen met in the prospectus filed with theSEC (including attribution to theappropriate third-party), and theprospectus is publicly available at the timethe Form ABS-15G is furnished by theissuer or underwriter, the Form may,however, refer to that section of theprospectus rather than providing thefindings and conclusions once again in full.

A Form ABS-15G filing would not berequired if an NRSRO engaged to providean ABS credit rating provides the issueror underwriter with a representation that itwill publicly disclose the findings andconclusions of the relevant third-partydue diligence report. If the issuer orunderwriter reasonably relies on theNRSRO to make this disclosure and theNRSRO fails to do so in a timely manner,the issuer or underwriter will have untiltwo business days prior to the first sale ofsuch ABS to file a Form ABS-15G. AForm ABS-15G must be filed regardlessof whether an NRSRO in fact uses thethird-party due diligence report in itscredit rating decision.

The necessity of this form with regard topre-securitisation due diligence activities(e.g., acquiring underlying assets from theoriginator or a third-party seller) is unclear.The regulation requires the filing of a

Form ABS-15G in respect of “allthird-party due diligence reports obtainedby the issuer or underwriter, includinginterim reports, related to an offering ofasset-backed securities.”

Third-party due diligence reportsA “third-party due diligence report” forpurposes of Rule 15Ga-2 and FormABS-15G means any report that containsthe findings and conclusions of any duediligence services performed by a thirdparty. In this context, the meaning of“findings and conclusions” is currently thesubject of discussion in the industry andremains open to interpretation. Theconservative view is that each interimreport (in its entirety) and the final reportneed to be disclosed. On the other end ofthe interpretive spectrum would be thedisclosure of just a redacted final report.This would be done for two reasons:(1) there may be some privacy issuesraised in connection with some of theinformation in these reports; and (2) muchof the information in interim reports may besuperseded by information in a final report.

For purposes of the definition ofthird-party due diligence report, “duediligence services” includes evaluationsof any of the following:

1. the accuracy of the information ordata about the assets provided,directly or indirectly, by the securitiseror originator of the assets;

2. whether the origination of the assetsconformed to, or deviated from,stated underwriting or creditextension guidelines, standards,criteria, or other requirements;

3. the value of collateral securingthe assets;

4. whether the originator of the assetscomplied with federal, state, or locallaws or regulations; or

5. any other factor or characteristic ofthe assets that would be material tothe likelihood that the issuer of theasset-backed security will pay interestand principal in accordance withapplicable terms and conditions.

The first four categories address thetypes of due diligence the SEC believes istypically conducted for offerings ofRMBS, the primary area in which duediligence is conducted. The fifth categoryis a catch-all for other asset classeswhere such services may be performed inthe future.

Whether a report issued by a custodianconstitutes a “third-party due diligencereport” is currently the subject of industrydebate, especially with respect toseasoned loans (i.e., reports on whatdocuments are missing).

Beginning 15 June 2015, Rule 17g-10will require a third-party provider of duediligence services in connection with ABSofferings to U.S. investors to deliver awritten certification on Form ABS DueDiligence-15E disclosing who paid forsuch services, a detailed description ofthe manner and scope of the duediligence services provided and asummary of the findings and conclusionsof the due diligence. In practice, theeffective date means that writtencertifications will need to be provided fordue diligence services that are completedon or after 15 June 2015. There is someconcern that this requirement wouldapply to third-party due diligence reportsprovided on or after 15 June 2015 inrespect of a transaction that closed priorto this effective date, which may affectcertain CLOs.

Application to agreed-uponprocedures performed byaccounting firmsSome, but not all, services performed byaccounting firms as agreed-uponprocedures (“AUP”) will be considered“due diligence” services. Those servicesthat are not considered “due diligence”will not be subject to these rules. If theprimary purpose of the service is to assistissuers and underwriters in verifying theaccuracy of disclosures, the service willnot be subject to the new rules.Examples of this type of service includeperforming procedures that tieinformation included in the offeringdocuments to the loan tape or thefinancial statements, or recalculations ofprojections of future cash flows.

AUP services consisting of comparison byaccountants of data on a loan tape to asample of loan files are an example of aservice that must be disclosed. This type ofreview is typically reflected in AUP lettersthat are delivered to underwriters or initialpurchasers for ABS offerings, and can alsobe provided in connection with Rule 193letters provided by accountants.

The SEC has acknowledged thataccounting firms most likely will bereluctant to provide Rule 17g-10certifications. As a result, the SEC will not

object to including a description of thestandards that govern the performance ofAUP on Form ABS Due Diligence-15E.

Exemptions for non-U.S. transactionsand municipal securitiesThe requirements of Rule 15Ga-2 will notapply to a non-U.S. offering of ABS wherethe following conditions are satisfied:

n the offering is not registered (and isnot required to be registered) underthe Securities Act;

n the issuer is not a “U.S. person”; and

n The security issued by the issuer willbe offered and sold upon issuance,and any underwriter or arranger linkedto the security will effect transactionsof the security after issuance, only intransactions that occur outside theUnited States.

In addition, the requirement to file a FormABS-15G will not apply to a municipalissuer of rated securities for privateplacements of ABS that are exempt fromthe registration requirements of theSecurities Act. These municipal ABSofferings will, however, remain subject tothe requirements under Section15E(s)(4)(A) of the Exchange Act.Accordingly, these issuers will still need tomake the findings and conclusions of anythird-party due diligence report obtained

by the issuer or underwriter publiclyavailable – either by posting thisinformation on a website maintained bythe issuer or by voluntarily furnishing aForm ABS-15G on EDGAR.

Transaction considerationsDeal teams should be aware of thethird-party due diligence report filingrequirements, as the ABS-15G forms aredue five days prior to the first sale. Afailure to timely file a report may cause aninadvertent delay in the pricing of anoffering. Filing on EDGAR, while simpleand straightforward, requires at least 2-3days of lead time for issuers that have notyet obtained the requisite passcodes andidentifiers. In addition, issuers andunderwriters will need to consider what, ifany, provisions should be added tothird-party due diligence service providerengagement letters to ensure that suchparties comply with the newrequirements, as well as the content andform of the disclosure to be included inthe Form ABS-15G. In particular, issuersand underwriters should make sure thatthe confidentiality provisions in suchengagement letters contain appropriatecarve-outs to permit transaction partiesto comply with the new regulations underthe Dodd-Frank Act.


A never ending road42

43A never ending road


8. Bank recovery and resolution –A narrow escape

BackgroundThe Special Resolution Regime (SRR)The SRR is the overall name for thevarious stabilisation and resolutionpowers given to HM Treasury and theBank of England under Part 1 of theBanking Act.

In relation to relevant entities, the UKauthorities now have a series ofstabilisation powers, useable in advanceof that entity’s insolvency. These are inaddition to the Bank InsolvencyProcedure and the BankAdministration Procedure.

One of the important features that hasrecently changed in is geographicalscope of these powers. As mentionedabove, the Banking Act was initially aUK-specific response to the financialcrisis. The SRR powers were accordinglynot able to be exercised in relation toentities incorporated outside of the UK.With the recent changes made to theBanking Act as a consequence of theimplementation of the BRRD, there is

now greater harmonisation amongEuropean Union Member States,including mutual recognition of recoveryand resolution measures, meaning, e.g. aUK bank’s subsidiary in the Netherlandswill in future be subject (via theNetherlands’ implementation of the BRRDand associated recognition of UKmeasures) to Banking Act SRR powers.The Banking Act also provides forrecognition of third country recovery andresolution measures in certaincircumstances. The reach of Banking Actstyle powers, therefore, is nowsubstantially wider than it used to be.

