UK: EU Commission Sets Sights On Minimum Standards For Credit Servicers

Last Updated: 16 July 2018
Article by Michael Huertas, Markus Schrader and Katja Michel

QuickTake: New rules aim for a more single servicers market but potentially at a cost

Credit servicers, originators and credit purchasers will all be impacted in the form of new authorization requirements, including conduct of business obligations, (also creating possible new options), notification requirements to enforce against and/or transfer in-scope credit agreements as well as a breadth of standard form contracts and polices that will need to be implemented. Affected firms will want to use the time between now and potential entry into full force by July 2021 to lobby and prepare for a move to these new standards.

The EU's proposed Servicing Directive – why now?

For originators and investors, credit servicers play an important role in a breadth of financial transactions, in particular for securitizations and non-performing loans and exposures (collectively herein NPEs), often framed as the "legacy hangover from the crisis." It should therefore come as no surprise that the following reform moves to improve and harmonize the EU regulatory and legislative framework for both securitizations as well as NPEs. The EU Commission has now decided—independent of a Capital Markets Union priority and Banking Union supervisory objectives (especially on resolving NPEs)—to introduce a legislative proposal for a Directive on credit servicers, credit purchasers and the recovery of collateral1 (the Servicing Directive) which was published on 14 March 20182 and is intended to be adopted in 2019. The proposal is made on the basis of two separate consultations on elements that both form part of this new piece of EU legislation, and the approach being taken means there is a strong political will for it to be approved as is. This Client Alert assesses the impacts of this far-reaching proposal and how it might affect originators, investors and services.

Before delving into detail, it is important to note that this proposal is (currently) an EU Directive3, so whilst it may aim to advance harmonization for a pan-EU market based on minimum standards of servicing quality, the Directive, when published in the Official Journal of the EU, will need to be transposed in each of the EU-27 Member States. For the UK, which will presumably by then cease to be a member of the EU, it will remain interesting to see whether the Servicing Directive would be copied-out, in particular given that the UK has long been both a standard setter and knowledge center for servicing standards.

Irrespective of the UK's departure, the Servicing Directive will conceivably not only translate into documentation but also operation-based changes. This will presumably affect a wide range of stakeholders and may also yield costs over and above those highlighted by the EU Commission in its communications on the Servicing Directive. Despite all of this, the proposal is a necessary step both in creating a more "single" Single Market for financial services across the EU but also in allowing pockets of talent, often borne out of the depths of the 2008 Great Financial Crisis, to be rolled out across the wider EU. This has the potential for wide-reaching opportunities for a wide range of stakeholders and transactions.

Putting the proposal and its priorities into context

As with the Banking Union work on NPEs in the form of the European Central Bank, acting in its Single Supervisory Mechanism capacity (ECB-SSM) rules and now EU efforts in the form of an EU NPL Action Plan4, a lot of the concepts introduced in the Servicing Directive build upon the experiences of two jurisdictions hardest hit by the crisis – Ireland and Spain. One of the key "game-changers" in the proposals is a "common accelerated extrajudicial collateral enforcement procedure" or AECE for short5. Conceptually the AECE is simple, i.e. it offers out of court work-out options in the form of a "common menu" of solutions–many of which were used in Ireland and Spain, albeit the Servicing Directive balances the needs of consumer protection and workable divestment and secondary market channels in a much more pronounced manner. This ties on to the ECB-SSM's rules on NPLs that are being rolled out to the wider EU in the form of the EU Action Plan. In many ways the Servicing Directive aims to expand the reach of the menu to all EU Member States. The AECE is part of the beginning of offering further work-out options and thus greater increase in certainty of recovery of collateral. That alone should be applauded as a quantum leap and an important tool for investors and originators alike.

The second key change is the introduction of measures, which tack on to those in the EU Action Plan on NPLs, and, coupled with the work of the European Banking Authority (EBA), aim to facilitate a greater development of a sustainable secondary market for NPLs. The Servicing Directive's common standards aim to underpin a move in that direction. The same is true in ensuring that buyers and investors in credit portfolios do not suddenly take those portfolios outside the scope of EU and national consumer protection rules that would apply and be in place in respect of those portfolios rest with originators in a pre- as well as post-enforcement environment. The Servicing Directive's proposal to prevent disapplication of rules protecting consumers follows similar action taken in national Member States, notably Ireland. Those benefits however do come with some barriers that the Servicing Directive's Arts. 18 and 19, unless lobbied, would mean to transfers of in-scope credit agreements and in respect of an ability to enforce against these.

