European Regulators Question Validity of Third-Party CLO Equity Vehicles

Relevant Document:
Joint Committee Report

The Joint Committee of the European Supervisory Authorities, or ESAs, has taken aim at third-party CLO equity vehicles in a report on potential reforms to the European Union’s Securitization Regulation, citing “supervisory concerns” that they “may not meet the objective of ensuring economic alignment between the sell-side and buy-side parties of a securitisation transaction.”

The report notes that the vehicles meet the definition of originator for risk retention purposes within the Securitization Regulation but argues that they fail the “sole purpose” test detailed within EU regulatory technical standards, or RTS, which provide a safe harbor for entities that meet certain criteria to confirm they are not created for the sole purpose of establishing and operating securitizations.

In particular, an originator must not “rely on the exposures to be securitised, on any interests retained or proposed to be retained in accordance with Article 6 of Regulation (EU) 2017/2402, or on any corresponding income from such exposures and interests as its sole or predominant source of revenue.”

The report states that “predominant” should be interpreted to mean “a threshold of more than 50%” and that “going forward, any new issuance should apply this interpretation, which should also be used by the supervisors when assessing whether an entity has been established or operates for the sole purpose of securitising exposures.” The ESAs also urge the European Commission to provide a more precise definition of “sole purpose” to align with the intent of the RTS.

Because the regulatory technical standards were not finalized until after Brexit, in contrast, the U.K. rules implementing the sole purpose test are different and do not include the “sole or predominant source of revenue” language.

“It looks bad,” a CLO manager told Octus, formerly Reorg. “It feels like there could be a pause until people can find a way to comply. Maybe it could even hit resets and refis.”

Conversely, the joint committee is also recommending changes to make retention by CLO managers easier, by allowing “a wider catchment of regulated entity types to act as eligible retainers.” While it still insists that the permitted modalities of retention should be those in Article 6, it proposes dropping the requirement of a specific format for disclosure of the retention.

“We welcome the ESAs’ recommendation to broaden the definition of sponsor to include CLO managers,”said Jiří Król, deputy CEO and global head of government affairs at the Alternative Investment Managers Association. “This measure would be a boost to the European CLO market, improving the availability of finance and liquidity for European businesses. We hope to see this recommendation included in the upcoming proposal to reform the Securitisation Regulation.”

Another area with explicit application for the CLO market is a proposal to broaden the definition of public securitizations from those for which a prospectus is required to be drawn up. The ESAs propose to also include any transactions traded on EU-regulated markets, multilateral trading facilities and other EU trading venues, and also to introduce a test along the lines of the U.S. Regulation S to capture all securities “marketed broadly with non-negotiable terms.”

Even private securitizations (though not third-country securitizations) would be required to report to securitization repositories, the committee suggests, limiting the significance of the distinction. The committee does, however, propose exempting intragroup transactions from securitization repository reporting.

Most of the other recommendations in the report are aimed at streamlining disclosure and due diligence requirements.

On the transparency side, the ESAs call for templates to be streamlined and more tailored to specific asset classes, including CLOs, with loan level data not required where unspecified granularity and concentration tests are met.

For due diligence, the committee recommends an approach closer to the recently introduced principles-based U.K. regime, applicable to both public and private securitizations and to EU and third-country deals.

“This approach aims to prioritise substance over form by allowing flexibility in the format in which the information is provided, as long as it enables a meaningful risk assessment,” the report reads. “It also ensures that investors receive sufficient information for risk assessment and obtain commitments from sell-side parties to provide the required information throughout the transaction lifecycle.”

As well as decoupling the Article 5 obligation from the specific modalities of Article 7, the regulators urge a clarification of how due diligence should be proportionate or commensurate to the risk of the investment, specifically mentioning features such as “(i) the type of transaction … , (ii) the seniority of the tranche to be held (i.e. senior, mezzanine, junior), (iii) the type of structural features involved, (iv) the underlying exposure type, (v) in case of STS, the presence of a confirmation (if any) provided by a supervised TPV [third party verifier], (vi) if they have already invested in securitisation positions issued in the context of previous similar transactions involving the same originator (the so-called ‘repeat deals’).”