United States: U.S. Regulatory Update – Credit Risk Retention for CLOs

Last Updated: September 18 2013
Article by Grant E. Buerstetta, Marianne Caulfield and Jaiho Cho

Financial Services

On August 28, 2013, six federal agencies, including the Board of Governors of the Federal Reserve System, the U.S. Securities and Exchange Commission, and the Federal Deposit Insurance Corporation (collectively, the "Agencies"), issued a re-proposed rule (the "Proposed Rule") to implement the credit risk retention requirements of Section 15G of the Securities Exchange Act of 1934, as added by Section 941 of the Dodd-Frank Act.

This memorandum summarizes key points of the Proposed Rule that may affect the collateralized loan obligation ("CLO") market practice.


  • Two risk retention options would be available: (a) retention of horizontal or vertical interests or a combination of the two; or (b) in connection with an "open market CLO," a new option that requires the lead underwriter of corporate loans to hold five percent of the face amount of the term loan tranche purchased by the CLO.
  • Additional disclosure and certification requirements are proposed with respect to "open market CLOs."
  • The risk retention requirements for CLOs would become effective two years after the final adoption of the Proposed Rule (i.e., no earlier than the fourth quarter of 2015).
  • Comments to the Proposed Rule must be submitted no later than October 30, 2013.

Combined Vertical and Horizontal Risk Retention Option

The Proposed Rule brings more flexibility in satisfying the requirements by allowing a sponsor to retain any combination of vertical and horizontal interests as long as its total interests retained is at least five percent of the "fair value" of all ABS interests (rather than the prior 50%-50% split).1 The Proposed Rule also makes clear that the sponsor may hold interests through majority-owned affiliates.

This standard risk retention option is replete with various additional requirements, including the disclosure requirements for the fair value methodology used, the certification requirements relating to eligible horizontal residual interest ("EHRI") recovery percentages, and certain limits on payments that exceed the expected percentage of the EHRI's fair value (compared to all ABS interests).

Lead Arranger Risk Retention for "Open Market CLOs"

The Proposed Rule allows a new option available for "open market CLOs."2 An "open market CLO" must acquire more than 50 percent of its assets from non-affiliate syndicates. Accordingly, the proposed "open market CLO" option is intended to exclude "balance sheet" CLOs.

In addition to the definitional scope of an open market CLO, the proposed new option (the "Open Market CLO Option") has the following requirements:

  • The lead arranger3 for each loan purchased by the CLO must retain at the origination of the syndicated loan at least five percent of the face amount of the term loan tranche purchased by the CLO.
  • The lead arranger would be required to retain this portion of the loan tranche until the repayment, maturity, involuntary and unscheduled acceleration, payment default, or bankruptcy default of the loan.
  • This requirement would apply regardless of whether the loan tranche was purchased on the primary or secondary market, or was held at any particular time by an open market CLO issuing entity.

The Agencies anticipate that this would effectively create a new type of "CLO-eligible loan tranches" in the market.

In addition, the sponsor of an open market CLO could avail itself of this option only if the following conditions are satisfied:

  • the CLO does not hold or acquire any assets other than CLO-eligible loan tranches and servicing assets;
  • the CLO does not invest in ABS interests or credit derivatives (other than permitted hedges of interest rate or currency risk); and
  • all purchases of assets by the CLO (directly or through a warehouse facility used to accumulate the loans prior to the issuance of the CLO's liabilities) are made in open market transactions.

The sponsor under the Open Market Option would be required to disclose a complete list of each asset held by the open market CLO (or before the CLO's closing, in a warehouse facility in anticipation of transfer into the CLO at closing).4


It is too early to fully anticipate the practicality of the Open Market Option other than to note that for the Open Market CLO Option to become a meaningful alternative, the syndicated loan market would have to achieve some notable changes. Given current market practices, the following challenges and potential drawbacks may arise for any sponsor to utilize the Open Market CLO Option.