In addition, under the Banking Act asoriginally enacted, these powers appliedonly to banks and bank holdingcompanies. Following the amendmentsmade in the last few years, it nowprovides the UK authorities with therelevant powers to stabilise or resolve notonly banks, but also building societies,systemically important investment firms,recognised CCPs, banking groupcompanies and certain other entities.

The most important of these additions forthe structured debt markets is clearly theaddition of banking group companies(BGCs) which can now be the subject ofSRR powers in order to assist with thestabilisation of the bank of whose groupthe BGC is a member. A BGC will,broadly, be any company that controls, iscontrolled by, or is under common controlwith, a bank (or other entity subject to theSRR). This is mainly an accounting testand is very similar (though not identical)to the test many securitisation originatorshave been working through in respect oftheir securitisation SPVs for EMIRconsolidation purposes.

There are, however, a number ofexceptions from that general definition of aBGC, including where the entity is a“covered bond vehicle” or a “securitisationcompany”, which definitions are broadlyintuitive. Unfortunately, however, evenwhere an entity falls within one of theseexceptions, it will nonetheless be a BGC(and thus subject to the SRR powers) if it isalso an “investment firm” or a“financial institution”.

45A never ending road


One of the key pieces of financial stability legislation introduced by the UK governmentin the aftermath of the financial crisis of 2007-08 was the Banking Act 2009 (the“Banking Act”). It introduced wide-ranging new powers to promote the stability ororderly resolution of failing banks with the aim of preventing the kind of uncertaintyand market disorder that followed the collapse of Lehman Brothers. More recently, theEU authorities have introduced the Bank Recovery and Resolution Directive(2014/59/EU) (the “BRRD”), which entered into force on 2 July 2014 and covers verysimilar ground, but with a wider geographic and substantive scope. Having just got toa point of comfortable coexistence with the existing regime, securitisation and coveredbond market participants are now facing new uncertainties caused by the BRRD andthe associated amendments to the Banking Act, which implements the BRRD for theUK and came into force in January 2015. The best publicised of these amendmentsare the ones relating to the bail-in power, which we discuss in more detail below.



In practice, the “investment firm” categoryit is unlikely to be problematic. Thedefinition of that term requires that theentity carry out MiFID services that nosecuritisation company or covered bondvehicle is likely to engage in.

The “financial institution” category is moreproblematic. That term includes any entitywhose principal activity is any of anumber of activities on a long list, whichlist includes both “lending” and“guarantees and commitments”.Obviously, securitisation companiestypically stand in the shoes of theoriginator (lender) under a number ofcredit agreements and covered bondvehicles exist largely to guarantee theobligations of the covered bond issuer.

It is nonetheless often possible toconclude that that securitisationcompanies and covered bond vehiclesshould escape the application of the SRRpowers, but this analysis is nuanced andhighly dependent on the specific facts.

Bail-inPerhaps the most widely discussed newpower in the Banking Act is the bail-inpower, a power specifically required to belegislated under the BRRD. Under the bail-in option, the authorities have the ability,inter alia, to write down debt, write off debtor convert debt into equity, the whole toabsorb losses and stabilise the entity orgroup. The exercise of these powers issubject to a general “no creditor worse off”rule, requiring that bail-in not put anycreditor in a worse position than it wouldhave been in under an insolvency. Thismeans that equity holders should be writtenoff before debt, subordinated debt holdersshould be bailed in before senior debtholders, etc. It is, however, unclear howhelpful this would be in practice because ofthe complexity of analysing the alternativescenario of an insolvency, particularly when

the entity concerned is not actually insolvent(as it would, by definition, not be when bailin – a pre-insolvency stabilisation power – isbeing used).

Various exemptions from the scope of thebail-in power are, however, available. Firstof all, in order for an entity’s debt to beaffected, that entity has to be subject tothe SRR powers generally, i.e. it must bea bank, BGC, building society, investmentfirm, CCP, etc. Even where an entity isgenerally subject to the SRR powers,specific kinds of debt will be “excludedliabilities” and therefore not subject tobail-in (although at an entity level the SRRpowers are still generally available). Forpurposes of the structured debt markets,the main useful category of “excludedliabilities” is secured liabilities.

Today’s Banking Act –practical analysisSecuritisationsTaking the above background andapplying it to a typical paradigm true salesecuritisation structure with a bankoriginator, the main concern in relation tothe Banking Act will be to ensure that thenotes issued cannot be affected by theapplication of the SRR powers. Thetransaction being a securitisation, thenotes themselves will be secured andtherefore excluded liabilities, so there isno need to go through the full bail-inanalysis. It remains only, therefore, to seewhether the issuer can be affected by theSRR powers more broadly.

The issuer is likely to be a specialpurpose vehicle and therefore not in anycategory that would lead to theapplication of the SRR powers to theissuer in its own right. It will, however,potentially be subject to the application ofthe SRR powers to the extent that it is a

BGC in relation to the originator. Thefollowing questions therefore arise:

a) Is the issuer in the same group as theoriginator? This will largely be anaccounting analysis, but it will behelpful as a starting point to refer tothe EMIR consolidation analysis thatwill need to have been done in orderto determine the issuer’s status aseither an NFC+ or an NFC- forEMIR purposes.

i. If the issuer is not in the samegroup as the originator, then theSRR powers will not apply to itand the analysis need not betaken any further.

ii. If the issuer is in the same groupas the originator, furtherinformation is required and theanalysis must proceed as below.

b) If the issuer is in the same group asthe originator, does it meet thedefinition of a “securitisationcompany”? This definition is alignedwith the Taxation of SecuritisationRegulations 2006, so the parties arelikely to have carried out this analysisfor tax purposes already.

i. If the issuer is not a securitisationcompany, the SRR powersgenerally will apply, but the noteswill not be subject to bail-in to theextent they are fully securedbecause they will beexcluded liabilities.

ii. If the issuer is a securitisationcompany, further information isrequired and the analysis mustproceed as below.

c) If the issuer is a securitisationcompany, is it also an “investmentfirm” or a “financial institution”? Asmentioned above, securitisation firmswill almost never be investment firms.It is not entirely clear, but it will often



be possible to conclude that issuersshould not be considered financialinstitutions either, on the basis thattheir principal activity is not lending.Although they hold the rights of thelender in respect of many loans, theygenerally are not originating loans,providing further advances orotherwise engaging in the day-to-dayactivity one would associate with theterm “lending”. Further comfort canbe derived from the fact that, in othercontexts, the Financial ConductAuthority has given guidance that“lending” as described in the relevantlegislation refers to origination ofloans, and not to the mere holding ofthe lender’s rights under a loan onehas acquired from the original lender.

i. If the issuer is an investment firmor a financial institution, the SRRpowers generally will apply, butthe notes will not be subject tobail-in to the extent they are fullysecured because they will beexcluded liabilities.

ii. If the issuer is neither aninvestment firm nor a financialinstitution, it will be excluded fromthe definition of a BGC and will beentirely exempt from theSRR powers.

Covered bondsIn the case of a typical UK regulatedcovered bond, the BGC analysis abovewould be largely similar. The LLP thatprovides the guarantee would, ofcourse, be in the same group as thebank issuer, since the bank issuer is amember of the LLP. The LLP would,however, almost certainly meet thedefinition of a “covered bond vehicle”and not be an “investment firm”.

