For Dentons' London Structured Finance team, 2017 has been a transformative year where we have gone from strength to strength, becoming a New Force in the London structured finance market. Dentons is now the world's largest law firm and we recently merged with Scottish law firm Maclay Murray & Spens.
Dentons Team News
We are pleased to welcome Catriona (Kitty) Lloyd as a partner in the corporate trust practice. Kitty is widely seen as one of the go-to corporate trust lawyers in the City. We are also delighted to welcome new partner Jonathan Garforth to the financial services regulatory team. Both join us from magic circle law firms. We have also expanded the team significantly at the associate level, lending further support and capacity to the structured finance team. Our new colleagues from Maclay Murray & Spens bring key Scottish law expertise to our structured finance practice.
During the course of 2017, we worked on many significant transactions, including mortgage loan securitisations, portfolio acquisitions, auto loan and lease securitisations, CMBS, trade receivable securitisations, warehouse facilities and CLOs, to name but a few.
Market Developments in 2017
2017 was an eventful year for European legislation and other significant regulatory developments affecting the structured finance and securitisation market. Below we highlight some key topics relevant to our clients.
The Securitisation Regulation
On 28 December 2017, the Securitisation Regulation was published in the Official Journal of the European Union and entered into force on 17 January 2018.
However, it will only apply to securitisations, the securities of which are issued on or after 1 January 2019. Existing securitisations which are being refinanced or having additional notes issued on or after 1 January 2019 will, therefore, become subject to it on the refinancing or additional note issuance. The following is a summary of some of the key provisions:
The risk retention quantum of at least 5% of the net economic interest in the securitisation and the five methods of risk retention remain the same.
There is now a "direct" obligation on the originator, sponsor or original lender themselves to ensure they retain a 5% material net economic interest, as opposed to the compliance burden resting solely on investors (as is the case under the existing provisions of Articles 405-410 of the Capital Requirements Regulation).
The originator may not be an entity which has been "established or operates for the sole purpose of securitising exposures". The intention behind this requirement is to prevent structures being set up to comply with the literal requirements of the retention rules but not with the "spirit".
The definition of sponsor is widened to include "credit institutions, whether located in the Union or not", and "investment firms". Investment firms are no longer restricted to being EU licensed MiFID entities but now include any legal person whose regular occupation or business is the provision of investment services to third parties and/or the performance of investment activities on a professional basis.
A sponsor that has established a securitisation is also permitted to delegate the day-to-day active portfolio management to an authorised EU entity.
An SSPE (securitisation special purpose entity), namely the securitisation issuer, may not be established in a non-EU country if:
- that country is listed as high-risk and non-cooperative by the FATF; or
- that country has not signed an agreement with a Member State to ensure it fully complies with the OECD standards on exchange of information in tax matters.
The originator, sponsor and SSPE must make certain information available to holders of a securitisation position, the competent authorities and upon request to potential investors, including quarterly information on the underlying exposures.
The final offering document and transaction documents (excluding legal opinions) shall be made available before pricing.
The originator, sponsor and SSPE shall designate responsibility for this reporting obligation between themselves, and make the information available through a securitisation repository.
Credit granting requirements
Originators, sponsors and original lenders shall apply the same sound and well-defined criteria for credit-granting for securitised exposures as the criteria used for non-securitised exposures.
Originators shall not cherry-pick assets to be transferred to the SSPE with the aim of rendering higher losses on those assets than assets remaining on their balance sheet. This is measured either over the life of the transaction or 4 years if the transaction is longer than 4 years.
In cases of negligence or intentional infringement of the risk retention, transparency or credit-granting criteria requirements, Member States shall impose effective, proportionate and dissuasive sanctions, including pecuniary sanctions.
Other points to note
- On 15 December 2017, the EBA published a draft RTS consultation paper specifying the new risk retention requirements in greater detail.
- On 19 December 2017, ESMA published draft technical standards for consultation on disclosure requirements, operational standards and access conditions. The consultation is open for feedback until 19 March 2018.