First, it is not clear what the long-term impact would be if the Proposed Rule creates a subset of leveraged loans by making them CLO-eligible. While the CLO-eligible tranche and the non-CLO-eligible tranche may share the same terms and conditions and would have the same credit risk associated with them, the CLO-eligibility may create different supply-demand dynamics that may affect the price and the liquidity of these loans. If the CLO-eligible loans were to receive special treatment in the syndicated loan market, it is likely that trading of those loans would be less frequent. This may result in CLOs, and by extension, CLO noteholders, paying more for the same loan issued by the same obligor.

Second, it is not clear what incentives corporate loan underwriters would have to create CLO-eligible loans. It is possible, under certain market conditions, that a successful syndication of certain corporate loans would be difficult without creating CLO-eligible loans. That consideration would need to be measured against the potential regulatory capital cost of owning the five percent retention piece.

In particular, these banks (which may have not other involvement in the securitization markets) may be further disincentivized in the context of one bank taking on an obligation to hold the five percent retention piece of a loan in one or more CLOs to be underwritten by a competitor bank.

Furthermore, the Proposed Rule would require that these banks hold (without hedging) the retention piece until the loans pay in full or default. This means additional credit risk would be borne by the originating banks that may or may not benefit from CLO business. The market will need to help determine whether there is a compatible economic solution to the proposed regulatory approach.

Continuing Discussion of CLO Risk Retention Rules

The Agencies have requested comments on a long list of questions, and robust industry feedback is expected to develop throughout the comment period, which expires on October 30, 2013.

For ease of reference, the Agencies' list of questions is reproduced in the appendix. Please feel free to contact us if you would like to discuss further the details of the re-proposed rules and how they may impact your business.

  1. The Proposed Rule would provide for a combined standard risk retention option that would permit a sponsor to satisfy its risk retention obligation by retaining an "eligible vertical interest," an "eligible horizontal residual interest," or any combination thereof, in a total amount equal to no less than five percent of the fair value of all ABS interests in the issuing entity that are issued as part of the securitization transaction.
  2. The Proposed Rule defines an "open market CLO" as "a CLO whose assets consist of senior, secured syndicated loans acquired by such CLO directly from sellers in open market transactions and [related] servicing assets, and that holds less than 50 percent of its assets by aggregate outstanding principal amount in loans syndicated by lead arrangers that are affiliates of the CLO or originated by originators that are affiliates."
  3. The lead arranger must have taken an initial allocation of at least 20 percent of the face amount of the broader syndicated facility, with no other member of the syndicate assuming a larger allocation or commitment.
  4. The disclosure would need to include the following information: (i) the full legal name and Standard Industrial Classification category code of the obligor of the loan or asset; (ii) the full name of the specific loan tranche held by the CLO; (iii) the face amount of the loan tranche held by the CLO; (iv) the price at which the loan tranche was acquired by the CLO; and (v) for each loan tranche, the full legal name of the lead arranger subject to the sales and hedging restrictions.


50(a). Does the proposed CLO risk retention option present a reasonable allocation of risk retention among the parties that originate, purchase, and sell assets in a CLO securitization?

50(b). Are there any changes that should be made in order to better align the interests of CLO sponsors and CLO investors?

51. Are there technical changes to the proposed CLO option that would be needed or desirable in order for lead arrangers to be able to retain the risk as proposed, and for CLO sponsors to be able to rely on this option?

52(a). Who should assume responsibility for ensuring that lead arrangers comply with requirement to retain an interest in CLO-eligible tranches?

52(b). Would some sort of ongoing reporting or periodic certification by the lead arranger to holders of the CLO-eligible tranche be feasible?

52(c). Why or why not?

53(a). The agencies would welcome suggestions for alternate or additional criteria for identifying lead arrangers.

53(b). Do loan syndications typically have more than one lead arranger who has significant influence over the underwriting and documentation of the loan?

53(c). If so, should the risk retention requirement be permitted to be shared among more than one lead arranger?

53(d). What practical difficulties would this present, including for the monitoring of compliance with the retention requirement?

53(e). How could the rule assure that each lead arranger's retained interest is significant enough to influence its underwriting of the loan?

54(a). Is the requirement for the lead arranger to take an initial allocation of 20 percent of the broader syndicated credit facility sufficiently large to ensure that the lead arranger can exert a meaningful level of influence on loan underwriting terms?
54(b). Could a smaller required allocation accomplish the same purpose?

