30 September 2015

Capital Markets Union: Securitisation proposals come closer but risk missing the mark

As expected, earlier today the European Commission published its Capital Markets Union (CMU) action plan and certain corresponding materials (linked here).  The action plan follows on from earlier consultations and describes in high-level terms the various steps to be taken with respect to the creation of a single market for capital in Europe.

Certain workstreams under the CMU are described to be short-term priorities, meaning that they are targeted for immediate action.  Such priorities include reviving the securitisation markets in Europe and, in keeping with this, the Commission today published its much anticipated legislative proposals for harmonising the current regulatory regime and for establishing a new framework for simple, transparent and standardised (STS) securitisations (linked here and here).  Notwithstanding that today’s announcements are warmly welcomed in general and represent an improvement on previous consultations and recent leaked drafts, aspects of the published proposals risk missing the mark.

The legislative proposals must now go through the EU political negotiation process prior to final adoption, which could take a year or more.  Important follow-up work will also be required in connection with the treatment of STS securitisations under Solvency II and the liquidity coverage ratio (LCR).  In any event, market participants will want to focus closely on the proposals sooner rather than later, with a view to identifying key areas of focus for continuing advocacy and engagement efforts.  Given the current state of the securitisation markets in Europe in general, much hangs in the balance in terms of getting the new regime right.  Based on our preliminary review of today’s proposals, we consider that the right targets have been identified but, in order to be successful in reviving the markets, the EU authorities need to sharpen their aim and strengthen their arrows.

This eAlert provides a preliminary overview of the securitisation proposals and highlights certain key points.  However, it should be noted that other aspects of the CMU action plan are relevant from a structured finance perspective more generally and that additional materials have been published today in this regard, including a consultation paper on covered bonds (linked here).  Some of these other topics and materials are listed at the end of this eAlert.

Legislative proposal basics and follow-up work

As noted above, the legislative proposals published today provide for the harmonisation and revision of the current EU regulatory framework for securitisation.  In form, the proposals are comprised of two draft regulations.

Broadly, the first regulation (STS regulation) proposes to establish certain harmonised rules for all securitisations and to create common foundation criteria for identifying STS securitisations.  The second regulation (CRR amendment regulation) proposes to amend the Capital Requirements Regulation (CRR) to implement (with key adjustments) the revised securitisation framework adopted by the Basel Committee in December 2014 (linked here) and to provide for recalibrated regulatory capital treatment under the implemented framework for STS securitisation positions that satisfy certain additional credit risk-related requirements in line with recent recommendations from the European Banking Authority (EBA) (linked here).

The proposals make it clear that full implementation of the CMU-securitisation workstream requires steps to be taken in addition to those contemplated by the two draft regulations published today.  The proposals expressly refer to amendments to other legal acts in due course.  In particular, it is intended that certain existing legislative provisions (including existing regulatory technical standards relating to risk retention and disclosure requirements) will be repealed or amended once the STS regulation is agreed and adopted.

Moreover, the proposals indicate that amendments will be put forward in due course to make the Level 2B securitisation requirements in the LCR delegated act consistent with the STS foundation criteria, although it is not clear based on the published materials that general changes will be made providing for better or more flexible treatment of asset-backed securities under the LCR (in particular, market participants have called for an adjustment to the disproportionate haircuts applied to securitisations).  It is also intended that changes will be made to the provisions which apply under the Solvency II Directive regime (including to the Type 1 securitisation provisions) to ensure consistency with the STS foundation criteria and to provide for a (much needed) recalibration of the treatment of STS securitisation positions for insurers.  In this regard, the materials published today suggest that the intended methodology will result in “a significant reduction of the capital charges for non-senior tranches of STS securitisations” but further details are not provided.  While the Commission notes that it is intended that the new calibrations in the banking sector (via the CRR amendments) and the insurance sector (via the Solvency II amendments) will apply from the same date, it is not clear that the changes to be made to the LCR will be done on the same timeline.

The application date of the revised regime is not known but it seems unlikely to be before late 2016.  This means that the treatment of asset-backed securities under Solvency II (which insurers must fully comply with from the start of 2016) and the LCR (which starts to apply from 1 October 2015) will remain unchanged for a material period of time, and in the case of the LCR, this could be an even longer period.  This timing is cause for significant concern and it is not clear that the support signals provided by today’s proposals will be enough in themselves to stop the exit of further participants from the market over the coming months, particularly once full compliance is required under Solvency II.

In addition to these timing concerns, it is not clear at this point what the proposed recalibration under Solvency II will look like and, as noted above, whether material changes in treatment will be made under the LCR for STS securitisations.  As a result, the benefits of satisfying the STS securitisation criteria remain largely uncertain except under the CRR.