Whether the LLP would be a “financialinstitution” is, once again, a somewhat

vexed question. If the LLP’s “principalactivity” were “guarantees andcommitments”, then that would bring theLLP into the definition of a financialinstitution. Providing the guarantee inrespect of the covered bonds is, ofcourse, a main function of the LLP on acovered bond transaction, but it may bepossible to conclude that this should notbe considered its only principal activity.One of the requirements to meet thedefinition of a “covered bond vehicle” isthat the entity should acquire, own andmanage assets making up the cover pool.There is a reasonable argument that theacquisition, ownership and managementof those assets is also a principal activityof the LLP and therefore “guarantees andcommitments” would not be the LLP’ssole principal activity and the LLP couldthereby escape the definition of a financialinstitution and the application of the SRRpowers generally. Although not strictly alegal argument, this interpretation issupported by the fact that any otherconclusion would nullify the entire purposeof providing the “covered bond vehicle”exemption from the definition of a BGC.

Even if the LLP is a financial institution,and therefore a BGC, it is likely that thecovered bonds themselves would not besubject to being bailed in, insofar as thecover pool is sufficient to meet theobligations under them.

As mentioned above, certain types ofdebt will constitute “excluded liabilities”for the purposes of bail-in, and theseexcluded liabilities include any liability, sofar as it is secured. Of course, standardregulated UK covered bonds are not,themselves, secured. They areguaranteed and that guarantee is securedon the cover pool. For these purposes,however, “secured” means securedagainst properly or rights, or otherwisecovered by collateral arrangements.

Although not directly secured in thetraditional sense, the reference tocollateral arrangements may well be wideenough to encompass the type ofarrangements in place in respect of acovered bond. It seems likely that this willhave been the intention, particularly giventhe very clear prohibition in the BRRD (ofwhich the Banking Act is the UKimplementation) against exercising bail-inpowers in relation to “secured liabilitiesincluding covered bonds”.

ConclusionThe BRRD and the Banking Act areone of several areas of newlegislation that are not specificallyintended to deal with structureddebt, but nonetheless have asignificant effect on it. While bankrecovery and resolution legislationwas always going to be of concernto securitisation and structured debttransaction parties, unfortunatelegislative drafting at both the BRRDand Banking Act levels has resultedin difficulties that are perhaps morepronounced than they need havebeen in determining the precisenature and scope of the powers andtheir practical effect on structureddebt transactions. It is to be hopedthat future amendments will help toclarify some of the more difficultquestions discussed above and thata developing body of practice will, inthe interim, help to provide comfortto all market participants as to thenature of the bank-related risks theyare taking when investing insecuritisation products andcovered bonds.

9. Volcker Rule implementation –challenges for structured financeunderwriters



BackgroundThe “Volcker Rule” is a new Section 13 tothe Bank Holding Company Act of 1956(“BHC Act”) which was inserted bySection 619 of the Dodd-Frank WallStreet Reform and Consumer ProtectionAct (“Dodd-Frank Act”). This provisionapplies to any “banking entities”, whichmeans, generally, any entity within thesame group as a bank that has a U.S.branch or agency.

The Volcker Rule generally prohibitsbanking entities from:

n engaging in proprietary trading; or

n acquiring or retaining any ownershipinterest in, or sponsoring, certaintypes of funds, which can includestructured finance issuers, unless anappropriate exemption is available.

The Volcker Rule also prohibits bankingentities from engaging in “covered

transactions” (under Section 23A of theUS Federal Reserve Act) with a relatedsponsored, advised or managed coveredfund or a covered fund that is offered asa permitted activity in connection withbona fide trust, fiduciary or investmentadvisory services. This prohibition isknown as the “Super 23A” prohibitionand mainly prevents banking entities fromexecuting loans, derivatives and othertransactions that would expose thebanking entity to credit risk of a relatedcovered fund.

The proprietary tradingban and the underwritingexceptionThe Volcker Rule’s proprietary tradingprohibition covers positions held in a“trading account,” which is defined by theImplementing Regulations as any accountthat is used to take positions principallyfor the purpose of short-term resale,

benefitting from short-term pricemovements, locking in short-termarbitrage profits, or hedging anothertrading account position. TheImplementing Regulations provide abroad exception for underwriting activitiesfrom this ban on proprietary trading.

The underwriting exception requiresverifiable compliance with a number ofconditions, including that:

n the underwriting position of a bankingentity’s trading desk must be relatedto the banking entity’s role asdistributor of the securities that aresubject to the underwriting activity;

n the amount and type of securities thatthe trading desk holds must bedesigned not to exceed thereasonably expected near-termdemands of clients, customers orcounterparties; and

In the period following the adoption by US federal regulators of regulations toimplement the Volcker Rule (the “Implementing Regulations”), investment banks havebeen considering on a case-by-case basis whether the structured finance transactionsthey underwrite present compliance concerns with respect to this rule. In ourexperience, many structured finance issuers are eligible for a regulatory exemption orexception from the Volcker Rule. Underwriters are increasingly seeking assurancesthat an exemption is available or that the issuer is not within the scope of the VolckerRule. Where the issuer has U.S. counsel (for example, if the securities are offeredunder Rule 144A), that assurance may take the form of a contractual representationand warranty from the issuer. In wholly non-U.S. transactions, where the issuer doesnot have U.S. counsel, market practice is coalescing on the provision of amemorandum from underwriter’s US counsel as to the Volcker treatment of the issuer.If no such assurances can be provided, then transaction participants typically considerwhether offering documentation should include disclosure regarding the possibility thatthe Volcker Rule could restrict banking entities from investing in the issuer’s securities.



n the banking entity must takereasonable efforts to reduce itsposition in the relevant securitieswithin a reasonable period, taking intoaccount the liquidity, maturity anddepth of the market for therelevant securities.

In addition, the Implementing Regulationsspecify the features of compliancepolicies and procedures that a bankingentity should have in place to ensure thatit analyzes and tests its compliance withthe conditions for this exemption. As thisexception relates only to the proprietarytrading ban of the Volcker Rule, theavailability of additional regulatory reliefmust be considered if the securitiesproposed to be underwritten raiseconcerns regarding compliance withother aspects of the Volcker Rule.

Assuring compliance withcovered fund relatedprohibitionsAs originally postulated by Paul Volcker,the Volcker Rule was not aimed atsecuritisation or structured financeactivities. However, the statutory definition

of a “covered fund”, and the scope of theImplementing Regulations make clear thatsecuritisation issuers can be coveredfunds, and that banks’ involvement withthem is now highly regulated.

The definition of a “covered fund” set outin the Implementing Regulations includesan entity that relies on the exclusionsfrom the definition of “investmentcompany” provided in Sections 3(c)(1)and 3(c)(7) of the US InvestmentCompany Act of 1940 (the “InvestmentCompany Act”). These provisions wereselected because they are commonlyused by private equity and hedge funds,which were the original targets of theVolcker Rule. However, they were alsocommonly used by securitisation issuers(particularly 3(c)(7)), because they aregenerally based on the composition andstatus of the investors in the fund, and donot restrict the nature of assets oractivities that a fund can acquireor undertake.

As stated above, the Volcker Ruleprohibits banking entities from sponsoringor acquiring ownership interests incovered funds.

For purposes of the Volcker Rule, to“sponsor” a fund means:

n to serve as a general partner,managing member, or trustee of thecovered fund, or to serve as itscommodity pool operator;

n in any manner to select or to control(or to have employees, officers, ordirectors, or agents who constitute) amajority of the directors, trustees, ormanagement of the fund; or

n to share with the fund, for corporate,marketing, promotional, or otherpurposes, the same name or avariation of the same name.