- A seller can only sell securitisation positions to retail clients if it conducts a suitability test which is satisfied.
- There is a ban on resecuritisation, so that underlying exposures in a securitisation cannot include securitisation positions. There are limited exceptions to this ban.
The Securitisation Regulation introduces the concept of STS (simple, transparent and standardised) securitisations for qualifying transactions. STS securitisations may be more appealing to investors because under the CRR Amendment Regulation the regulatory capital requirements for institutions' exposures to STS securitisations will generally be more favourable than for non-STS securitisations.
In this context, the EBA draft RTS for consultation sets out draft proposals for the homogeneity requirement of the underlying exposures in a STS securitisation. ESMA has also published draft RTS for consultation on the content and format of the STS notification, as well as on third-party firms providing STS verification services.
Impact on self-certified mortgages
Previous drafts of the Securitisation Regulation contained provisions seen as potentially problematic. These proposed to prohibit the securitisation of self-certified residential mortgage loans (as defined below) after the coming into force of the Regulation to the RMBS Market on 1 January 2019. Market participants reacted unfavourably to this proposal, due to the fact that many financial institutions have portfolios of self-certified loans on their books (many dating back prior to the 2008 financial crisis), and many outstanding securitised portfolios also contain self-certified loans, and such a restriction would have hindered the refinancing of such loan portfolios.
It is important to note that Article 9(2) of the Securitisation Regulation prohibits not all self-certified loans, but rather those loans which are marketed and underwritten on the premise that the applicant or intermediaries were made aware that the information provided by the loan applicant might not be verified by the lender.
Following discussions with the industry, the Securitisation Regulation wording was revised so that the prohibition now only applies to self-certified residential mortgages (as defined above) originated after the entry into force of the Mortgage Credit Directive (the "MCD") on 20 March 2014. The MCD prohibits self-certified mortgage loans in any event. This new wording is certainly an improvement as legacy portfolios, (i.e. comprising self-certified loans originated prior to 20 March 2014) can now be refinanced.
There are two issues to note: although the MCD came into force in March 2014, its implementation into the national law of EU Member States was not required to occur until 21 March 2016. This means that lawfully originated self-certified residential mortgage loans in the period between March 2014 and March 2016 will be not be securitisable. Furthermore, the restriction applies to securitisations where the securities are issued after 1 January 2019, i.e., securitisations containing non-grandfathered self-certified loans can still be brought in 2018 without infringing the Securitisation Regulation.
MiFID II – Product Governance
MiFID II is now in effect, including the Product Governance requirements thereunder. In this regard, the protagonists in structured finance transactions should consider whether they are "manufacturers" or "distributors" of "financial instruments". If so, they will be required to identify and periodically review a target market of investors. In practice we expect transaction parties to make clear that securitisation notes are not intended to be available to retail investors in the EEA, and at the outset to define a target market which can remain valid for the life of the financial instrument. Where offerings are aimed at sophisticated professional investors who have the experience and expertise to evaluate the risks and benefits of their investment decisions, the Product Governance requirements should be largely complied with in this respect if the transaction is structured such that sales are only expected to be made to such investors. This can be achieved by, among other things, including legends and selling restrictions in documentation and issuing notes in high denominations.
Manufacturers are also under an obligation to undertake a scenario analysis and assess the risks of poor outcomes for end investor clients posed by the product and in which circumstances these outcomes may occur. Risks which manufacturers may wish to consider may include market risk, repayment risk, macro-economic risk, geopolitical risk, regulatory risk, liquidity risk, interest rate and FX risks etc.
Where there are co-manufacturers of a financial instrument, they will be required to allocate their responsibilities in respect of Product Governance in a written agreement, likely to be the Engagement Letter or Subscription Agreement for the transaction.
What now for LIBOR?
Andrew Bailey, chief executive of the FCA, announced on 27 July 2017 that the FCA would no longer use its influence or legal powers to persuade or compel LIBOR panel banks to continue making LIBOR submissions after 2021. This announcement has accelerated work already underway to find alternative benchmarks. It has also focused attention on how LIBOR-based finance documents should cater for the possible demise of LIBOR.