STS regulation

As noted above, the STS regulation includes proposals to establish certain harmonised rules for all securitisations and to create common foundation criteria for identifying STS securitisations.  The regulation also includes provisions relating to supervision and enforcement and provides for certain related amendments to other legal acts, including the EU Market Infrastructure Regulation (EMIR).

Harmonised rules for all securitisations

In response to the fact that the securitisation risk retention, due diligence and disclosure requirements implemented in the EU to date do not fully line up in all respects, the STS regulation includes provisions which re-cast and streamline these requirements and certain corresponding definitions.  The definitions (including the CRR definition of securitisation and related guidance in recital 50) are carried over broadly intact, however, amendments are proposed to be made to the retention, due diligence and disclosure requirements.  While harmonising initiatives are helpful in principle, certain questions and concerns arise under the proposals as drafted.

One of the areas of key focus under the re-cast requirements is scope of application and the treatment of existing transactions given that retrospective application of requirements to such transactions is highly problematic.  The re-cast requirements are stated to apply in general in respect of transactions entered into on or after the date of entry into force of the STS regulation, reflecting what we understand to be a high-level policy intention to apply the re-cast regime in respect of new transactions and to maintain the existing regime for legacy arrangements.  That said, there are certain qualifications to the general application approach which result in unhelpful uncertainty.

In particular, the re-cast investor due diligence requirements are proposed to apply in respect of both new and existing transactions and such requirements refer to pre-investment verification of compliance with the re-cast retention requirements.  This suggests that investors may be unable to satisfy their due diligence obligations in respect of existing transactions where the relevant retention arrangements are not fully compliant with the new regime as adopted, although it is not clear that this is the outcome intended by the Commission. Based on our understanding of the general policy intention with respect to application, it is hoped that the technical deficiencies in the current drafting may be easily fixed.

Due diligence

Under the proposals, the existing investor due diligence requirements applicable under the CRR, Alternative Investment Fund Managers Directive (AIFMD) and the Solvency II Directive would be repealed and replaced with common requirements for new and existing transactions.  These common requirements would be applicable to a range of EU regulated institutional investors including banks, investment firms, insurers, AIFMs, UCITS management companies, certain internally managed UCITS and institutions for occupational retirement provision (IORPs).

As under the current regime, the re-cast requirements would require relevant investors to undertake certain assessments prior to investing in a securitisation position and on an ongoing basis.  Amongst other things, prior to investing, an investor would need to verify that an eligible entity has retained an interest in accordance with the re-cast retention requirements (discussed below) and that the relevant entities make available the required information under the re-cast disclosure requirements (also discussed below).  While the explanatory memorandum published with the STS regulation suggests that the revised due diligence obligations should operate such that investors will “in a simple manner be able to check” whether these matters are met, the drafting of the relevant operative provisions in the proposals does not make it clear that the required verification exercise does not need to go beyond checking disclosures.

The proposals would also require investors in respect of STS securitisations (discussed below) to carry out a due diligence assessment prior to investing with respect to whether the securitisation meets the STS requirements.  On this front, the provisions in the proposals state that investors may place “appropriate reliance” on the STS notification and related information disclosed by the originator, sponsor and issuer on compliance with the criteria.  While it is not clear what will be regarded to be appropriate reliance in these circumstances and how much work an investor will need to do, it is helpful that the proposals expressly indicate that investors may rely on the STS notification and other information to be provided.  It appears that at least some additional work will be necessary as the draft recitals to the STS regulation indicate that “it is essential that investors make their own assessment … [and] take responsibility for their investment decisions…”.  Market participants had expressed concerns that the imposition of onerous STS assessment obligations on investors would discourage, rather than encourage, securitisation investment activities and the question of what “appropriate reliance” means is likely to be a key area of focus.

More generally, it should be noted that the proposals reflect certain improvements and clarifications to the due diligence obligations as compared to the existing regime.  In particular, the requirements under the proposals are cut down and significantly streamlined.  For example, the matters to be analysed and recorded prior to investing are reduced in general and certain unclear items under the current regime would be removed (including required checks relating to the reputation and loss experience of originators and sponsors in earlier securitisations and the methodology on which the valuation of the collateral is based).

In addition, existing due diligence requirements applied to AIFMs and insurers requiring an assessment of various qualitative matters related to the originator or sponsor are significantly pared down, with only a verification requirement relating to the originator’s credit granting policies and systems remaining and the disapplication of this requirement in circumstances where the originator is a bank or CRR regulated investment firm.  Market participants have long questioned the rationale for, and feasibility of, investors properly undertaking the qualitative assessment exercise required under the current regime and so the proposed changes in this regard are positive.