An ownership interest includes not onlytraditional equity interests, but also anysecurity that receives income from theissuer on a pass-through basis and anysecurity that entitles the holder toparticipate in the selection or replacementof certain managers (including investmentmanagers) of the issuer, other than uponan event of default. Banking entities aretherefore significantly restricted in thenature of structured finance securities theycan hold, and underwriters are limited inthe securities they can sell to such bankingentities. As a result, underwriters havebegun to ask for assurances that anexemption or exception from the VolckerRule would apply to them.

As we mention above, when a sponsor orissuer has engaged US counsel to adviseon the transaction, the assurances maybe provided by the issuer in the form ofrepresentations and warranties in theunderwriting agreement.

However, non-US offerings by non-USissuers are often executed without involvingUS counsel. In those circumstances, UScounsel would not be engaged to advisethe issuer with respect to representationsand warranties regarding the applicability of

Potential causes for Volcker Rule compliance concernsIn structured finance transactions, circumstances where Volcker Rule compliancemay become a concern include:

n the originator, underwriter, investment manager or any key investor is a bankingentity subject to the Volcker Rule;

n the underwriter is affiliated with the sponsor of a securitisation;

n the issuer is a special purpose vehicle that holds a significant amount ofinvestment securities or proposes to hold a significant amount of investmentsecurities in the future that do not fully conform to the portfolio requirements ofthe Volcker Rule’s exception for loan securitisations or meet another exemptionor exclusion;

n the transaction involves an extension of credit to the issuer by a banking entityor a banking entity enters into a derivative transaction with the issuer.



the Volcker Rule as part of the transactiondocumentation, and the issuer could notgive those representations and warrantieson an informed basis. Consequently, it isbecoming market practice for underwritersto engage special US counsel to provide amemorandum confirming the basis onwhich the issuer complies with, or isexempt from, the Volcker Rule.

A variety of exclusions from the definitionof covered fund may be applicable tostructured finance transactions, oftendepending on the types of assetsbeing securitised.

Alternate exemptions from theInvestment Company Act An issuer would not be considered to bea “covered fund” for purposes of theVolcker Rule if it could rely on anexclusion or exemption from the definitionof “investment company” under theInvestment Company Act other than theexclusions set forth in Sections 3(c)(1)and 3(c)(7). Accordingly, if the issuer iseligible to rely on an alternate exemptionfrom the definition of “investmentcompany” under the InvestmentCompany Act, the underwriters of theissuer’s securities would not face“covered fund” related complianceconcerns under the Volcker Rule. Twoexemptions on which structured financevehicles often rely are found in Section3(c)(5) of the Investment Company Act.

Mortgage ABS. RMBS or CMBS issuersmay qualify for the exception found inSection 3(c)(5)(C) of the InvestmentCompany Act. Under this exception, anissuer would not be an investmentcompany for purposes of the InvestmentCompany Act if that issuer “is notengaged in the business of issuingredeemable securities, face-amountcertificates of the installment type orperiodic payment plan certificates, and …

is primarily engaged in … purchasing orotherwise acquiring mortgages and otherliens on and interests in real property”.Whether an issuer qualifies for thisexception depends almost entirely on thecomposition of the issuer’s portfolio ofassets. The “primarily engaged”requirement of Section 3(c)(5)(C) meansthat the issuer’s portfolio should have thefollowing composition:

n mortgages and other liens on, andinterests in, real estate (“qualifyinginterests”) are at least 55% of theissuer’s total assets;

n other real estate-type interests are atleast 25% of the issuer’s totalassets (or less, to the extent thatqualifying interests exceed 55% of thetotal); and

n miscellaneous investments are nomore than 20% of the issuer’stotal assets.

Accordingly, to qualify for this exception,the fair value of an issuer’s portfolio ofmortgage loans should exceed 55% ofthe fair value of the issuer’s total assetsthroughout the life of the financing, andthe fair value of any miscellaneousinvestments should not exceed 20% ofthe fair value of the issuer’s total assets.

A qualifying interest is an asset thatrepresents an actual interest in real estateor is a loan or lien fully secured by realestate. An asset that is the functionalequivalent of, and that provides the sameeconomic experience as, a directinvestment in real estate or a loan or lienfully secured by real estate, may be considered a qualifying interest forSection 3(c)(5)(C) purposes.

Non-mortgage ABS. Many types ofnon-mortgage structured financetransactions, including auto loan or creditcard transactions, can rely on the

exception found in Section 3(c)(5)(A) ofthe Investment Company Act. Under thisexception, an issuer would not be aninvestment company if it “is not engagedin the business of issuing redeemablesecurities, face-amount certificates of theinstallment type or periodic payment plancertificates, and … is primarily engaged in… [p]urchasing or otherwise acquiringnotes, drafts, acceptances, openaccounts receivable, and otherobligations representing part or all of thesales price of merchandise, insurance,and services”.

Redeemable securities not eligible.Redeemable securities would not qualifyfor any exemption provided underSection 3(c)(5) of the InvestmentCompany Act. Section 2(a)(32) of theInvestment Company Act defines a“redeemable security” as “any security,other than short-term paper, under theterms of which the holder, upon itspresentation to the issuer or to a persondesignated by the issuer, is entitled(whether absolutely or only out of surplus)to receive approximately his proportionateshare of the issuer’s current net assets, orthe cash equivalent thereof.” As a result,if the securities are redeemable withoutany significant restrictions at the option ofthe holders, this exemption would not beavailable. Provisions permitting the issuerto redeem the securities in certaincircumstances would, however, not causethe securities to be treated asredeemable securities for these purposes.

Volcker Rule exemption for loansecuritisationsTo the extent that an alternate InvestmentCompany Act exemption is not available,structured finance underwriters may beable to instead rely on the “loansecuritisation” exemption provided in theImplementing Regulations. Thisexemption excludes structured finance



vehicles that meet specified conditions ofthe loan securitisation exemption from thedefinition of covered fund. A “loansecuritisation” is defined as an issuingentity for asset-backed securities thatmeets the conditions of the rule and theholdings of which are comprised solely of:

n loans (this is a defined term thatincludes any loan, lease, extension ofcredit, or secured or unsecuredreceivable that is not a securityor derivative);

n rights or other assets (i) designed toassure the servicing or timelydistribution of proceeds to holders ofsuch securities or (ii) related orincidental to purchasing or otherwiseacquiring and holding the loans,provided that each asset is apermitted security meetingspecified requirements;

n interest rate or foreign exchangederivatives that meet specifiedrequirements; and

n special units of beneficial interest andcollateral certificates that meetspecified requirements.

A loan securitisation must own the loansto be securitised directly and not througha synthetic exposure, such as a creditdefault swap. In addition, to qualify forthis exemption, the issuer’s portfolio ofunderlying assets must not contain any ofthe following impermissible assets:

n any security, including anasset-backed security, or any interestin an equity or debt security;

n any derivative; or

n any commodity forward contract.

For these purposes, “impermissibleassets” does not include:

n investments in high-quality, highlyliquid, short-term investments whosematurity corresponds to thesecuritisation’s expected or potentialneed for funds and whose currencycorresponds to either the underlyingloans or the asset-backed securities;

n securities received in lieu of debtspreviously contracted with respect tothe loans supporting the asset-backedsecurities (i.e., securities received inbankruptcy in exchange for loans); and

n interest rate or foreign exchangederivatives that meet the followingrequirements: (1) the written terms ofthe derivative directly relate to theloans, the asset-backed securities, orthe servicing assets; and (2) thederivatives reduce the interest rateand/or foreign exchange risks relatedto the loans, the asset-backedsecurities, or the contractual rights orthe servicing assets.