Possible alternative benchmark rates
In the UK, the Bank of England's Working Group on Sterling Risk-Free Reference Rates has confirmed the Sterling Overnight Index Average (SONIA) as its preferred alternative benchmark to LIBOR for use in sterling derivatives and other relevant financial contracts. However, SONIA is an overnight rate and does not currently address the forward-looking terms and the credit risk element that LIBOR seeks to reflect.
In the US, the Alternative Reference Rates Committee has recommended the Secured Overnight Financing Rate, a broad measure of overnight Treasury financing transactions, as a robust alternative to US dollar LIBOR.
In the eurozone, the Financial Services and Markets Authority, the European Securities and Markets Authority and the European Central Bank have launched a new working group tasked with identifying and adopting a risk-free alternative overnight rate for euro-denominated finance transactions.
The Benchmarks Regulation (BMR)
The BMR entered into force on 30 June 2016 and applies from 1 January 2018 within EU Member States, with limited provisions applying before this date.
The BMR will impose specific obligations on administrators of, and advisers of contributors to, benchmarks (benchmarks being an interest rate reference index or indices, including LIBOR and EURIBOR). The BMR requires a supervised entity (broadly, regulated firms, including credit institutions and investment firms) that uses a benchmark to have robust written plans in place setting out what actions will be taken if a benchmark "materially changes or ceases to be provided". Supervised entities must reflect these plans in their contractual relationships with clients.
Amendments to finance documents
For securities maturing after 2021 with floating rate interest rates, it may be appropriate to include a risk factor in offering documents highlighting the upcoming transition away from LIBOR and other IBOR reference rates. Any such risk factors should be carefully drafted and tailored to the specific circumstances of the relevant financial instrument. Examples of risks that could be highlighted include:
- any change to the relevant benchmark rate could affect the level of the published rate (including causing it to be lower); and
- the application of the fall-back provisions could result in a fixed rate effectively being applied if the ultimate fall-back is by reference to the rate which last applied when the relevant IBOR reference rate was available.
In structured finance transactions, negative consent provisions are typically being extended to authorise the trustee to agree amendments relating to the discontinuation of a relevant IBOR reference rate, provided that certain conditions are satisfied. The relevant conditions may include:
- the provision of certificates on behalf of the issuer confirming that the amendments relate to the reference rate's material disruption or discontinuation;
- the alternative reference rate being officially recognised;
- notice of the proposed amendments having been provided to all bondholders; and
- a specific percentage of bondholders not having objected to the proposed amendments within a specified time period.
Where there is a controlling class of noteholders, the right to consent to amendments relating to the discontinuation or material disruption of IBOR reference rates may be reserved to that controlling class.
Changes to the calculation of interest rates are often reserved matters or "Basic Terms Modifications" requiring higher quorum and/or voting thresholds. Where this is the case, specific exemptions may be included for amendments relating to the introduction of (widely recognised) alternative reference rates in the event of the relevant IBOR reference rate being discontinued or materially disrupted.
Increasingly, trustees and agents are not wanting to exercise discretion to determine or calculate interest rates in the absence of a screen rate being available or an interest rate failing to be determined. They will be keen to ensure that clear fall-back provisions, which remove any discretion on the part of the trustee or the calculation agent, are included from the outset in the documentation.
Government to reintroduce the Assignment of Receivables Regulations as early as February 2018
At the time of writing, the Business Contract Terms (Assignment of Receivables Regulations) (the "2018 Regulations") are being re-drafted with a view to being laid before Parliament in early February 2018. Given this highly compressed timetable, it seems likely that any opportunity for stakeholders to comment on the 2018 Regulations will range from extremely brief to non-existent.
In a move some saw as unhelpful for the development of a deeper market for the financing of corporate receivables, the government withdrew its previous (2017) draft of the Business Contract Terms (Assignment of Receivables) Regulations 2017 (the "2017 Regulations") in November 2017. The government had previously laid the 2017 Regulations before the House of Commons in September 2017 with a view to them becoming law in Q4 of 2017.