Less helpfully, there is no reference in the proposals to corresponding regulatory technical standards to specify in greater detail aspects of the due diligence requirements.  The reasoning for this is not clear given that key guidance currently applies under the existing regime for the purposes of bank, investment firm and AIFM investors and this guidance would remain helpful if made available under the proposed re-cast requirements.  If appropriate guidance is not carried over under the new regime, this may give rise to new compliance uncertainty, which would seem unlikely to encourage investment and inspire confidence as intended.

Risk retention

Under the proposals, the current risk retention requirements applicable under the CRR, AIFMD and the Solvency II Directive would be repealed and replaced in part by revised common requirements for new transactions.

Key aspects of the re-cast retention requirements are consistent with the current regime.  For example, no changes are provided for with respect to the required interest level of 5%, the restriction on transferring or hedging the retained interest or the available holding options (although helpfully the proposals make it clear that the seller’s share holding option is available for revolving pool securitisations in general regardless of the nature of the underlying assets).

Notwithstanding these key areas of consistency, the proposals do provide for certain substantive changes.  These changes relate to two matters – namely, application approach and eligible retainers – and pick up on recommendations made by the EBA in its December 2014 report (linked here).

In particular, the proposals revisit the current “indirect” (i.e. investor focused) application approach of the EU retention regime by imposing a new direct obligation to retain on the originator, sponsor or original lender.  While the move to a direct application approach was expected, it was hoped that the proposed requirements would make it clear that the new obligations would only arise in respect of relevant entities involved in the securitisation (as this is not a given for all entities which may be regarded to be an originator or original lender).  Unfortunately, today’s proposals do not include clarifying wording in this regard.

It should be noted that, notwithstanding the move to a direct application approach, EU regulated investors would not be “off the hook” with respect to retention compliance.  As noted above, the proposals provide that such investors would continue to be subject to related due diligence provisions requiring them to “verify” that the originator, sponsor or original lender retains the required interest in accordance with the retention requirements in the STS regulation and to check the disclosures made in this regard.

The corresponding explanatory memorandum also indicates that the current indirect application approach would continue to apply in certain circumstances.  In acknowledgement of the jurisdictional considerations raised by a direct application approach, the indirect approach would apply where none of the originator, sponsor or original lender is EU established, although it is not clear that provision for this is fully tracked through in the operative provisions in the proposals.  In addition, express provision is made for the current requirements to continue to apply to relevant investors in the context of transactions entered into prior to the date of entry into force of the STS regulation (although, as noted above, as a respect of deficiencies in the drafting, satisfaction of the investor due diligence obligations would appear to require investors to assess the compliance of such arrangements under the new regime, which would be problematic).

The retention requirement applicable to the originator, sponsor or original lender indicates that “where the originator, sponsor or original lender have not agreed between them who will retain the material net economic interest, the originator shall retain…”.  While further consideration is required, our preliminary thinking is that issues should not arise in general under this wording.  This is because eligible entities will be minded to identify the retaining party and significant incentives for this to occur will continue to apply, including indirectly via the re-cast investor due diligence requirements.  However, the additional wording seems odd in general and if adopted may give rise to some confusion as the concept of greater responsibility for retention amongst retainers is new, as is the concept of formally agreeing amongst retainers who should hold the interest.

More significantly, in addition to the application approach differences described above, the proposals differ from the existing regime in that they include a new restriction on originators.  The proposed restriction seeks to address concerns identified by the EBA that, under the CRR definition of originator, it is possible for third party equity investors to establish an “originator SSPE” solely to act as retainer in a securitisation.  Under the proposed restriction, an entity established or operated “for the sole purpose of securitising exposures” would not be an originator for retention purposes.  This wording represents an improvement over wording included in previous leaked drafts, which referred to a “primary purpose” test and raised issues relating to uncertainty.  The revised “sole purpose” wording included in today’s proposals is much less likely to create confusion with respect to the compliance position of retainers and more workable in general in that it should not unintentionally capture legitimate uses of the originator route.

Interestingly, the explanatory memorandum to the STS regulation includes some discussion of the “sole purpose” restriction (relevant extract below), which suggests that the policy intention behind the proposed new restriction is perhaps more nuanced than a literal reading would suggest.  Market participants will want to bear this in mind when assessing any adopted sole purpose restriction, although, strictly speaking, statements included in the explanatory memorandum would not be operative provisions under the coming new regime.  It is worth noting that the approach pursued in today’s proposals largely follows the substance of comments submitted to the Commission by Allen & Overy and four other major law firms operating in the CLO market.

This proposal also takes into account the EBA recommendation to close a potential loophole in the implementation of the risk retention regime whereby the requirements could be circumvented by an extensive interpretation of the originator definition. To this aim, it is specified that for the purposes of Article 4 an entity established as a dedicated shelf for the sole purpose of securitising exposures and without a broad business purpose cannot be considered as an originator. For instance, the entity retaining the economic interest has to have the capacity to meet a payment obligation from resources not related to the exposures being securitised.