Any derivatives held by a loansecuritisation must be related to the typesof risks associated with the underlyingassets and may not be derivativesdesigned to supplement income basedon general economic scenarios, incomemanagement or unrelated risks, such ascredit default swaps.

The limited scope of eligible assets in theloan securitisation exemption hassignificantly altered the CLO market,where transactions are structured eitherto meet the relatively exactingrequirements of Investment Company ActRule 3a-7 (and thereby obviate the needto rely on either 3(c)(1) or 3(c)(7)),meaning the issuer would not be acovered fund, or to avoid investment incorporate bonds and other securities(and thereby fit the criteria for the loansecuritisation exemption from theVolcker Rule).

Material conflicts or high riskstrategies. The Implementing Regulationsprovide that the loan securitisationexemption (and other exemptions providedunder the Volcker Rule) would bedisallowed to a banking entity with respectto a particular issue of securities if theinvestment in the securities:

n involves or results in a “materialconflict of interest” between thebanking entity and its clients,customers or counterparties; or

n results, directly or indirectly, in amaterial exposure by it to a “high-riskasset” or a “high-risktrading strategy”.

For purposes of the Volcker Rule, a“material conflict of interest” would exist ifthe transaction or activity at issue wouldinvolve or result in the banking entity’sinterests being materially adverse to theinterests of its client, customer, orcounterparty with respect to suchtransaction, class of transactions oractivity. The Implementing Regulationswould permit circumstances in whichconflicts of interest were mitigated bymaking clear, timely and effectivedisclosure or, in certain cases, byimplementing information barriers. Forthese purposes, a “high-risk tradingstrategy” means a trading strategy thatwould, if engaged in by a banking entity,significantly increase the likelihood thatthe banking entity would incur asubstantial financial loss or would pose athreat to the financial stability of theUnited States. In our experience, thepractical effect of these provisions isminimal because transactions fallingwithin its ambit are exceedingly rare, forgood and obvious reasons.

The SOTUS ExemptionIf none of the above describedexceptions apply, non-US structured



finance underwriters may be able toinstead rely on the solely outside theUnited States, or “SOTUS”,exemption provided by theImplementing Regulations.

This exemption permits certain non-U.S.banking entities to have an ownershipinterest in, or sponsor, a “covered fund”that is organised and offered solely outsidethe United States.

The SOTUS exemption provides relief to alimited subset of non- U.S. banking entitiesand must therefore be evaluated on anentity-by-entity basis. It is only available tobanking entities that are not (1) organisedunder U.S. law or (2) directly or indirectlycontrolled by a banking entity that isorganised under U.S. law. In addition, thenon- U.S. banking entity must exceedspecified U.S. bank regulatory thresholdsregarding the relative size of its non- U.S.business (in broad terms, its total assets orrevenues outside the United States shouldbe greater than its total assets or revenuesinside the United States).

This exemption also requires that thenon-U.S. banking entity and any relevantpersonnel that makes the decision tosponsor or acquire or retain any ownershipinterest in the issuer not be located in theUnited States, and not be controlleddirectly or indirectly by, a banking entity thatis located in the United States. Itsinvestment in the issuer, including anytransaction arising from risk-mitigatinghedging related to an ownership interest,should not be accounted for as principaldirectly or indirectly on a consolidated basisby any branch or affiliate that is located inthe United States or organised under U.S.laws. Furthermore, no financing for itssponsorship of the issuer or purchase ofthe securities may be provided, directly orindirectly, by any branch or affiliate that is

located in the United States or organisedunder U.S. laws.

A non-US banking entity seeking to rely onthe SOTUS exemption may not engage inan offering of ownership interests thattargets residents of the United States. Ifintends to resell the securities, it shouldonly offer for sale and resell the securitiesto purchasers who are not “U.S. persons”(as defined in Regulation S). Thismarketing restriction only applies to theparticular non-U.S. banking entity inconnection with its own activities withrespect to covered funds. The U.S.Federal Reserve Board has clarified thatthe SOTUS exemption is available toqualified non-U.S. banking entities withrespect to funds in which there are U.S.investors as the result of marketing orselling activities of unaffiliated third parties.

DisclosureIssuers that are not banking entities butpossibly are “covered funds” for purposesof the Volcker Rule are not expected to beresponsible for policing whether thebanking entities that buy their securities aredoing so in compliance with the VolckerRule. In other words, a “covered fund”issuer would not be expected to implementtransfer restrictions on its securities toprevent transfers to banking entities thatare subject to the Volcker Rule.

These issuers should consider, however,whether they are providing sufficientdisclosure in their offering materials topermit potential investors that are bankingentities to comply with the Volcker Rule. Tothe extent that the securities are offered toU.S. investors, U.S. federal securities lawimposes civil liability on issuers,underwriters and other distributionparticipants for material misstatementsand omissions contained in any offeringdocument circulated to prospective

investors or otherwise made (orally or inwriting) in connection with any securitiesoffering. For these purposes, amisstatement or omission is consideredmaterial if disclosure of the misstated oromitted fact would be viewed by areasonable person as having altered thetotal mix of information available.

Depending on the facts andcircumstances of a particular offering, thatan issuer may be considered to be a“covered fund” for purposes of the VolckerRule, which would restrict banking entitiesfrom owning the issuer’s securities, maybe considered material information thatwould be prudent to include in the offeringmaterials provided to potential investors.

ConclusionMost structured finance underwritersare banking entities subject to theVolcker Rule. Since the VolckerRule’s implementing regulationswere adopted in December 2013,structured finance underwriters havebeen evaluating on a case-by-casebasis whether the transactions theyunderwrite present Volcker Rulecompliance issues . Often theyrequest assurances that exemptiverelief would apply to them in theform of a contractual representationand warranty in the underwritingagreement or in the form of amemorandum from underwriter’sU.S. counsel. Depending on relevantfacts and circumstances, if no suchassurances can be given, disclosuremay need to be included in theoffering documentation regardingthe Volcker Rule’s potential impacton the offering.

10. Securitisation swaps – recentregulatory developments andchallenges ahead



EMIR and securitisationswapsWithin the EU, the regulatory reformsimpacting on the derivatives industry areprimarily to be found in the EuropeanMarket Infrastructure Regulation(Regulation (EU) No 648/2012, commonlyreferred to as “EMIR”) and the varioussecondary measures which have beenintroduced pursuant thereto. Most ofthese reforms have been devised primarilywith traditional over-the-counter (OTC)derivatives in mind. However, they applyto all OTC derivatives, and thus also applyto swaps entered into by securitisationissuers in connection with securitisationtransactions. Many of these regulationsalso apply to swaps entered into inconnection with covered bonds, althoughsome important differences do apply.

Flow market derivatives, such as vanillainterest rate swaps, currency swaps andcredit default swaps, are characterised bybeing both highly standardised and highvolume, where it is common for parties tohave many outstanding transactionsbetween them at any point in time. It is,therefore, unsurprising that when theserules are applied to more bespokederivative transactions, such assecuritisation swaps, difficulties can arise.

Securitisation swaps are highly bespokeinstruments. The terms of the transactionare usually tailored to meet the specificfeatures of the securitisation to which theyrelate, thus departing from the morestandard form contracts seen in the flowmarket. For example, whereas most flowmarket interest rate swaps will have a fixednotional amount which applies for the lifeof the swap, or a pre-determined notionalamount profile that is agreed at the outset,in many securitisation swaps, the notionalamount will be linked either to theoutstanding balance of the notes, or to theperforming balance of the underlying assetpool backing the notes, and, accordingly,may fluctuate unpredictably over the life ofthe transaction. Because of this, pricingand trading securitisation swaps requires adetailed knowledge of the underlyingasset portfolio and the broader terms ofthe securitisation transaction. This isvery different from the way in whichmarket makers price more standardOTC derivatives.

