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COMMENT
The work of complying
with US Risk Retention
Rules continues
John Timperio and Mary Bear of law firm Dechert, examine
how managers are preparing for the impending regulation
change in the US
O
ne of the thorniest issues in the
securitisation industry since
the enactment of the final
US Risk Retention Rules has
concerned the development
of commercially viable capital formation approaches. This is acutely the
case in the small segment of the securitisation
marketplace occupied by asset managers of
CLOs who were amongst the hardest hit by the
new "skin-in-the-game" mandates of the Risk
Retention Rules.
However, as registered investment advisers
that were already subject to extensive regulation, CLO managers also had the compliance
infrastructure and internal expertise in establishing and managing separate businesses
to respond to the new mandates. Part of
responding to this new mandate has involved
implementing new capitalisation strategies
such as the capitalised manager vehicle (CMV),
the majority-owned affiliate (MOA) and the
capitalised majority owned-affiliate (C-MOA)
approaches. Such approaches were the result of
broad-based industry wide efforts among CLO
market participants unseen prior to advent of
the Risk Retention Rules, and are now being
incorporated in various forms throughout the
securitisation industry.
With only two months left until the 24
December 2016 effective date, a significant
amount of work remains to be done. Indeed,
according to one recent research report, only
35 of 95 new issue CLOs were purported to be
compliant with the Risk Retention Rules, and
only 46% of CLO managers have priced a compliant CLO.
The rise of the C-MOA
Two of the most frequent questions we receive
are “what capital formation approaches are
available?” and “what is everyone else doing?”
Although the details will vary, among the
primary approaches (e.g., the CMV, MOA and
C-MOA), the C-MOA is and continues to be the
most commonly utilised approach.
The C-MOA approach (a hybrid between a
CMV and an MOA) involves the establishment
of a “majority-owned affiliate” of a CLO manager that is capitalised in a manner to support
CLO issuance over a number of years. As such,
the C-MOA approach is designed to facilitate a
CLO manager’s “dual compliance” or, in other
words, compliance with the EU risk retention
rules as well as the US Risk Retention Rules.
The CMV approach, which is also designed
to facilitate dual-compliance, involves an existing CLO manager spinning out its CLO management business into an entity that is owned
and controlled by investors. Due to the required
infrastructure and corporate disruption associated with this approach, CMVs tend to be best
suited to large platforms eyeing an eventual
public listing and for platforms with a high
degree of sensitivity to consolidating the risk
retention holding entity.
Finally, the MOA approach involves a CLO
manager establishing a special purpose entity
Our hope is that, over time, as the market
coalesces around 'best practices,'
uninformed speculation will drop off and the
regulatory terrain will become more certain”
NOVEMBER 2016
which meets the requirements for being a
“majority-owned affiliate” of the CLO manager
(i.e., it is an entity in which the CLO manager
owns greater than 50% of the equity or holds
a controlling financial interest as determined
under GAAP) to hold the required retention
interests for one (or, in certain instances, a
few) CLOs. Pure MOA approaches tend to be
employed for only US compliance and on a oneoff (or opportunistic) basis or as a transitional
step prior to the implementation of a longer term
capital formation strategy by a CLO manager.
An approach which is worth mentioning due
to the attention it has been garnering as of late
is the joint venture (JV). JVs involve two or more
like minded strategic partners joining together
to create a risk retention solution. The parties
may either create a new JV entity (in which both
parties participate but neither party controls)
to act as the CLO manager or the parties may
seek to manage CLOs under some form of advisor-subadvisor arrangement.
Either way, the linchpin of the JV analysis
involves ensuring that the entity acting as the
retention holder has substantive input into the
asset selection and underwriting decision-making and receives appropriate compensation in
the form of CLO management fees for such
activities. Although not spelled out in the Risk
Retention Rules, in our view, the more equality
between the two JV partners, the more likely
the structure will withstand regulatory scrutiny.
Although market practices have not yet crystallised, CLO market participants have been
working to develop accepted methodologies for
implementing such JV approaches.
Accounting analysis
For the CLO managers seeking to comply with
the Risk Retention Rules via the C-MOA or
MOA options, another quandary concerns
how to establish the “controlling financial
interest” link which is necessary to establish
“majority control”.
The relevant definition from the Risk Retention Rules states that “majority control” includes
“ownership of more than 50% of the equity of
an entity, or ownership of any other controlling
financial interest in the entity, as determined
under GAAP”. When relying on the “controlling
financial interest” prong, the best practice for
CLO Managers entails obtaining some form
of express guidance (ideally in the form of an
opinion letter) from a nationally recognised
outside accounting firm specifically confirming
its “controlling financial interest”.
