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.

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.

Authors
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
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
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). 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 & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd 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 or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.