The nature of securitisation issuers asspecial purpose vehicles also has animpact on the number of transactions theyenter into. Most securitisation issuers willonly enter into a small number oftransactions at the time the notes areissued, and will not subsequently enter

into any additional swaps or even amendthose existing swaps. Even in the case ofprogramme issuers, they will only enterinto a limited number of swaps inconnection with each issue. This is areflection of the fact that securitisationissuers have only limited assets, and arebound by covenants to apply those assetsin specific, pre-defined ways, meaningthey have no flexibility to change the waythey deal with their assets over the life of atransaction. This is very different from thesituation with financial or corporateentities, or even investment funds, whichmay enter into numerous OTC derivativeson a continuous basis.

When assessing the impact the EMIRreforms have on securitisation swaps, thereforms can be classified into two broadcategories. The first category can bedescribed as administrative or process-related, and are reforms designedprimarily to ensure that parties haveaccurate records of the transactionswhich they enter into and procedures inplace to identify and resolve anydiscrepancies between them as to theterms of those transactions. The secondcategory are those which are designed toreduce or mitigate the counterparty riskassociated with derivative transactions.While the first category of reforms has

It is almost seven years since the height of the crisis which engulfed global financialmarkets in September 2008. During those seven years, regulators around the worldhave responded with many reforms, and a particular target of those reforms has beenthe global derivatives industry. While these reforms have not been primarily directed atsecuritisation swaps, they are, nevertheless, having a significant impact on suchswaps, and are likely to have even more of an impact in the years ahead.

This article discusses the EMIR reforms which apply in the EU, analysing the impactwhich those reforms have for securitisation swaps, and some of the resultingchallenges and difficulties.



now largely bedded down, the regulatorsare still formulating many of the rules togive effect to the second category.

Classification of transactionpartiesBefore considering the impact of thevarious EMIR regulations on securitisationswaps, it is useful to pause to considerhow EMIR classifies entities, whi ch in turndetermines to what extent the variousrules apply to a swap transaction.Broadly-speaking, EMIR divides entities intwo ways. First, there is a divisionbetween EU entities and non-EU entities(referred to as third country entities, orTCEs). EU entities are then divided intoone of three categories for the purpose fordetermining whether or not they aresubject to the various rules. The first ofthese categories is financialcounterparties, such as banks. Inpractice, the hedge counterparty enteringinto a swap with a securitisation issuer willalmost always be a financial counterparty.Entities which are not financialcounterparties are referred to as non-financial counterparties (NFCs), and are inturn sub-divided into what are termedNFC+ and NFC– entities, depending onwhether the aggregate notional amount ofderivative transactions which they enterinto exceeds a particular threshold (oftenreferred to as the clearing threshold).However, determining whether or not anentity has entered into transactions whichexceed the clearing threshold is not asstraightforward as it may initially appear,for two reasons described below. TCEsare similarly divided into entities equivalentto financial counterparties, NFC+s orNFC-s. As discussed below, however it isnot always the case that the various rulesapply to a TCE in the same way as theyapply to an equivalent EU entity.

First, in calculating the aggregate notionalamount of derivative transactions, hedging

transactions should be excluded. Whilethe precise definition of what constitutes ahedging transaction is complex, in mostcases, the types of swaps entered into bysecuritisation issuers are likely to fall withinthis definition.

Secondly, and more difficult, it is not justthe aggregate notional amount of non-hedging derivative transactions enteredinto by the entity itself which needs to beconsidered, but also non-hedgingderivative transactions entered into byother members of the group to which theentity belongs. For this purpose, an entitycan belong to the same group as anotherentity if one entity is in a position toexercise dominant influence or controlover the other entity, or if a third entity is ina position to exercise dominant influenceon control over both entities. This isessentially an accounting determinationrather than the determination that wouldapply for many other regulatory purposes.This presents an issue for manysecuritisation issuers because, while it willusually be established as an “orphan”SPV, it is not uncommon for such entitiesto be consolidated with the originatorbank or another institution for accountingreasons on the basis that that otherinstitution does have dominant influenceor control over the issuer. Whether this isthe case can also change over the life of atransaction as, for example, noteholderschange or the structure of other entities inthe group changes. Thus, while it may berelatively easy to conclude that asecuritisation issuer would be a NFC–when viewed on a standalone basis, it ismuch more difficult to reach thisconclusion if the issuer forms part of alarger corporate group. It is also possiblethat, even if an issuer is a NFC– at thetime it enters into a transaction, it maysubsequently become a NFC+, andthus become subject to a higher levelof regulation.

A further complication arises in the caseof TCEs. While such entities are notgenerally themselves subject to EMIR, tothe extent that the hedge counterparty isan EU entity, the rules will still apply.However, there is inconsistency in howthe various rules under EMIR apply totransactions with TCEs. While in mostcases parties are required to comply withthe level of regulation which would applyif the TCE were established in the EU(and was therefore either a NFC+ orNFC–), this is not always the case. Inparticular, as discussed in more detailbelow, in the case of the mandatorymargining rules, EU entities which arefinancial counterparties or NFC+s arerequired to exchange margin with allTCEs, regardless of whether the TCE inquestion would be classified as a NFC+or NFC– entity if it was established in theEU.

It is likely that this group test, and how itapplies to TCEs, will be one of the issuesconsidered during the review of EMIRwhich is to be undertaken later this year(2015). Whether this results in anyreforms, and if so whether those reformsprovide some form of relief forsecuritisation issuers, remains to be seen.

The first category –administrative andprocedural requirementsAs noted above, the first category ofEMIR reforms are essentiallyadministrative and process-related, andcomprise the following: (i) a requirementfor timely confirmation of transactions,(ii) procedures for reconciling portfolios oftransactions, (iii) procedures for identifyingand resolving disputes, (iv) procedures forcompression of portfolios of transactionsand (v) transaction reporting.

Of these, the compression rules areunlikely to be relevant for most



securitisation swaps, as they only applywhere there are in excess of 500transactions outstanding betweenthe parties.

The requirement for portfolioreconciliation requires the exchange ofportfolio information between the partieson a periodic basis, which for mostsecuritisations will be either annually(where the issuer is a NFC–) or quarterly(where the issuer is a NFC+). In mostcases this should not be onerous giventhe small number of swaps which theissuer will enter into, and the fact that theterms of those swaps are unlikely tochange over the life of the transaction.However, corporate service providersresponsible for managing SPVs do needeither to have systems in place to carryout this reconciliation, or appoint a thirdparty to do so on the issuer’s behalf. Theelement of these reconciliationrequirements which is most likely tocause an issue is the requirement that theparties exchange mark-to-marketvaluations of the transactions. Althoughthis requirement only applies where theissuer is a NFC+, it may nevertheless bedifficult for the issuer to calculate thismark-to-market value, and in many casesit may need to appoint a third party to dothis calculation on its behalf.

The dispute resolution procedures areusually addressed by inserting provisionsinto the swap documentation setting outhow the parties will go about resolvingany disputes should they arise.

The transaction reporting requirementscan present a challenge for securitisationissuers, because in order to reporttransactions it is necessary for an entityto have a relationship with a traderepository. This has timing and costimplications, particularly for an entitywhich is only ever likely to enter into a

very small number of transactions.However, the practice which is largelydeveloping in the market is for issuers todelegate responsibility for reporting to thehedge counterparty, and most hedgecounterparties are now willing to providethat service.

