What is a securitisation?
Although there is a carve out for specialised lending (i.e., transactions involving physical assets meeting certain criteria), the broad and unwieldy definition of ‘securitisation’ means that the Regulation captures transactions which do not look or feel like a securitisation in the traditional sense (e.g., certain loan-on-loan transactions). Over the past year, there has been renewed focus on how to apply the definition in practice.
A transaction will be treated as a securitisation under the Regulation where “the credit risk associated with an underlying exposure, or pool of exposures [mortgages, loans, non-performing loans, trade receivables, etc.], is tranched” and has all of the following characteristics:
- Payments in the transaction are dependent on the performance of the exposure or pool of exposures (the so-called ‘dependency test’). Such payments will be treated as dependent if there is a direct correlation between payments made by obligors in relation to the underlying exposure or pool of exposures and payments made to ‘investors’ (including lenders and buy side entities) under the transaction documents. Limited recourse transactions normally fall within scope but transactions that have repayment guarantees or where the investor has recourse to other (non-securitised) assets may not satisfy the dependency test.
- The subordination of tranches determines the distribution of losses during the ongoing life of the transaction (i.e., those entitled to receive payments under the transaction documentation do not rank pari passu).The transaction is not a specialised lending transaction – this applies to certain types of physical asset financing (such as shipping and commodities).
- The Regulation defines a tranche as a “a contractually established segment of credit risk associated with an exposure or pool of exposures, where a position in the segment entails a risk of credit loss greater than or less than a position of the same amount in another segment”.
- Transactions structured as tranches of debt securities with differing levels of subordination (e.g., senior and junior notes) or as senior loans and junior loans (where the repayment of the junior loan is subordinated to payments due to the senior lenders) are normally treated as meeting the ‘subordination test’. Even if there is only a single tranche of funding, the transaction may qualify as a securitisation if there is overcollateralization.
- There has been some debate in the market over whether the financing of a transaction that is structured as a combination of a single tranche of debt and a single slice of equity falls within scope. This is because common equity is not normally a contractually established segment of credit risk (rather, its subordination to debt is a matter of general law or structural subordination). In practice, a careful legal analysis of the specific terms of the transaction documentation (including the waterfall provisions and/or the presence of a proceeds deed (where applicable)) is required to determine whether the contractual provisions have the effect of subordination. The structure of the payment flows up the chain and whether the borrower or sell side entity is newly established may impact the analysis.
- The transaction is not a specialised lending transaction – this applies to certain types of physical asset financing (such as shipping and commodities).
It is possible that some of these issues and uncertainties will be addressed in future regulatory guidance or through the European Securities and Markets Authority’s (ESMA) Q&A process. In the meantime, each transaction should be assessed against the securitisation definition on a case-by-case basis applying a common sense and risk based approach.
What does it mean in practice for the sell side?
Definitional issues
The Regulation imposes direct obligations on the originator, original lender or sponsor (the risk retention entity or RRE) (depending on the nature of the transaction, this may be the note issuer, the borrower, the sell side entity, a related entity or another qualifying entity). The Transparency Requirements (see below) also apply to the securitisation special purpose entity (the SSPE).
The definition of ‘originator’ was tightened under the Regulation, with the effect that an entity that “has been established or operates for the sole purpose of securitising exposures” (e.g., certain newly formed special purpose vehicles (SPV) cannot be designated as an originator for the purposes of the risk retention requirement as described further below (the so-called ‘sole purpose test’). The delegated technical standard requires an entity to take account of the following principles when considering the application of the sole purpose test:
- Does the entity have a broader business enterprise?
- Does the entity have the capacity to meet payment obligations consistent with a broader business enterprise (involving material support from capital, assets, fees or other income available to the entity, but disregarding any securitisation assets and income – so-called ‘alternate income’)?
- Does the entity have adequate corporate governance arrangements and responsible decision makers with the required experience to enable the entity to pursue the established business strategy? Where the entity is a fund, this limb of the sole purpose test is normally satisfied if decisions are taken by the fund’s manager and the fund has proper oversight of the manager’s performance as well as the ability to appoint and remove the manager.
In the absence of regulatory guidance, it is unclear how much alternate income is required for the purposes of the sole purpose test, so a prudent risk based approach has been taken by many in the market. In loan-on-loan transactions, arrangement fees, which are not dependent on the performance of the underlying loans, have been treated as alternate income.
For transactions that involve ‘secondary assets’ (i.e., assets and exposures that are acquired rather than originated by the borrowing entity or sell side entity), the RRE is required to have 100 per cent market risk to the secondary assets for a period of time before the secondary assets can be securitised (the so-called ‘seasoning period’). There is limited regulatory guidance on the duration of the seasoning period, which has led to the market taking a view based on a risk based approach. The seasoning period requirement has created a commercial challenge for structures that do not wish to self-finance the entire exposure or pool of exposures, even for a short period of time. As a consequence, certain contractual and structural solutions have been developed in the market to address this concern.
Risk retention Requirement (Article 6)
The Regulation requires the originator, the original lender or the sponsor to retain 5 per cent of the material net economic interest in the securitisation transaction (i.e., to have economic exposure to the performance of the underlying exposure or pool of exposures) for the life of the securitisation transaction (the so-called ‘risk retention amount’ or RRA). The RRA must not be hedged or subject to any credit mitigation techniques, and can be held as a vertical slice, a revolving assets slice, a random selection slice, a first loss tranche slice or a first loss exposure slice. There is often more than one entity that can qualify as the RRE in a given structure, so the Regulation also allows the RREs to agree to collectively hold the RRA on a pro rata basis if the RREs are the same type (i.e., either all originators or all original lenders or all sponsors).