The power to make the 2017 and 2018 Regulations is contained in section 1 of the Small Business, Enterprise and Employment Act 2015 (the "Act"). The purpose of that section 1 is:
- to give United Kingdom SMEs greater access to finance; and
- to make receivables more attractive to invoice financiers and investors in securitisation programmes.
To achieve these aims, the 2017 Regulations were to override prohibitions on assignment of receivables arising under relevant contracts. A relevant contract was a contract for the sale or supply of goods, services or intangibles, or another contract between the parties to that sale or supply contract. To be a relevant contract, the contract had either to be:
- governed by English law (or the laws of Wales or Northern Ireland, but not Scotland); or
- one which would have been so governed but for a choice of another country's laws made to evade the 2017 Regulations.
Certain contracts could not be relevant contracts under the 2017 Regulations. These included contracts for the supply of a widely defined range of financial services, contracts concerning any interest in land, consumer contracts and certain UK energy contracts.
As well as overriding prohibitions on assignment, the 2017 Regulations were to override confidentiality clauses and other clauses that might hinder the ability of a receivables purchaser to value or enforce a purchased receivable.
The 2017 Regulations' withdrawal resulted from cogent criticisms of their drafting from stakeholders and industry bodies. Criticisms from the Loan Market Association, the City of London Law Society and the Financial Markets Law Committee and others included the following:
- the 2017 Regulations were unclear on whether they applied to pre-existing contracts or only to future contracts;
- on a literal reading, the 2017 Regulations would have overridden negative pledges in credit and security documents;
- also on a literal reading, it was arguable some of the 2017 Regulations were ultra vires the Act. This made them potentially unenforceable;
- the 2017 Regulations contained various overly complex provisions on the governing law of the receivables to which they would apply. It was also arguable these provisions were inconsistent with article 14 of the Rome I Regulation on the Law Applicable to Contractual Obligations;
- the 2017 Regulations did not define the key term "assignment". This made it unclear whether they applied to all of the ways receivables can be transferred or encumbered. Among other things, this could make it uncertain whether a prohibition on charging receivables came within the 2017 Regulations; and
- although the Act's intention was to give UK SMEs greater access to finance, the 2017 Regulations were not expressly confined to receivables originated by UK SMEs. Further, the 2017 Regulations were so wide and unclear that they could have undermined other forms of SME finance (including structured finance transactions) by making key terms in such structured finance deals ineffective.
At the time of writing, the text of the (new) 2018 Regulations has not been released and it is thus unclear to what extent the government has addressed the above concerns. One can only hope that the government has done so in ways that promote invoice finance and securitisation programmes without creating uncertainty and other obstacles to structured and other financings. If this is not the case, and there is an opportunity to comment on the 2018 Regulations, the industry would do well to respond rapidly and emphatically.