Finally, the requirement for timelyconfirmation of transactions can presentsome challenges. In many securitisations,the swaps are “priced” at the same timeas the pricing of the notes, which willusually occur a period of time before theclosing date of the notes. Traditionally,this “pricing” would not actually result in abinding transaction coming into placebetween the issuer and the hedgecounterparty. Rather, the swap wouldonly actually be entered into at closing,even though the rates that will apply willbe those that were determined at thetime of pricing. This reflects the fact that,particularly for a standalone issuer, part ofthe analysis underpinning the bankruptcyremoteness of the issuer rests on the factthat it has not entered into transactionsprior to the closing date.

However, where the hedge counterpartybooks the swap in its system at the timeof pricing, the requirement for timelyconfirmation means that thedocumentation for the swap needs to beexecuted (and become effective) soonafter the transaction is booked – withinone or two business days depending onwhether the issuer is a NFC+ or NFC–.This represents a departure from theconventional approach described above.

The second category –mitigating counterpartycredit riskWe turn now to the second category ofreforms, being those designed to reduceor mitigate the counterparty risk

associated with derivative transactions.There are two broad planks to thesereforms: (i) the clearing obligation and (ii)mandatory margining requirement forswaps which are not subject to theclearing obligation. Both these reformshave the potential to have significantimpact on securitisation swaps, althoughthe extent to which they will apply is likelyto vary considerably from transactionto transaction.

The clearing obligationThe policy objective underpinning theclearing obligation is to require as manyderivative transactions as possible to becleared through a central counterparty soas to replace the counterparty risk withexposure to the clearing house. Clearinghouses across the EU have beenestablishing offerings to facilitate clearingof of such transactions, but this is aprocess which takes time, and not alltransactions will ultimately be capable ofbeing cleared. As clearing housesbecome capable of clearing a particulartype of transaction, the regulators maymake an order extending the clearingobligation to that type of transaction.Once that occurs, any transactions ofthat type must be cleared through aclearing house unless one of the partiesto that transaction is a NFC– or, in thecase of TCEs, would be a NFC– if it wasestablished in the EU.

In practice, whether or not the clearingobligation applies to a particulartransaction actually involves a two-stepanalysis. The approach taken by ESMA isto define a category of derivatives whichare subject to the clearing obligation byreference to a small number of variables,resulting in a relatively broad category.However, not all transactions which fallwithin these broad categories will actuallybe capable of being cleared by a clearing



house, as the clearing house willgenerally impose tighter parameters forthe transactions it will accept for clearingthan those which define the categoryitself. Thus, it is only those transactionswhich form part of a category oftransactions which ESMA has declaredare subject to the clearing obligation andwhich a central counterparty will acceptfor clearing which need to be cleared.

For the time being, the effect of this isthat most securitisation swaps areunlikely to be subject to the clearingobligation for either or both of thefollowing the reasons. First, if the issuer isa NFC– (or a TCE which would be aNFC– if it was established in the EU),then it will not be subject to the clearingobligation, although that would change ifthe issuer was subsequently become aNFC+ (or equivalent to a NFC+), even ifthat was merely the result of transactionsentered into by other entities within thesame group.

Secondly, most securitisation swapscontain bespoke features which mean thatthey would not be accepted by anyclearing house at the present time. Whilethis could change in the future, there is noindication that it is likely to do soimminently. Nevertheless, if this did changeat some point during the life of a swap,and the issuer was a NFC+, it wouldbecome necessary to clear the swap.

At this time, no securitisation swaps inthe European market are structured in away that would make it possible for themto be cleared through a centralcounterparty. Doing so would present anumber of significant challenges, not onlyto the terms of the swaps themselves,but also to the broader structuralframework that underpins securitisation.The only way in which a securitisationswap could be cleared would be by the

hedge counterparty agreeing to clear theswap on the issuer’s behalf. However, themodel by which this occurs under EMIRis a “riskless principal” model, underwhich the issuer would be required tocover the hedge counterparty for all costsand obligations which it incurs to theclearing house in connection with thatswap. Whether a hedge counterpartywould be willing to clear the swap on theissuer’s behalf, while also agreeing to thestandard limited recourse and non-petition provisions which are central toestablishing the bankruptcy remotenessof the issuer (and which are inconsistentwith the “riskless principal” model)remains to be seen – not least becausedoing so is likely to have significantimplications for the regulatory capitaltreatment of the swap for the hedgecounterparty. Similarly, under the “risklessprincipal” model, the hedge counterpartywould only be obliged to perform itsobligations to the issuer to the extent thatthe clearing house performs its obligationto the hedge counterparty. Whether therating agencies would be willing to acceptthis limitation, or whether they wouldrequire the hedge counterparty tocontinue to perform, even in the case of aclearing house default, also remains to beseen. Finally, and at a purely practicallevel, as collateral would need to beprovided to the clearing house inconnection with the swaps, and theissuer is unlikely to have eligible collateralavailable for this purpose, that collateralwould need to be provided, either by thehedge counterparty itself, or by a thirdparty, which would introduce anadditional cost into the securitisation.

The only alternative would be to terminatethe swap, which would leave the issuerunhedged, or to amend the swap in someway so that it was no longer subject tothe clearing obligation. Terminating oramending a securitisation swap in this

way would, however, be difficult, due tothe restrictive covenants which apply inmost securitisations, as well as the factthat the issuer would not have access tothe collateral which it would need toprovide for posting to a clearing house inconnection with the swap.

MarginingMore likely to be an issue forsecuritisation swaps are the mandatorymargining rules. These rules will apply toall OTC derivatives which are not clearedthrough a central counterparty, unlessone of the parties to that that derivative isa NFC–. In contrast with the clearingobligation, however, for the purpose ofthese draft rules, only entities establishedin an EU member state can be classifiedas a NFC–. Thus, in the case of entitiesestablished outside the EU, they will besubject to the margining rules regardlessof the notional amount of derivatives theyenter into.

At time of writing, the mandatorymargining rules are still in draft form, andhave been subject to extensivecomment from across the financialindustry. However, if they were to beimplemented in their present form,where the issuer is either a NFC+ or aTCE, the transaction would be subjectto the mandatory margining rules andboth parties would be required toexchange mark-to-market variationmargin. In addition, if the aggregatenotional amount of transactionsoutstanding between the partiesexceeds a particular threshold, theparties will also be required to exchangeinitial margin. The collateral eligible to beprovided as initial or variation margin isessentially limited to high quality liquidcash and securities.

As noted above, most of the EMIR rules



have been devised with the high volumeflow market in mind, and do not applyparticularly well to securitisation swaps. Inthe case of the administrative andprocess-related requirements this islargely a case of parties complying withrules even though they do not appear tooffer much benefit in the context ofsecuritisation swaps. In the case ofmandatory margining, however the failureof the rules to take into account thespecific nature and features ofsecuritisation swaps means that, if therules were implemented in their currentdraft form, many securitisations wouldsimply be unable to comply with them.

The key difficulty is, of course, thatsecuritisation issuers do not have accessto eligible collateral to post as margin.Thus, in order to be able to post margin,the issuer would need access to someform of collateral facility or arrangementto give it access to such eligiblecollateral, which would introduce anadditional cost into the securitisation. It isalso unclear how requiring the issuer topost margin which is provided throughsuch an arrangement would actuallyprovide any net benefit to the financialsystem, as it would simply replace thehedge counterparty’s exposure to theissuer with the collateral liquidity facilityhaving what is essentially exactly thesame exposure to the issuer.