Credit granting (Article 9)
The originator must apply to the underlying exposure or pool of exposures that form part of the securitisation “the same sound and well defined criteria for credit granting which they apply to non-securitised exposures”, including “the same clearly established processes for approving and where relevant amending, renewing and refinancing credits” (the Credit Granting Requirements). This also requires having effective systems in place to apply those criteria and procedures to ensure that the credit-granting process is based on a thorough assessment of the obligor’s creditworthiness.
Transparency Requirements (Article 7)
The originator, sponsor or SSPE must report certain information to investors (including lenders and the buy side entity), regulators and, upon request, potential investors both before and after closing, on a quarterly basis and, where relevant, on an ad hoc basis (the Transparency Requirements).
The precise application of the Transparency Requirements depends on whether the securitisation is public or private. For public securitisations, the information must be disclosed via an ESMA registered securitisation repository (or if no ESMA registered securitisation repository exists, disclosure is permitted to be made via a website if the website meets specified requirements as to data control and security). The Transparency Requirements broadly require disclosure of:
- The transaction documentation (before pricing);
- The prospectus or final offering document for public securitisations (before pricing);
- The transaction summary in the case of private securitisations;
- The asset level data (quarterly, or monthly for asset-backed commercial paper (ABCP)) using the designated template;
- The investor report (quarterly, or monthly for ABCP) using the designated template;
- Certain specified events (e.g., insider dealing or significant material changes) without delay using the designated template.
Complying with the Transparency Requirements in the Regulation has been the biggest challenge and cost for market participants, particularly in relation to private securitisation transactions due to the: (a) delayed approval of the reporting templates; and (b) amount of field items that need to be populated in the standardised templates.
Furthermore, it has often been difficult to understand how to complete the relevant data fields for a given transaction or to determine whether it is even relevant. It is hoped that better and more comprehensive guidance will be forthcoming and that the possibility of a “no data” or “N/A” response is extended.
A further challenge for cross border transactions is that reports may need to be submitted to different EU regulators, who appear to have different expectations with regard to compliance with the Transparency Requirements. This increases the operational complexity of compliance as well as the cost. While it is possible to delegate the performance of the Transparency Requirements to a third party, the originator, sponsor or SSPE remains liable for compliance.
What does this mean for investors (Article 5)?
The Regulation imposes certain due diligence and ongoing monitoring obligations on investors in securitisation transactions that qualify as ‘Institutional Investors’. Broadly speaking, these include EU banks, EU regulated investment firms, EU insurers, EU reinsurers, UCITS managers and alternative investment fund managers.
Institutional investors are required to verify that: (a) the RRE complies with the risk retention requirement; (b) the Transparency Requirements have been complied with; and (c) the originator or original lender (assuming they are not credit institutions or investment firm) has complied with the Credit Granting Requirements. In order to facilitate compliance with the due diligence requirements, Institutional Investors will require borrowers and sell side entities to make certain representations and warranties in the transaction documentation (including entering into a risk retention letter).
Furthermore, Institutional Investors are required to conduct due diligence on the risks associated with investing in the securitisation transaction, at the outset and on an ongoing basis. This includes having written procedures in place, performing regular stress tests and being able to demonstrate to the regulator that they understand the risks associated with investing in the transaction. Institutional Investors will therefore need to engage with the reports and information that they receive from borrowers and buy side entities on an ongoing basis.
Restrictions
The Regulation introduced the following restrictions on securitisation structures:
- the exposure or pool of exposures in a securitisation transaction must not include any securitisation positions (subject to certain exceptions); and
- retail investors can only invest in a securitisation if (a) a suitability assessment has been performed by the seller; (b) the seller concludes that such an investment is suitable; and (c) the amount invested by the retail investors is subject to certain caps.
Simple, transparent and standardised (STS) securitisations
The Regulation provides that certain securitisation transactions can be treated as STS securitisation transactions if they satisfy specific eligibility criteria. It is important to note that investing in an STS securitisation transactions may afford certain investors more favourable regulatory capital treatment.
The specific eligibility criteria for STS securitisation transactions include:
- the originator, sponsor and SSPE in an STS securitisation transaction must be established in the EU;
- only true sales are eligible for inclusion (and so synthetic securitisations and commercial mortgage backed securities transactions are excluded);
- the transaction must be backed by pools of exposures that are homogeneous in asset type, and must not include transferable securities (other than certain types of corporate bonds);
- clear specification requirements must be met for the relevant transaction documentation and obligation to provide a precise liability cash flow model to potential investors; and
- transactions must not include actively managed assets (e.g., actively managed collateralised loan obligation).
Originators and sponsors will be required to jointly notify ESMA that a securitisation meets the STS requirements. The notification, which must include an explanation of how the STS criteria are satisfied, will be published by ESMA on its website.
Legacy transactions
Although the Regulation is intended to apply to transactions that involve (a) securities being issued on or after 1 January 2019; or (b) securitisation positions that were created on or after 1 January 2019, material changes to transactions that were issued or created before 1 January 2019 (so-called “legacy transactions”) may result in those transactions being brought within the scope of the Regulation. In the absence of regulatory guidance, the market has tried to apply a common sense approach to the application of the Regulation to legacy transactions that are subject to material changes.
The application of the Regulation to legacy transactions has also arisen in the context of the upcoming retiring of LIBOR. Market participants have been engaging with local regulators for guidance on this topic. It is hoped that a sensible outcome will be reached.
Client Alert 2020-046