EMIR and Securitisation Swaps
On 4 May 2017 the European Commission published a draft regulation amending the European Market Infrastructure Regulation (Regulation 648/2012) ("EMIR"). The draft follows the European Commission's publication in November 2016 of a report on a review of EMIR. While the report indicated that a fundamental update of EMIR was not required, it recognised the potential for simplification and elimination of disproportionate costs of compliance for certain counterparties. However, one of the proposed changes was to include securitisation special purpose entities ("SSPEs") in the definition of Financial Counterparty ("FCs"). If implemented, this would subject SSPEs to EMIR's clearing requirements and to margin requirements for non-cleared over-the-counter ("OTC") transactions (this proposed change will be referred to as the "FC Proposal")
Note that the practical impact of the FC Proposal would be mitigated by the following factors:
- many SSPEs would benefit from the "small FC" exemption which was also proposed by the Commission in its draft regulation. This would exempt SSPEs from EMIR's clearing requirements if, broadly, the aggregate notional amount of their derivatives activity is below EUR 3 billion for interest rate and foreign exchange derivatives. However, the margin requirements for non-cleared OTC transactions would continue to apply to such SSPEs;
- the references to securitisations (and therefore to SSPEs) are defined by reference to the Securitisation Regulation (Regulation 2402/2017). Consequently, SSPEs in simple, transparent and standardised ("STS") securitisations are carved out from both the clearing and (to an extent) the margin requirements imposed by EMIR. This would, however, still leave non-STS securitisations, such as CLOs, within scope; and
- some asset-backed financing vehicles fall outside the definition of "SSPE" and so would not be within the new EMIR requirements. This would be the case for repackaging vehicles that issue only one tranche of debt, for example
Despite these mitigating factors and the fact that the proposed changes attempted to align the European rules with those in the US, the securitisation industry's reaction to the FC Proposal was hostile for a number of reasons:
- there is typically no excess cash or liquid assets in a securitisation structure that could be used to post margin or collateral. Potential solutions such as retaining more cash in the structure, introducing third party liquidity facilities or restructuring transactions to avoid currency and interest rate mismatches could make many securitisations uneconomic;
- in most instances there will be no need for SSPEs to be subject to additional margining or clearing requirements because a swap counterparty will already be a senior secured creditor in the securitisation;
- securitisation swaps are often complex, bespoke to the cashflows in the structure and limited recourse to the SSPE's assets. This makes them unsuitable for clearing as envisaged in the Commission's proposal. Additionally, the assets being securitised are often illiquid and so are unsuitable to be posted as collateral; and
- the classification of securitisation vehicles under Dodd-Frank as financial counterparties appears to have had little impact on domestic US securitisations, given the lack of a currency mismatch.
It has therefore been widely noted that the FC Proposal seems to be inconsistent with the European Commission's stated desire to help revive the securitisation market in Europe.
There are signs that EU institutions are re-considering the FC Proposal. On 11 October the European Central Bank ("ECB") published an opinion stating that STS SSPEs should be fully exempted both from the clearing and margin obligations under EMIR, and the FC Proposal was openly criticised by Yves Mersch, a member of the Executive Board of the ECB, in a speech on 16 November 2017. Most encouragingly, both the Council's final compromise text of 11 December 2017 and the European Parliament's Economic and Monetary Affairs committee draft report of 26 January 2018 had removed the FC Proposal.
The next steps are for the Permanent Representatives Committee of the Council to formally agree the Council's negotiating mandate, and for negotiations to be commenced with the European Parliament. It is to be hoped that the industry's concerns will be heeded and the FC Proposal abandoned
Legal Entity Identifiers ("LEIs") for securitisation SPVs
Securitisation SPVs are now required by a number of EU regulations and directives, including MiFID II / MiFIR and the Transparency Directive, to obtain a Legal Entity Identifier ("LEI"), as issuers of financial instruments. This is an identifying code unique to each legal entity which helps promote transparency in reporting of financial transactions and allows competent authorities to detect and investigate potential cases of market abuse.
As of 3 January 2018, investment firms must have an LEI and must receive their client's LEI before carrying out a service that would result in a transaction reporting obligation, under MiFIR. This obligation applies whether their client is domiciled in the EU or not. Clearing systems including Clearstream and Euroclear have also issued notices requiring LEIs. From 2 April 2018, a LEI of the issuer and their intermediaries will form part of the mandatory eligibility criteria of Clearstream and Euroclear, so that a security will not be accepted into the clearing systems without it. The clearing systems have also requested the LEIs of existing issuers whose securities have been accepted in the past and did not mature before 2 January 2018.
On 20 December 2017, ESMA granted a six month stay of execution for obtaining LEIs, starting on 3 January 2018. This was in response to discovering that a significant proportion of market participants would be unable to comply by 3 January 2018.
Global adoption of the LEI was encouraged at the G-20 Summit of June 2012. Accordingly, many regulators globally require LEIs or are in the process of implementing such legislation. A list of the progress of such rules in various jurisdictions, including the US, Canada and Asia-Pacific, can be found here.