It should be noted, however, that some
accounting firms interpret the accounting rules
in a manner that prohibits them from providing
express guidance. In such cases, we have been
working to develop alternative practices for
COMMENT
CLO managers to utilise. One such alternative
may involve a CLO manager (in consultation
with an outside accountant) preparing its own
accounting memorandum. An officer of the
CLO manager could then certify that he/she
hired a nationally recognised outside accounting firm as its outside adviser and that such
outside advisor assisted the CLO manager in
the preparation of the memorandum and has
indicated that the conclusion appears to be reasonable and supportable under GAAP. While
practices have not yet crystallised on this point
either, we do expect such alternative arrangements would be acceptable to CLO market participants and serve as useful back-up support in
the files maintained by CLO managers.
New disclosure requirements
While capital raising to ensure structural compliance with the Risk Retention Rules has understandably been the primary focus of attention
of CLO managers, there are a number of other
requirements contained in the Risk Retention
Rules that continue to increase in importance as
we inch closer to the effective date. Of particular
importance to CLO managers has been preparing disclosures to address the labyrinth of new
requirements. This is particularly the case with
respect to horisontal retention strategies, where
the Risk Retention Rules require the disclosure
of all of the key inputs in the fair value analysis.
Accordingly, CLO managers and market participants have been working collaboratively to
develop standard model disclosures.
Furthermore, on the disclosure front, CLO
managers will have to carefully determine, in
consultation with counsel, how much information is necessary or appropriate to disclose to
CLO investors concerning the specifics of their
particular risk retention approach. Although
CLO investors will expect to hear that the CLO
manager has determined it complies with the
Risk Retention Rules, it would be imprudent not
to disclose all applicable risks, including that regulators may disagree with such determination, as
well as the risks in any fair value determinations
or in any vertical strip leverage facilities.
New mandates, old narrative
Despite the mountains of empirical data documenting the stellar performance of CLOs
throughout the credit crisis as well as the widespread acknowledgment by economists and
others of the central role CLOs play in facilitating
economic growth and job creation, the familiar
narrative, particularly among outsiders with
only a superficial knowledge of the CLO market,
is that CLO managers continue to seek ways to
avoid the mandates of the Risk Retention Rules.
A recent article in the financial press attempted
to breathe new life into this tired and discredited
narrative. Specifically, the article suggested that
use of “majority-owned affiliates” represented a
clever attempt to engineer around the requirements of the Risk Retention Rules. Nothing could
be further from the truth. The fact is that the
standard regarding what type of affiliate could hold
risk retention was the product of several rounds of
purposeful deliberation by the rulemaking agencies composing the Risk Retention Rules as well
as the focus point of numerous comment letters.
Far from “pushing the envelope,” as was suggested, CLO managers were directed in the Risk
Retention Rules: (i) to ensure their management
business was capitalised in a manner sufficient to
hold the necessary “skin in the game”; and (ii) not
NOVEMBER 2016
15
to use third parties as retention holders (i.e., to
capitalise their own management business or an
entity that is a wholly-owned or “majority-owned
affiliate” thereof). Therefore, such capital raising
strategies (CMV, MOA, C-MOA) should come as
no surprise to anyone.
In our experience, CLO managers are acutely
aware of the fact that the burden of compliance
with the Risk Retention Rules falls on them, and
are laser-focused on compliance. Notably, in the
face of numerous unanswered questions in the
Risk Retention Rules as to which the rulemaking
agencies chose not to provide any clarity, most
CLO managers err on the side of caution and
try to meet both the letter and the spirit of the
law. Indeed, instead of seeking to evade the Risk
Retention Rules, CLO managers have been the
loudest advocates for a unified “best practices”
approach. Our hope is that, over time, as the
market coalesces around “best practices,” such
uninformed speculation will drop off and the
regulatory terrain will become more certain.
Given the looming shadow of the effective
date of the Risk Retention Rules, CLO managers must recognise that they may be “damned
if they do, and damned if they don’t,” and get
about the business of continuing to implement
their compliance programs. ¤
John Timperio
John Timperio is a partner at Dechert
and focuses on numerous areas including
structured finance, securitisation and real
estate finance
Mary Bear
Mary Bear is a consultancy attorney in
Dechert's finance and real estate practice
group