What the draft mandatory margining rulesfail to take into account, however, is thatsecuritisation swaps already containfeatures which mitigate counterparty riskfor both parties. First, in the case of thehedge counterparty’s exposure to theissuer, the hedge counterparty is aalready a secured party, ranking eithersenior to or pari passu with thenoteholders in the issuer’s paymentwaterfall. Thus, although the hedgecounterparty is not receiving cash or

securities collateral, it is neverthelesssecured on the portfolio of assets whichare the subject of the securitisation.

Secondly, in the case of the issuer’sexposure to the hedge counterparty,standard rating agency criteria includerating requirements for the hedgecounterparty, and obligations to postcollateral if the hedge counterparty isdowngraded below a particular threshold.If the hedge counterparty is furtherdowngraded below a second, and lower,threshold, then it is obliged to procure aguarantee of its obligations under theswap or transfer the swap to areplacement hedge counterparty whichdoes have the required rating. Theserequirements, and in particular therequirement for the hedge counterparty totransfer the swap to a replacement entityupon a second downgrade, are arguablybetter suited to the nature ofsecuritisations than merely requiring theparties to exchange variation margin ascontemplated under the draft rules. Thisis because the rating agencyrequirements are designed to avoid theissuer ever facing a defaulting hedgecounterparty. In contrast, the mandatorymargining rules would simply mean thatupon a default by the hedgecounterparty, the issuer would be able toapply the collateral against anytermination amount payable by the hedgecounterparty. This would then leave theissuer with the need to find areplacement swap counterparty to avoidbeing unhedged. As the issuer is usuallya SPV, it will have limited ability to findsuch a replacement without theassistance of an arranger, which may notalways be available.

It is unfortunate that the draft marginingrules do not take these features intoaccount, particularly given that, in recentyears, a market has developed for the

transfer of securitisation swaps fromhedge counterparties that have beendowngraded, thus providing evidence ofthe efficacy of the rating agencyapproach.

This is also unfortunate given that thedraft margining rules do provide anexemption from the requirement for acovered bond entity to post collateral to ahedge counterparty provided it satisfiescertain conditions that are very similar tothe features of securitisation swapsdescribed above. Given the similaritybetween covered bond swaps andsecuritisation swaps, and the similarfunding purposes served by coveredbonds and securitisation, this differentregulatory treatment creates an un-levelplaying field between these two keywholesale funding strategies. Once again,it remains to be seen whether thisinconsistency will be addressed as part ofthe review of EMIR to occur in 2015.

Representations as toNFC statusGiven the significance of the classificationof the issuer as a NFC+ or NFC– (or,where the issuer is a TCE, as an entitythat would be a NFC+ or NFC– if it wasestablished in the EU), many hedgecounterparties require the issuer to makea representation to that effect. In mostcases, this representation is based on aform which has been formulated by ISDA,and which can be adopted by the partiesincorporating the terms of what isreferred to as the “NFC Protocol” into theswap documentation.

However, the NFC Protocol alsocontains an additional termination rightfor the hedge counterparty if the issuerceases to be a NFC–, and the partiesfail or are unable to comply with anyclearing requirements or other risk



mitigation techniques (of which the mostlikely to be problematic are themandatory margining requirements).Including this termination right isinconsistent with the general restrictionswhich apply to the termination ofsecuritisation swaps which are requiredby rating agencies and which arenecessary to minimise the risk of theswap terminating while the notes arestill outstanding, thereby leaving theissuer unhedged. No clear consensushas yet developed in the market as towhether this termination right isincluded. In some ways, it is similar to aright to terminate for illegality, whichdoes generally apply to securitisationswaps. The similarities are particularlypronounced at the moment because therules for mandatory margining are stillbeing developed, and therefore whetheror not the parties would be able tocomply with those rules should theissuer become a NFC+ is difficult toassess. It remains to be seenwhether this termination right willbecome common once those rules havebeen finalised.

ConclusionAlthough primarily devised for the flow market, the EMIR regulatory reforms forOTC derivatives also apply to securitisation swaps. Some of these reforms areprimarily administrative or process-related and it is relatively easy for securitisationswaps to comply with those rules. However, other reforms such as the clearingobligation and mandatory margining rules cannot be complied with within currentsecuritisation frameworks. Currently, it is unlikely that the clearing obligation appliesto any existing securitisation swaps, and the margining rules are still in draft form,but this will change over time. While these rules would only apply to securitisationissuers which are NFC+s and, in the case of the margining rules, TCEs, thedifficulty of determining that an issuer is definitely (and will remain) a NFC– meansthat, once the rules do apply, they will pose significant challenges forsecuritisations that seem unnecessary and unjustified at a policy level.


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Clifford Chance contacts (London)

Stephen CurtisPartnerT: +44 20 7006 2281M:+44 7717542517E: [email protected]

Andrew ForryanPartnerT: +44 20 7006 1419M:+44 7785700124E: [email protected]

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Clifford Chance contacts (Global)

Lee AskenaziPartner, New YorkT: +1 212878 8230M:+1 646 894 7345E: [email protected]

Daniel BadeaPartner, Bucharest T: +40 216666 101M:+40 722205607E: [email protected]

Scott BachePartner, SydneyT: +61 28922 8077M:+61 423 420 077E: [email protected]

Jeff BermanPartner, New YorkT: +1 212878 3460M:+1 914 960 2996E: [email protected]

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Maggie LoPartner, BeijingT: +86 106535 2212M:+86 13910851406E: [email protected]

Tiecheng YangPartner, BeijingT: +86 106535 2265M:+86 13910895267E: [email protected]

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Pieter van WelzenPartner, AmsterdamT: +31 20711 9154M:+31 650285809E: [email protected]

Daniel ZerbibPartner, ParisT: +33 14405 5352M:+33 610283459E: [email protected]

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Oliver KronatPartner, FrankfurtT: +49 697199 4575M:+49 1605309086E: [email protected]

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Leng-Fong LaiPartner, TokyoT: +81 35561 6625M:+81 8013859804E: [email protected]

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Lee Askenazi

Andrew E. Bryan

Edda Caputo

Timothy Cleary

Andrew Forryan

Robert Gross

Rebecca Hoskins

Kevin Ingram

Kathryn James

William Kalaher

Gareth Old

Allein Sabel

Martin Sharkey

Amer Siddiqui

We would like to thank the following people for their contributions to this publication:

Acknowledgements

Other contributors

Tineke KotheSenior Counsel, AmsterdamT: +31 20711 9146M:+31 655798941E: [email protected]

Rebecca HoskinsProfessional Support Lawyer, New YorkT: +1 212878 3118M:+917 861 1507E: [email protected]

A never ending road

Allein SabelAssociate, New YorkT: +1 212 878 3371M:+1 646 457 5254E: [email protected]

Andrew BryanSenior Associate PSL, LondonT: +44 20 7006 2829M:+44 7950121431E: [email protected]

Kathryn JamesSenior Associate, LondonT: +44 20 7006 4930M:+44 7535654220E: [email protected]

Martin SharkeySenior Associate, LondonT: +44 20 7006 1926M:+44 7961950432E: [email protected]

Amer SiddiquiSenior Associate, LondonT: +44 20 7006 4542M:+44 7931502772 E: [email protected]

Edda CaputoLawyer, LondonT: +44 20 7006 2976M:+44 79 4905 5485E: [email protected]

Timothy ClearySenior Associate, LondonT: +44 20 7006 1449M:+44 79 8495 6439E: [email protected]

William KalaherLawyer, LondonT: +44 20 7006 1443M:+44 74 1530 4604E: [email protected]



Notes


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