On October 21 and 22, 2014, the Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Department of Housing and Urban Development, Federal Housing Finance Agency, Office of the Comptroller of the Currency, and Securities and Exchange Commission (collectively, the "Agencies") approved final rules (the "Final Rules") for implementing the requirements of Section 941 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Final Rules take into consideration comments received on the rules proposed in August 2013 (the "Modified Proposals") and those originally proposed in April 2011. The Agencies adopted the Final Rules pertinent to collateralized loan obligations ("CLOs") with few changes from the Modified Proposals, except for, most importantly, the elimination of the proposed "cash trap" on distributions to the sponsor holding the eligible horizontal residual interest retention option and the elimination of a fair value measurement for retention that is held in the form of an eligible vertical interest. The Agencies rejected industry comments and proposals that would exempt certain types of CLOs or offer greater flexibility for the CLO industry (e.g., a proposed reduced retention amount for "Qualified CLOs" or a third-party retention option).
II. WHAT IS THE REQUIRED RISK RETENTION?
The Final Rules require the "sponsor" of the CLO to retain, and to refrain from transferring, selling, conveying to a third party, or hedging, an economic interest in the credit risk of the securitized assets in an amount equal to at least five percent of the CLO securities issued in the transaction (the "Required Retention Interest").
III. HOW IS THE REQUIRED RETENTION INTEREST MEASURED?
The sponsor must determine its method of compliance as of the closing of the CLO, when it has the option of retaining an eligible vertical interest ("EVI"), an eligible horizontal residual interest ("EHRI"), or any combination of the two (an "L-shaped interest").1 An EVI for this purpose is five percent of the face value (i.e., par value) of each class of CLO securities issued in the transaction, or a vertical security representing the cash flows paid on each such class. An EHRI is a first loss interest (i.e., in the most subordinated class or classes of securities of the CLO) equal to no less than five percent of the fair value of all securities issued by the CLO, determined using a fair value methodology acceptable under GAAP.2 In the case of an L-shaped interest, the percentage of the fair value of the EHRI and the percentage of the face value of the EVI (by class) must equal at least five percent.3 Alternatively, the sponsor may establish and fund, in cash at closing, an "eligible horizontal cash reserve account" in an amount equal to the same dollar amount as would be required if the sponsor held an EHRI.4
IV. WHO MUST OR CAN RETAIN THE REQUIRED RETENTION INTEREST?
In defining the universe of potential retention providers, the Agencies focused on the party that actively makes decisions on asset selection and on loan underwriters. Their stated goals were to "help ensure the quality of the assets purchased by the CLOs, promote discipline in the underwriting standards for such loans, and reduce the risk that such loans pose to financial stability."5 The options are as follows:
A. CLO MANAGER AS "SPONSOR"
The Final Rules generally provide that the CLO manager, as the "sponsor" of the CLO, or a majority-owned affiliate of the CLO manager, must retain the Required Retention Interest.6 If there is more than one CLO manager in a transaction, each is required to ensure that at least one of them (or one of their majority-owned affiliates) retains the Required Retention Interest.7
B. "MAJORITY-OWNED AFFILIATE" OF A CLO MANAGER
A "majority-owned affiliate" of a CLO manager is "an entity (other than the issuing entity) that, directly or indirectly, majority controls, is majority controlled by oris under common majority control with," the CLO manager. Majority control means "ownership of more than 50 percent of the equity of an entity, or ownership of any other controlling financial interest in the entity, as determined by GAAP."8 The Agencies' explanation for permitting the majority-owned affiliate option is that it "ensures that any loss suffered by the holder of risk retention will be suffered by either the sponsor or an entity in which the sponsor has a substantial economic interest."9
Although the Agencies rejected an express "third party" class of potential retention providers, the option of a majority-owned affiliate of the CLO manager to hold the Required Retention Interest may provide meaningful flexibility for CLO managers that can source capital from other internal and external parties. For example, CLO managers with affiliates that have access to third-party, longer-term capital, whether through partnership arrangements, access to public or private equity or debt markets, by virtue of industry focus (e.g., insurance), or otherwise will be in a better position to access the financial resources to source the risk retention capital required to stay in the market.
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5 Final Rules at 231.
6 The conclusion that the CLO manager is the appropriate party in a CLO to retain the risk is viewed by many as controversial, and was vigorously disputed by industry groups. A "sponsor" is defined as a person who organizes and initiates a securitization transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the issuing entity. §_.2. The Agencies reasoned that the CLO manager "indirectly transfers" assets to the CLObecause the CLO manager selects the assets and directs the CLO issuer to buy them. Final Rules at 214. Moreover, the Agencies have explained that "an entity that serves only as a pass-through conduit for assets that are transferred into a securitization vehicle, or that only purchases assets at the direction of an independent asset or investment manager, only pre-approves the purchase of assets before selection, or only approves the purchase of assets after such purchase has been made would not qualify as a 'sponsor'." Final Rules at 33-34.
9 Final Rules at 20.
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