Lastly, the Servicing Directive, although one would not consider this on the face of it, introduces some groundwork for 'statutory prudential backstops' to discourage new NPEs. This translates into minimum levels of provisions and deductions that in-scope financial services firms (mostly those regulated as credit institutions and other firms regulated in relation to bank-like activity) will need to apply to their prudential capital own funds requirements to cover both incurred and expected losses on newly originated exposures that become non-performing. In addition, as much requested by a range of policymakers, the Servicing Directive swings in (the somewhat criticized and controversial topic) of minimum standards for national asset management companies i.e. "bad banks" (AMCs).

In summary, the Servicing Directive provides a lot of punch in a very compact form of legislative proposal. That punch is very much intended to be complementary to other EU and ECB-SSM led policy and/or supervisory workstreams.

So who is in scope?

Despite the wide range of exemptions, the Servicing Directive covers a breadth of bank and non-bank financial institutions, both as originators of in-scope credit agreements, but also as purchasers. This has the potential to impact a range of transaction types and existing as well as new relationships.

In scope

Out of scope

Servicers

  • Credit servicers acting on behalf of a credit institution in respect of a credit agreement issued by a credit institution or by its subsidiaries.
  • Credit servicers acting on behalf of a credit purchaser in respect of a credit agreement issued by a credit institution or by its subsidiaries.

Self-servicing by credit institution

  • Servicing of a credit agreement carried out by a credit institution or its subsidiaries established in the EU. NB it is not clear whether this would apply to agents and trustees in a range of syndicated loan transactions.

Non-EU credit agreements

  • Servicing of a credit agreement issued by a non-EU credit institution or its subsidiaries UNLESS such credit agreement is "replaced by a credit agreement"6 issued by an EU institution or its subsidiaries.

Purchasers

  • Credit purchasers of a credit agreement issued by a credit institution or by its subsidiaries.

Creditors and Borrowers

  • Application of AECE to secured credit agreements concluded between creditors and borrowers which are secured by collateral.

Specific Creditors and Borrowers

  • AECE will not apply to the following types of secured credit agreements concluded between:
    • Creditors and Borrowers that are "consumers" within the meaning of the Consumer Credit Directive;
    • Creditors and Business Borrowers that are non-profit making companies;
    • Creditors and Business Borrowers that are secured by collateral that qualifies as:
      • Financial collateral arrangements;
      • Immovable residential property, which is the primary residence of a business borrower.

Importantly the following definitions are perhaps wider than in other EU/national legislation. They are also in parts rather imprecise or uncertain. This is more down to a disconnect between the technical drafting matching the precise supervisory objectives set in the proposal and the recitals of the Servicing Directive. This matters, as much tidying up is required in respect of some of these core definitions if they are to follow the policymakers' intentions:

  1. "Creditor" means a credit institution or any legal person who has issued a credit in the course of his trade, business or profession, or a credit purchaser. NB the scope above also includes subsidiaries;
  2. "Borrower" means a legal or natural person who has concluded a credit agreement with a creditor;
  3. "Business Borrower" means a legal or natural person, other than a consumer who has concluded a credit agreement with a creditor;
  4. "Credit Purchaser" means any natural or legal person other than a credit institution or a subsidiary of a credit institution which purchases a credit agreement7 in the course of his trade, business or profession;
  5. "Secured Credit Agreement" means a credit agreement concluded by a credit institution or another undertaking authorized to issue credit8, which is secured by either of the following collateral:
  • A mortgage, charge, lien9 or other comparable security right commonly used in a Member State in relation to immovable assets;
  • A pledge, charge, lien or other comparable security right10 commonly used in a Member State in relation to moveable assets.

The definition of a credit agreement and a secured credit agreement is paramount as draft Art. 18 and subsequent provisions introduce a pre-notification requirement for EU credit purchasers in terms of a creditor informing its competent authorities (National Competent Authorities (NCAs) but possibly the ECB-SSM) in terms of the transfer to a credit purchaser and a credit purchaser informing the competent authorities in the EU as to who will undertake the credit servicing. The information requirements apply equally in relation to enforcement of a credit agreement and/or transfer to another credit purchaser. Moreover, the Servicing Directive also introduces an obligation for non-EU domiciled credit purchasers to appoint an "EU Representative." This will also be important prior to as well as at enforcement of a credit agreement. We anticipate that if the requirement stays as it is (and it is a tectonic conceptual change for a number of legal systems), this will require notification of details on the credit agreement to the NCA.