55(a). The proposal permits lead arrangers to sell or hedge their retained interest in a CLO-eligible loan tranche if those loans experience a payment or bankruptcy default or are accelerated. Would the knowledge that it could sell or hedge a defaulted loan in those circumstances unduly diminish the lead arranger's incentive to underwrite and structure the loan prudently at origination?

55(b). Should the agencies restrict the ability of lead arrangers to sell or hedge their retained interest under these circumstances?

55(c). Why or why not?

56(a). Should the lead arranger role for CLO-eligible loan tranches be limited to federally supervised lending institutions, which are subject to regulatory guidance on leveraged lending?

56(b). Why or why not?

57(a). Should additional qualitative criteria be placed on CLO-eligible loan tranches to ensure that they have lower credit risk relative to the broader leveraged loan market?

57(b). What such criteria would be appropriate?

58(a). Should managers of open market CLOs be required to invest principal in some minimal percentage of the CLO's first loss piece in addition to meeting other requirements for open market CLOs proposed herein?

58(b). Why or why not?

59(a). Is the requirement that all assets (other than servicing assets) consist of CLO-eligible loan tranches appropriate?

59(b). To what extent could this requirement impede the ability of a CLO sponsor to diversify its assets or its ability to rely on this option?

59(c). Does this requirement present any practical difficulties with reliance on this option, particularly the ability of CLO sponsors to accumulate a sufficient number of assets from CLO-eligible loan tranches to meet this requirement?

59(d). If so, what are they?

59(e). Would it be appropriate for the agencies to provide a transition period (for example, two years) after the effective date of the rule to allow some investment in corporate or other obligations other than CLO-eligible loan tranches or servicing assets while the market adjusts to the new standards?

59(f). What transition would be appropriate?

59(g). Would allowing a relatively high percentage of investment in such other assets in the early years following the effective date (such as 10 percent), followed by a gradual reduction, facilitate the ability of the market to utilize the proposed option?

59(h). Why or why not?

59(i). What other transition arrangements might be appropriate?

60(a). Should an open market CLO be allowed permanently to hold some de minimis percentage of its collateral assets in corporate obligations other than CLO-eligible loan tranches under the option?

60(b). If so, how much?

61(a). Is the requirement that permitted hedging transactions be limited to interest rate and currency risks appropriate?

61(b). Are there other derivative transactions that CLO issuing entities engage in to hedge particular risks arising from the loans they hold and not as means of gaining synthetic exposures?

62(a). Is the requirement that the holders of a CLO-eligible loan tranche have consent rights with respect to any material waivers and amendments of the underlying legal documents affecting their tranche appropriate?

62(b). How should waivers and amendments that affect all tranches (such as waivers of defaults or amendments to covenants) be treated for this purpose?

62(c). Should holders of CLO-eligible loan tranches be required to receive special rights with respect those matters, or are their interests sufficiently aligned with other lenders?

63. How would the proposed option facilitate (or not facilitate) the continuance of open market CLO issuances?

64(a). What percentage of currently outstanding CLOs, if any, have securitized assets that consist entirely of syndicated loans?

64(b). What percentage of securitized assets of currently outstanding CLOs consist of syndicated loans?

65(a). Should unfunded portions of revolving credit facilities be allowed in open market CLO collateral portfolios, subject to some limit, as is current market practice?

65(b). If yes, what form should risk retention take?

65(c). Would the retention of 5 percent of an unfunded revolving commitment to lend (plus 5 percent of any outstanding funded amounts) provide the originator with incentives similar to those provided by retention of 5 percent of a funded term loan?

65(d). Why or why not?

66(a). Would a requirement for the CLO manager to retain risk in the form of unfunded notes and equity securities, as proposed by an industry commenter, be a reasonable alternative for the above proposal?

66(b). How would this meet the requirements and purposes of section 15G of the Exchange Act?

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Grant E. Buerstetta
Jaiho Cho
Similar Articles
Relevancy Powered by MondaqAI
Milbank, Tweed, Hadley & McCloy LLP
In association with
Related Topics
Similar Articles
Relevancy Powered by MondaqAI
Milbank, Tweed, Hadley & McCloy LLP
Related Articles
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.


The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.


Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions