In a move that has been much anticipated by the finance market, the EU Commission published on 30 September 2015 a proposed Securitisation Regulation. The Proposed Regulation should be seen in the context of the EU Commission's plan to boost funding and growth across Europe by creating a Capital Markets Union, of which a recovery in the securitisation markets is acknowledged to be a key contributor.
The proposed Regulation is welcome since it will consolidate and replace provisions spread across several other regulations and, in doing so, will remove many of the inconsistencies which have caused headaches to market participants. In addition to consolidating existing provisions, the proposed Regulation will break new ground by taking a direct approach to the regulation of risk retention, requiring originators, sponsors and original lenders to retain the familiar 5% net economic interest, a marked movement away from the existing regulations which impose obligations only on regulated investors to check that transactions are compliant.
The proposed Regulation also represents a major step forward in setting out the framework which is expected to lead to a potential lessening of the disadvantageous capital treatment of securitisation transactions for banks and other regulated institutional investors, by proposing criteria for simple, transparent and standardised ("STS") securitisations.
This alerter looks at the scope of the proposed Regulation, summarises the new risk retention, due diligence and transparency rules and highlights the proposed STS criteria.
Scope of Regulation
Under the proposed Regulation, all of the existing, sector-based securitisation legislation1 relating to risk retention, due diligence and transparency is to be replaced by a new, all-encompassing regime applicable to "institutional investors", which is widely defined to encompass a broad range of securitisation investors including, for the first time, UCITS funds. The Regulation is divided into two main parts. The first part focuses on the rules that apply to all types of securitisation and the second part focuses on STS securitisation alone. With the exception of the due diligence requirements, the proposed Regulation will not have retrospective effect.
As mentioned above, the proposed new rules for retention contain several novel features. Under Article 4 of the Regulation, any one of the originator, sponsor and original lenders will have a direct obligation to retain a 5% net economic interest, defaulting to the originator if the sponsor and original lender are unable to reach agreement. This marks a change to the existing regime under which the obligation to ensure compliance - and the penalties for non-compliance - fall solely on investors, who will retain their existing obligations to check, as part of their due diligence, that the retention obligations are complied with. What happens in the case of multiple originators is unclear.
In a further development, SPVs established for the sole purpose of securitising exposures will not be permitted to act as retention holders. This reflects long-running regulatory concerns about the use of SPVs as "originators"; however, the requirements are much less restrictive than those proposed by the European Banking Authority in its paper of December 2014, which required originators to have "real substance" and hold exposures for a minimum period of time. Regulatory Technical Standards will be required in due course to provide full details of the new rules and, in the interim period between the coming into force of the proposed Regulation and the effectiveness of the new Standards, the old Regulatory Technical Standards will apply.
The new regulatory due diligence regime broadly mirrors the existing CRR rules. Article 3 of the proposed Regulation provides that institutional investors shall, before becoming exposed to a securitisation, verify various matters, including the soundness of the underlying asset criteria2, compliance with the risk retention and transparency requirements, the risk characteristics and structural features of the securitisation and whether the securitisation meets the proposed STS criteria. In addition, once exposed, institutional investors must establish and maintain written procedures to monitor the risk profile of their securitisation positions, perform regular stress tests, ensure an adequate level of internal reporting of material risks to management and be able to demonstrate to their regulator(s) a comprehensive and thorough understanding of their securitisation positions. The new rules apply to securitisations closed on or after 1 January 2011 and to revolving securitisations closed before that date, where new underlying exposures have been added or substituted after 31 December 2014.
Article 5 of the proposed Regulation sets out new disclosure rules requiring one of the originator, sponsor and securitisation SPV (identified as the applicable reporting body in the transaction documentation) to provide investors and regulators, via a website meeting stated criteria, with the following information: (a) periodic data on underlying asset performance; (b) key transaction documents; (c) a transaction summary for non-Prospectus Directive compliant deals; (d) where applicable, an STS notification (considered below); (e) any price-sensitive information pursuant to the Market Abuse Directive; and (f) information concerning significant events affecting the securitisation. Notably, the obligation is not to disclose the information publicly as is the case under the prospective regime set out in Article 8b of the Credit Rating Agencies Regulation. We believe that the proposed rules are intended to replace Article 8b of the CRA Regulation, but this is not expressly stated in the text. What the new rules mean is that information for private deals can stay private. As with the risk retention rules, Regulatory Technical Standards will be required in due course to provide full details of the new rules and interim rules will apply pending the effectiveness of these new Standards.