Notification does not (currently) equate to a clearance to enforce requirement, but this requirement seems potentially (rather) burdensome and will likely merit lobbying to something more workable. Similar obligations apply, courtesy of Art. 19, to the transfer of any credit agreement from one purchaser to another. In the absence of any workable transaction reporting solution (along MiFID II or EMIR terms), this also appears burdensome.

So while the above five definitions require additional merit, the definition of what constitutes the activities of a credit servicer is comparably more precise, even if it is very broad in the scope of who might be captured by this definition. A "credit servicer" means any natural or legal person, other than a credit institution or its subsidiaries, which carries out one or more of the following activities on behalf of a creditor:

  • monitors the performance of a credit agreement;
  • collects and manages information about the status of the credit agreement, of the borrower and of any collateral used to secure the credit agreement;
  • informs the borrower of any changes in interest rates, charges or of payments due under the credit agreement;
  • enforces the rights and obligations under the credit agreement on behalf of the creditor, including administering repayments;
  • renegotiates the terms and conditions of the credit agreement with borrowers where they are not a "credit intermediary" for the purposes of the Mortgage Credit Directive and/or the Consumer Credit Directive;
  • handles borrowers' complaints.

Firms that risk falling into this scope across a number of transactions and asset classes, may wish to consider documenting amongst themselves which entity will be designated to act as a "credit servicer" for the purposes of the Servicing Directive. This is important as credit servicers are required to obtain authorization in its home Member State prior to commencing activities within the relevant territory.

Authorization of credit servicers and post-authorization obligations

Authorization requirements will mean that existing servicers or those new entities wishing to become such will need to file applications with the respective NCAs. The pre-requisites to becoming authorized are similar to EU-led rules and principles that apply to other regulated financial markets and participants. Even if there are some transferable concepts, the Servicing Directive's focus on fitness and propriety of key function holders and senior management as well as governance, internal control and compliance mechanisms as well as a "fair and diligent treatment of borrowers" policy (a FDTB Policy) will likely require specialist and tailored legal and regulatory input reflective of both the applicant credit servicer firm and the jurisdictions and relevant markets in which the applicant firm intends to operate. The FDTB Policy is thus likely to need to be drafted as a dynamic "living" document, which sets a global top down tone on compliance with core obligations/principles but also is supplemented by "jurisdiction" and "borrower-type" specific chapters.

Just as the principles, threshold conditions and document obligations to be satisfied and submitted as part of an application process build upon existing yet tailored EU principles, the process and threshold conditions for an NCA to withdraw a license build upon similar concepts. Reasons for withdrawal include: non-use of licence, ceasing to engage in activities; false statements; breach of threshold conditions and/or breach of applicable conduct of business/consumer protection rules in respect of borrowers.

The Servicing Directive introduces measures permitting the passporting of credit service activities. Approvals between host and home state NCAs are required to be communicated within 30 working days of receipt of a passport notification. We anticipate that a range of commercial opportunities might arise for pools of talent that have proven themselves during the Great Financial Crisis to replicate standards and solutions across the EU. The passporting principles introduced both a branch passporting, i.e. physical presence, and a services passport. Cross-border supervision of credit servicers is covered by supervisory colleges—a proven concept in EU financial services regulation—which here is also extended to "agents" of the credit servicer appointed in another Member State—as a result of outsourcing or an EU domiciled "representative" in the case a credit purchaser is domiciled ex-EU. This latter concept allows the EU authorities to monitor and hold credit purchasers (and respective credit servicers) accountable where these are otherwise domiciled outside of the EU. For US investors this probably may lead to additional costs.