The process for obtaining an LEI is straightforward: a legal entity should register with its preferred LEI issuer, with a list available on the Global LEI Foundation (GLEIF) website. There is a small registration charge and the LEI must be renewed annually. Different LEI issuers are currently experiencing differing turnaround times for registration, so registration should be dealt with well in advance of closing.
For investment firms wishing to check if their client has an LEI, a complete database of existing LEIs is available here.
Insurance Linked Securities: a growing UK asset class
The passing in late 2017 of the Risk Transformation Regulations 2017 and Risk Transformation (Tax) Regulations 2017 (the "Regulations") introduced a new regulatory and supervisory framework for UK based insurance linked security ("ILS") vehicles ("ISPVs"). Dentons has advised market participants on this growing asset class, enabling qualified investors (for the purposes of MiFID 2) to invest in insurance and reinsurance risks, through an ISPV entering into risk transfer contracts and funding its exposure by issuing insurance-listed securities in the debt capital markets.
The coming into effect of the Regulations represents the culmination of a process which began with the UK Budget in 2015, when then Chancellor George Osborne announced a plan to design a framework to attract ILS business to the UK. It is hoped that this will grow the ILS market and reinforce the UK's position at the forefront of the global reinsurance industry.
Insurance linked securities transactions are securitisations
that use insurance returns as their underlying assets and which
pass on certain insurance risks into the capital markets. A common
type of ILS is the catastrophe bond, by which sponsors raise
capital to cover losses associated with natural catastrophes, such
as hurricanes. Flood risk is another area where ILS transactions
The new ISPV framework is based on the Solvency II Directive for insurance special purpose vehicles, and includes the following features:
1. New regulated activity of 'insurance risk transformation'
Prospective ISPV's should first apply to the PRA for permission to perform the new regulated activity of insurance risk transformation.
The PRA and FCA have published statements relating to the authorisation and ongoing supervision process of ISPVs, which aims to be as streamlined as possible. The PRA will determine complete applications for ISPVs within six months of receipt. The PRA has also stated that for a straight-forward proposal, with pre-application engagement and good supporting documentation, a timeframe of six to eight weeks is feasible.
All SPVs will need to be "fully funded" consistent with the Solvency II Directive.
2. A new corporate structure for ISPVs called protected cell companies (PCCs)
PCCs can be used as multi-arrangement SPVs, so that one PCC will be used for multiple ILS transactions. In order to protect buyers and investors and to manage the multiple contracts for risk transfer in the separate ILS transactions, PCCs can be composed of a core and cells. The core provides the management and administrative functions of the PCC. Each cell within the company represents one ILS transaction and achieves total segregation of its assets and liabilities; the assets held by one cell cannot be used to discharge a liability, obligation or claim against any other part of the PCC.
The FCA (not Companies House) will be responsible for registering PCCs.
A modified insolvency regime will apply to PCCs, which excludes company voluntary arrangements, voluntary liquidations and receiverships but does enable a cell to be put into administration.
3. A new tax treatment for ISPVs that qualify as a qualifying transformer vehicle ("QTV")
ISPVs are subject to a bespoke taxation regime in the UK. A qualifying transformer vehicle ("QTV") is a ISPV, authorised to carry out insurance risk transformation under FSMA and where substantially all of its insurance risk transformation activity 'relates to business other than basic life and general annuity business'.
A QTV will be exempt from corporation tax and debt and equity payments by the ISPV to investors will be exempt from withholding tax. The tax regime will only be available where there has been a genuine transfer of risk to an ISPV: it will not be available where risk is retained through a sponsor's investment in an ISPV.
Dentons represent a wide range of banking and financial institutions, as well as every type of market participant. Our global network is extensive and we remain a market leader in acting for issuers and underwriters of securitisation engagements.
Our Structured Finance team advises on all aspects of structured finance, including sales of loan portfolios, securitisation, RMBS, CMBS, ABS and CLO programmes, trade receivables securitisations, regulatory capital driven transactions, real estate and aircraft financing, synthetic securitisations, project bonds, debt capital markets, derivatives transactions, bank-sponsored conduit programmes, covered bonds, secured asset-backed lending and warehouse financing.
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