Articles 6 to 10 of the proposed Regulation set out the criteria for STS securitisation. The STS initiative is designed to breathe new life into the securitisation market by affording to bank investors favourable regulatory capital treatment3 in relation to their holdings of notes in compliant offerings. We expect that the same criteria, in due course, will apply to improve the regulatory treatment of investments in securitisations made by insurance companies under Solvency II, and also to define level 2B securitisations under the LCR Delegated Act. In order to be labelled "STS", originators, sponsors and issuers must jointly notify ESMA that the securitisation meets the relevant criteria by means of an "STS notification", which will then appear on an ESMA-maintained register. Different criteria apply depending on whether the deal is a term securitisation or an ABCP transaction. For the purposes of this alerter, we will focus on term securitisation criteria.
The simplicity criteria include the requirements that:
(a) the SPV should acquire the underlying assets by sale or assignment (so not synthetically) and appropriate trigger events should be included where the sale or assignment is deferred;
(b) the seller should represent that the underlying assets are unencumbered;
(c) there should be no active management of the portfolio (thereby precluding managed CLOs);
(d) underlying assets should be homogenous in terms of asset type, not being transferable securities, and there should be full recourse to underlying debtors;
(e) underlying exposures should not include securitisations;
(f) assets should be originated in the ordinary course of the originator's business, in accordance with its usual underwriting criteria and to the exclusion of non-verified residential mortgage loans;
(g) defaulted exposures should be excluded as should those to credit-impaired obligors;
(h) subject to certain exceptions, underlying obligors should have made at least one payment to the underlying lender; and
(i) repayment to noteholders should not depend substantially on the sale of assets that secure the underlying loans (which may in practice rule out many CMBS transactions).
The standardisation criteria include the requirements that:
(a) the risk retention requirement is met (see above);
(b) interest rate and currency risk should be hedged and only derivatives intended to achieve that purpose should be included in the securitisation, documented according to international standards4;
(c) interest payments on the underlying assets and on the notes should not be based on complex formulae or derivatives;
(d) post-enforcement or -acceleration, principal should be distributed in accordance with seniority, cash should not be "trapped" and there should be no provisions requiring automatic liquidation of the underlying exposures at market value;
(e) there should be credit impairment-based early amortisation triggers and triggers to end the revolving period in revolving transactions; and
(f) the transaction documentation should clearly specify the responsibilities of ancillary service providers; should provide for the continuity of credit-impaired swap, liquidity and account bank providers; should provide clearly for what is to happen upon the default or delinquency of underlying debtors and upon the occurrence of various triggers; should specify the payment priority and any changes thereto occasioned by trigger events; and should provide for the timely resolution of conflicts, with voting rights clearly delineated and the responsibilities of the trustee clearly defined.
The transparency criteria include the following:
(a) the originator, sponsor and SPV should provide investors with historical default and delinquency data for substantially similar exposures to those being securitised (with the basis of claiming similarity being disclosed) for a period of at least seven years for non-retail exposures and five years for retail exposures;
(b) a sample of underlying exposures should be verified by an appropriate and independent party, including verification that the data provided in respect of underlying exposures is accurate with a confidence level of 95%;
(c) the originator or sponsor should provide investors with a pre-pricing and ongoing cash-flow; and
(d) the originator, sponsor and SPV should be jointly responsible for compliance with Article 5 of the Regulation and should provide the information required by Article 5 to investors prior to pricing. Final documentation should be provided to investors no later than 15 days following closing.
Non-compliance under the proposed Regulation can result in strict penalties, including public censure, an order to desist from conduct, a temporary ban on activities, the imposition of fines and, at Member State discretion, criminal sanction.
Time-line to implementation
While the proposed Regulation is not excessively complicated or controversial, there are still matters that require final decision, such as the status of synthetic securitisations. Regulatory Technical Standards are to be published and agreed and the legislation will need to be reviewed by EU legislative bodies. Even though Capital Markets Union is a priority, of which STS securitisation is just one part, it would be optimistic, in our view, to expect the proposed Regulation to come into force much before 2017.
1 The Capital Requirements Regulation in the credit institution sector; the Solvency II Directive in the insurance and reinsurance sector; and the Alternative Investment Fund Managers Regulation in the asset management sector.
2 The requirement, which is stated to be applicable to non-credit institution/non-investment firm originators/original lenders only, is that institutional investors must verify that all originator/original lender credits (i.e. not just the securitised exposures) are originated on the basis of sound and well-defined criteria.
3 See the proposal to amend the Capital Requirements Regulation – released on the same date as the Securitisation Regulation but beyond the scope of this alerter.
4 Note that Article 27 of the Regulation includes an amendment to EMIR that removes the clearing obligation for derivatives in STS securitisations.