United States: Hope Springs Eternal: House Financial Services Committee

There can be no denying that this has been the winter of the CLO market's discontent. Primary market issuance has significantly declined, spreads have widened and looming above all is the ongoing challenge and uncertainty related to how CLO managers will be able to comply, and which CLO managers will be able to comply, with the new risk-retention rules (which come into effect for CLOs on December 24, 2016). This client alert will describe what, as spring approaches, may be a glimmer of hope for the CLO market, in particular with regard to the risk-retention challenge: the recent approval by the House Financial Services committee of a bill1 that, if passed into law, would permit managers of so-called "qualified collateralized loan obligations" to comply with an alternative, less demanding form of risk retention. There is by no means any certainty that the bill will be enacted into law in the current highly politicized climate in Washington DC. However, it is something that is worthy of note to market participants.

Background

The Securities and Exchange Commission and several other agencies jointly adopted the US risk-retention rule for asset-backed securitizers in late December 2014. As applied to CLOs, from and after December 24, 2016, the rule will require a CLO manager or its majority-owned affiliate (a term that is defined in the rule) to retain, for each CLO that it manages, an economic interest in the credit risk of the securitized loan portfolio by holding (i) an equity interest in the CLO equal to at least five percent of the fair value of all of the CLO's securities, (ii) a vertical interest representing five percent of each class of the CLO's securities, or (iii) some combination of (i) and (ii) that totals five percent (collectively, the Standard Risk-Retention Methods). This application of the rule has been criticized in part because the underlying statute requires asset-backed securitizers to hold at least five percent of the securitization's credit risk, while the most senior tranches of CLOs have never in fact experienced a payment default. Additionally, some critics continue to question whether a CLO manager should be the entity responsible for risk retention since, in a typical arbitrage or open-market CLO transaction, the manager merely manages the selection, purchase and sale of a CLO's loan assets; it does not, like a more traditional ABS securitizer, underwrite and originate the loans that are being securitized.

A new bill intended to alleviate this burden, H.R. 4166, the Expanding Proven Financing for American Employers Act (the Bill), introduced in the House in 2015, was approved by the House Financial Services Committee on March 2, 2016. The summary of the Bill set forth herein incorporates an amendment to the Bill proposed by Representative Bill Foster of Illinois (the Foster Amendment) and accepted in a voice vote by the Committee.2

Alternative Risk-Retention Requirement

The Bill would allow a qualified CLO to satisfy the risk-retention requirement through an alternative method in lieu of the Standard Risk-Retention Methods described above. The retention requirement would be satisfied if the relevant risk retainer retains in the aggregate an amount of the CLO's securities equal in "value" to at least five percent of the CLO's equity, provided that at least some of the retention piece would need to be in each of the CLO's "higher tranches," and at least 70 percent of the retention piece would need to be in the CLO's equity (i.e., the risk retainer would need to retain at least 3.5 percent of the CLO's equity).

The retention piece could be purchased and held by the CLO's manager, one or more of the manager's majority-owned affiliates, or its knowledgeable employees or other employees. Equity for purposes of the Bill would include the most junior class of the CLO's securities and any additional classes junior to the CLO's debt securities. In conformity with the existing rule, the credit risk would not be permitted to be hedged or otherwise transferred and would need to be maintained for the applicable period of time specified in the rule. The Bill would only apply to open-market CLOs, as opposed to balance-sheet CLOs.

While the Bill certainly offers up to CLO managers an alternative to the Standard Risk-Retention Methods that both requires them to keep a level of "skin in the game" and is better-suited to the CLO market, it leaves open to interpretation a number of material issues. The Bill does not specify:

  • How the risk retainer should value the CLO's securities when determining which, and how many, CLO securities to retain;
  • Whether the amount required to be retained is based on a one-time valuation (we presume it should be) as opposed to a floating valuation over time and at what time the valuation should occur (pricing? closing?);
  • What is intended by "higher tranches;" we presume this means any tranche other than an equity class, but that is not clear; and
  • How to allocate the 3.5 percent equity retention piece if there is more than one class of equity securities (as contemplated by the definition of equity in the Bill).

Qualifying CLOs

Under the proposal contained in the Bill, a CLO would have to satisfy the requirements described below in order to qualify for exemption. The good news is that, for the most part, these requirements reflect fairly standard practices of open-market CLOs. However, we highlight below a few noteworthy discrepancies.

1. Asset criteria

A qualified CLO would only be able to hold assets that:

  • Are issued by "companies" (a term that is not defined in the Bill);3
  • Are not asset-backed securities or derivatives (other than loan participations, interests related to or in letters of credit, and derivatives entered into to hedge interest rate or currency rate mismatches);
  • At the time of purchase, are not in default, and are not margin stock or equity convertible securities;
  • Are loans held or acquired by three or more investors or lenders unaffiliated with the manager; and
  • Are loans to borrowers whose financial statements are subject to an annual audit from an independent, accredited accounting firm.4

The "three or more investors" requirement appears to be targeted at precluding the CLO from purchasing bilateral loans or loans that are not broadly syndicated and instead are held only by the manager, its affiliates and one or two other investors. This requirement seems innocuous (since CLOs typically only invest in syndicated loans anyway), but it raises a few practical and logistical challenges. For example: Would the requirement need to be satisfied at the time of purchase only? If not, how would the CLO manager verify compliance with the requirement over time? How is affiliation with the manager determined? Is it based on majority-ownership or control?

2. Concentration limitations

At the time of purchase of any asset, a qualified CLO would need to comply with the limitations listed below or, if not in compliance, maintain or improve its level of compliance after giving effect to the purchase:

  • 100 percent of the CLO's assets are senior secured loans or cash equivalents;
  • At most 60 percent of its assets are covenant lite loans;5
  • At most 3.5 percent of its assets relate to a single borrower; and
  • At most 15 percent of its assets relate to a single industry.6

The first requirement was introduced by the Foster Amendment. The original version of the Bill would have required only 90 percent of the CLO's assets to be senior secured loans or cash equivalents and was consistent with the current market practice for CLOs. The revised requirement seems inconsistent with the ability of a qualified CLO to invest in loan participations, letters of credit, second-lien and unsecured loans, and hedge agreements and is in tension with the existing loan-securitization exemption under the Volcker Rule, which allows banking entities to invest in CLOs holding a limited amount of non-loan assets under certain circumstances.

For purposes of the second requirement, a covenant lite loan would be defined as a loan whose underlying instruments:

  • Do not require the obligor to comply with any maintenance covenant; and
  • Do not contain a cross-default provision to another loan or financing facility that includes a maintenance covenant (including one that may apply only upon the funding of the other loan or financing facility).

A loan that is pari passu with another loan of the same obligor that is not a covenant lite loan pursuant to the criteria above would not itself be deemed to be a covenant lite loan.

3. Over-collateralization

A qualified CLO would need to meet the following over-collateralization requirements:

  • A qualified CLO's equity would need to be at least eight percent of the value of its assets. The Bill does not specify how "value" would be determined for this purpose. It also does not specify whether this requirement would apply only at the inception of a CLO, something that would seem to be both appropriate and necessary for securitizations like a CLO (in which the aggregate value of the underlying assets will fluctuate over time and in which amortization and de-levering occur once the CLO completes its reinvestment period).
  • A qualified CLO would need to have over-collateralization and interest-coverage tests, and, if any such test falls below the required level prescribed by the CLO's governing documents, available interest collections (and if necessary, available principal collections) would need to be applied to repay the CLO's debt in order of seniority until compliance with the applicable test is restored.

4. Manager

A qualified CLO would need to meet the following requirements pertaining to the manager, some of which are intended to maintain a modicum of alignment of interests between the manager and the investors:

  • Equity holders (excluding any holder of the "risk retention equity" required by the Bill) would need to have the right to remove the manager for cause. While variants of such a right already appear in most CLO management agreements, the Bill does not specify which ones would satisfy the requirement. For example: Would the requirement be satisfied if the removal right could be exercised by only some of the CLO's equity investors (for example, a super-majority, a majority or perhaps even a lesser percentage)? Would it be satisfied if investors in other classes of the CLO's securities (for example investors in a "controlling class") could also participate in the removal of the manager? How would the requirement be satisfied if all of the CLO's equity is held by the risk-retention holder?
  • A majority of the manager's fees, including any incentive fee, would need to be subordinated to payments to holders of the CLO's debt securities. In a typical CLO, the manager's fees include a senior fee (calculated using a contractually fixed amount of basis points) that is payable prior to payments to noteholders and both a subordinated fee (also calculated using a contractually fixed amount basis points) that is payable after payments to secured noteholders and a purely contingent "incentive" fee that is payable usually only after the CLO's equity holders achieve a certain rate of return. Given that both the payment of the subordinated fee and the payment and amount of the incentive fee are contingent on the manager's performance, it is not clear how the majority requirement of the Bill should be interpreted. For example, would a CLO satisfy the requirement if, according to its governing documents signed at closing, the amount of basis points used to determine the senior fee is less than those used to determine the subordinated fee, or would a CLO only satisfy the requirement if, based on reasonable assumptions and cash-flow models, more of its total fee compensation would be actually paid to it as the subordinated fee and the incentive fee than as the senior fee?
  • Discretionary sales of the CLO's assets by the manager would need to be limited each year to not more than 30 percent of the principal amount of all of the CLO's assets (other than sales of defaulted or credit-deteriorated, credit-risk, or credit-improved loans);7
  • The manager would need to be an investment adviser registered with the SEC under the Investment Advisers Act of 1940 (the Advisers Act); and
  • Purchases and sales of assets would need to be conducted on an arm's-length basis in compliance with the Advisers Act.

5. Investors

Each investor in a qualified CLO that is a US person8 would need to be a "qualified investor," as defined in the Bill. With respect to an investment in any of the CLO's securities that require the payment of principal and interest (typically, all but the most junior class of the CLO's securities), "qualified investor" would include a qualified purchaser9 or an entity owned exclusively by qualified purchasers.

With respect to an investment in any of the CLO's securities that do not require the payment of principal and interest (typically the most junior class of the CLO's securities):

  • If the CLO relies on the exclusion from the definition of "investment company" contained in Section 3(c)(7) of the Investment Company Act of 1940, "qualified investor" would include a qualified purchaser, a knowledgeable employee, or an entity owned exclusively by qualified purchasers or knowledgeable employees; and
  • If the CLO relies on the exclusion from the definition of "investment company" contained in Rule 3a-7 promulgated under the Investment Company Act, and the investor's securities are not fixed-income securities as defined in the rule, "qualified investor" would include a qualified institutional buyer,10 a person (other than any rating organization rating the CLO's securities) involved in the organization or operation of the issuer or an affiliate11 of such a person, or any entity in which all of the equity owners are qualified institutional buyers or such persons.

6. Monthly report

A monthly report would need to be made available to holders of the debt securities of a qualified CLO. The report would need to include, among other things, a list of loans and loan level details, the aggregate principal balance of the CLO's assets, over-collateralization and interest coverage test levels, details regarding trading activity, and the identity of default assets.

The Bill was reported out of the Financial Services Committee on March 2, 2016. It faces consideration by the full House next. If the Bill is revised to address the issues discussed above and is subsequently enacted into law, it may reinvigorate the CLO market.

Footnotes

[1] H.R. 4166, available at https://www.congress.gov/bill/114th-congress/house-bill/4166/text.

[2] The amendment is located at http://financialservices.house.gov/uploadedfiles/bills-114hr-hr4166-f000454-amdt-001.pdf. The text of the Bill itself has not yet incorporated this amendment.

[3] The Bill does not define the term "companies," but it is safe to assume that the term is used to exclude loans made to natural persons. Less clear is whether the term is also intended to exclude public, non-profit, and/or governmental entities.

[4] See the discussion of the Foster Amendment in footnote 4 below.

[5] The Foster Amendment introduced an additional requirement in this criterion that "each asset shall require the disclosure of unaudited financial statements quarterly within 45 days of the end of the quarter and audited financial statements annually within 90 days of the end of the fiscal year." It is unclear whether this requirement is limited to covenant lite loans or applies generally to all assets.

[6] The term "industry" is not defined. Typical CLO documents use Moody's and Standard and Poor's industry classification groups.

[7] The Bill does not specify when the principal amount should be measured, or whether the one-year periods should be sequential or rolling. Most CLOs measure the principal amount as of the beginning of the relevant calendar year (if done on a calendar year basis) or the beginning of the relevant one-year period (if done on a rolling basis).

[8] As that term is defined in Regulation S (17 C.F.R. §§ 230, 249) under the Securities Act of 1933.

[9] As defined in section 3(c)(7) of the Investment Company Act of 1940 (15 U.S.C. § 80a–3(c)(7)).

[10] As defined in Rule 144A under the Securities Act of 1933.

[11] As defined in Rule 405 under the Securities Act of 1933.

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.

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