UK Regulatory Reform Aims to Ease Investment In US CLOs

The U.K.’s Financial Conduct Authority and Prudential Regulation Authority have launched consultations on the next phase of their reform of the securitization framework, proposing material relaxation of the due diligence and transparency rules in a way that will facilitate investment in U.S. CLOs. The consultations do not address the prudential treatment of securitizations outside of a few niche structures such as guaranteed residential loans.

In particular, the regulators propose removing the requirement for investors to verify that the U.K.’s risk retention rules are met, where none of the originator, sponsor or original lender are U.K. entities. Instead, investors must ensure that “one of them has and will maintain on an ongoing basis sufficient and appropriate alignment of commercial interest with the institutional investor in the performance of the securitization.” The regulators argue that any additional risks are outweighed by the benefits to investors.

“The risk retention rules are designed to align the interests of manufacturers and investors in securitization,” the FCA said in an explanatory note. “However, we do not have a clear appreciation for the effectiveness of this mechanism when it comes to CLOs and, in the context of this paper, are soliciting the market’s views on whether we should consider targeted exemptions for UK-managed CLOs from the SECN requirements. We continue to request alignment of interest as a necessary investment condition, but we propose to give investors the opportunity to consider whether alignment of interest can be achieved through another means. Accordingly, we judge that allowing UK investors to participate in this market will not appreciably increase systemic risk.”

Where risk retention is required, the U.K. is proposing to recognize a new modality, already permissible in the U.S., known as “L-shaped” retention. This involves a combination of horizontal and vertical retention, provided that the combined total amounts to at least 5% of the nominal value of the securitized exposures.

The U.K. has already moved to more principles-based due diligence when it comes to transparency requirements, so adherence to standardized templates is no longer required for third country securitizations. The regulators are however proposing a new specific loan-level data template that U.K. “manufacturers” of CLOs must use, replacing the more generic corporate loan template, which is being discontinued for other types of securitization. They argue that the template will save money by reducing the number of required fields by 43%, and be more useful to investors.

“This reduction is driven by the deletion of fields which are not applicable to CLOs and by the replacement of the Collateral information section with a single data field to capture information on the loan security of each exposure,” the FCA consultation reads. If managers want to reach European investors as well, however, they would still need to follow the European requirements. The consultation seeks feedback on whether to disapply the template for CLO warehouses.

Transparency requirements would change dramatically in other ways under the proposals. As well as abolishing the requirement to file templates in XML format, removing certain loan level templates and the templates for investor reports, inside information and significant events, they would abolish the distinction between private and public securitizations for transparency purposes and remove the obligation to submit transparency information to repositories. Instead the required information must be made available by means that meet the previous interim requirements for when no repositories were authorized.

Both public and private securitizations would be required to provide information via templates where applicable. The public/private distinction, using the existing definition based on the legal requirement to draw up a prospectus, would remain in certain other contexts such as STS and supervisory notification requirements.

Other proposed changes relevant to the CLO market include further revisions to make the due diligence requirements more principles-based. They would remove prescriptive rules on what structural features must be considered, instead providing guidance on what features may be material and requiring investors to “obtain a comprehensive and thorough understanding of the risks involved” in a securitization investment. The requirement to verify credit granting standards has also been loosened so that, for non-U.K.-regulated originators or original lenders, investors must only “consider” “the credit granting standards and processes … applicable to the underlying exposures” in their risk assessment. On the sell-side, the rules around credit granting criteria are being clarified.