Credit servicers will however need to be mindful that in certain jurisdictions, notably in Germany, some aspects of the "credit servicing" activity in the Servicing Directive may also trigger requirements to apply and/or obtain an appropriate licence under Germany's Banking Act (Gesetz über das Kreditwesen – KWG). Consequently, any such commercial/strategic planning for existing and/or new servicers may require some regulatory mapping as to what additional national driven or concurrent EU-legislative and/or regulatory requirements may need to be complied with. Whilst we anticipate that forthcoming technical standards may set out undertakings to be given in relation to a credit servicer passport notification, it might be advisable for the relevant cover letters to a home state NCA to be clear on disclosure. This is the case, as cover letters accompanying passport notifications that are submitted to the home state NCA may also—with the notification itself—be passed on to the host state NCA. If such additional disclosures are passed on, it signals a clear commitment to observance of the applicable regime in respect of borrower-types and markets in the host state, and this might translate into a more favorable level of supervisory engagement.

The Servicing Directive also points to existing EU workstreams, notably the NPL Action Plan in respect of data standards, and mandates the European Banking Authority to develop additional templates for credit servicers.

What is the impact on originators and investors?

The Servicing Directive also introduces minimum requirements that an agreement between a credit servicer and the defined term of a creditor (thus originator and/or investor/purchaser) must fulfil. This Credit Servicer Agreement must provide:

  1. A detailed description of credit servicing activities that the credit servicer is to carry out;
  2. Remuneration levels of the credit servicer and calculation methodology;
  3. The extent to which the credit servicer can represent the creditor in relation to the borrower;
  4. An undertaking by the parties to comply with EU and national laws applicable to the credit agreement, including in respect of consumer protection.

Whilst most of these changes may seem to be expected, it is important to note that the NCAs policing the credit servicer and performance of credit servicing standards, in line with policing compliance with national consumer protection and/or other conduct of business rules, as well as the obligations of the Servicing Directive, will presumably use the Credit Servicer Agreement as the base case to check whether compliance is being observed, evidenced, remedied in case of breach and/or performance as well as record-keeping audited.

Record-keeping also takes center stage in stringent compliance obligations that the credit servicer must keep and maintain (presumably readily available) for at least 10 years from the date of the Credit Servicer Agreement:

  • All correspondence of the credit servicer with both the creditor and the borrower – NB this is separate to existing obligations for record-keeping of communication and compliance obligations that are determined by reference to the date of the actual credit agreement and which may be binding on parties other than the servicer;
  • All instructions received by the credit servicer from the creditor in respect of each credit agreement that it manages and enforces on behalf of that creditor.

A credit servicer may outsource activity to a third-party. The Servicing Directive's rules on outsourcing apply similar existing EU principles to perform a risk assessment and due diligence on the outsourced service provider, retain primary responsibility for compliance, ensure effective supervision and so on. Whilst these provisions may be at the commercial discretion of the outsourced service provider, it will be the originator who will, in the relevant Credit Servicer Agreement, set specific limitations and/or key performance indicators (if any) in relation to outsourcing and delegation.

Outlook and next steps

Whilst the Servicing Directive's authorization requirements may build upon EU principles and obligations applicable to other financial services market participants, there will be a degree of specialist legal and regulatory input required into the regulated business plan along with other core documents and policies that are submitted as part of an application pack or which are to be implemented and maintained by a servicer following receipt of its licence.

If you would like to receive more from our Eurozone Hub on the issues discussed herein, including how we might be able to assist with authorization applications and drafting policies, including an FDTB Policy, or the regulated Credit Servicer Agreement, then please do get in touch with our key Eurozone Hub Contacts to the right.

Footnotes

1. See: https://ec.europa.eu/info/law/better-regulation/initiatives/com-2018-135_en

2. And was long called for by a range of stakeholders. See inter alia publications by Huertas in the Journal of International Banking Law & Regulation.

3. The proposal justifies a Directive, i.e., requiring transposition, as opposed to a directly applicable EU instrument in the form of a Regulation given the wider range of "...multiple links with civil, commercial, property and insolvency laws."

4. See our dedicated coverage on this from our Eurozone Hub.

5. Please see our standalone coverage on this from our Eurozone Hub.

6. It is debatable whether the drafting contemplates a narrow legal interpretation, i.e., an amended credit agreement may not constitute a replacement whereas an amend and restate approach may constitute a "replacement".

7. This makes no distinction whether this applies to a portfolio or financial or other instruments referencing the underlying credit agreement(s).

8. And it is unclear why the drafting here does not use the defined term "creditor".

9. Each of the aforementioned security interests should be taken at a non-legal meaning – see work by Huertas describing the issues in EU law regarding the incorrect or imprecise usage of terms to cover security interest.

10. Again as above – this should also be taken to mean right as well as interest.

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