Also with respect to eligible retainers, it is worth noting that notwithstanding calls from market participants for adjustments to the sponsor definition to create sufficient flexibility for the full range of MiFID investment firms and (in circumstances where the indirect application approach remains applicable) firms not established in Europe, the sponsor definition in the proposals remains the same, essentially carrying over the current CRR definition.  More helpfully, however, amendments are proposed to be made to the provision which permits retention on a consolidated basis in circumstances involving entities included within the same group from a prudential supervision perspective.  Whereas the current regime only permits retention on this basis where the arrangement involves the securitisation of assets from “several” relevant entities within the group, the re-cast requirements would accommodate more usual scenarios involving the securitisation of assets from “one or more” relevant entities within the group.

Given the importance of the regulatory technical standards which apply under the current retention regime to making sense of the requirements, a key question under the re-cast framework relates to whether the existing guidance will be carried over and, if so, whether there will be any delays or gaps in this regard.  The proposals seek to address these questions by expressly providing for the development by the EBA (in cooperation with the other European Supervisory Authorities) of draft regulatory technical standards on the retention requirements within six months of the date of entry into force of the STS regulation and provision is made for the existing standards to be carried over under the new regime until the new standards are made.  While these provisions are helpful on some level, it is not clear that the new standards will cover all of the areas addressed by the current guidance.  In particular, the list of items to be addressed does not refer to scenarios involving multiple originators or sponsors and the flexibility for the retention requirement to be met by a single entity where certain conditions are met, which is a key part of the current standards which needs to be carried over under the new regime.

Having been through two prior rounds of extensive consultation relating to retention guidance in the EU since the requirements were first introduced, we hope the next round under the STS regulation is able to build on previously agreed positions rather than starting from scratch.

Disclosure

Under the legislative proposals, the current disclosure requirements applicable under article 409 of the CRR and article 8b of the Credit Rating Agency Regulation would be repealed and replaced by a single set of requirements for new transactions.  It is not entirely clear but it appears that article 8b would continue to apply in respect of relevant legacy transactions, being public securitisations backed by certain asset types and involving securities issued on or after 26 January 2015, including provisions applicable under the corresponding regulatory technical standards indicating that no reporting action is required to be taken in respect of such transactions until the start of 2017.

While it is helpful that the re-cast requirements would seem to be intended to apply in respect of new transactions only (unlike under previous leaked drafts), there are other application and scope related concerns under today’s proposals.  In particular, the re-cast requirements would appear to apply in respect of all securitisations regardless of the nature of the underlying assets subject to the development of disclosure templates.  There is no carve-out for private and/or bilateral transactions (unlike under the article 8b regime).  Express references in the new requirements to ABCP operate only to require more frequent reporting for these arrangements (e.g. to require loan-level information and standardised investor reporting on a monthly rather than a quarterly basis), rather than providing for relief or greater flexibility as market participants have repeatedly indicated is necessary.  Notwithstanding this, the explanatory memorandum notes that in making any disclosure templates for ABCP, “there is a need to find the right balance between the level of detail and the proportionality of the disclosure requirements”, which suggests that further work is to be done.

In general, the re-cast requirements included in the legislative proposals are modelled closely on the technical standards which apply under article 8b and similar wording is used.  In keeping with this, the requirements refer to a joint disclosure obligation on the originator, sponsor and securitisation special purpose entity (SSPE) to make available certain information as a matter of course and with specified frequency (including loan-level data and certain other information similar to that required under the Bank of England transparency requirements) and to provide certain event-based reporting if the transaction is not otherwise subject to the ongoing disclosure obligations under the EU market abuse regime.

That said, there are a number of important differences between article 8b and the re-cast requirements.  For example, it appears that full public disclosure may not be required under the proposals and, as expected, the concept of disclosure through a website established by the European Securities and Markets Authority (ESMA) seems to have been dropped (at least for the purpose of compliance with the re-cast requirements).  In this regard, the provisions refer to disclosure of the relevant information to competent authorities and holders of a securitisation position only and for this to be done via a website which satisfies certain conditions (the European Datawarehouse is referred to by way of example in the explanatory memorandum).  Given the matters to be verified by institutional investors prior to investing under the due diligence requirements (discussed above) and the considerations which may arise in cases involving selective disclosures to certain entities only, it is likely that information would need to be made available to both prospective and existing investors in practice.

While the move away from full public disclosure appears to be an attempt to address certain concerns previously identified by market participants with respect to the application of disclosure requirements to private and/or bilateral transactions, the re-cast requirements would not resolve the full range of confidentiality and commercial sensitivity issues raised by the application of loan-level and other standardised reporting requirements to these transactions.  Market participants have worked hard to date to highlight the issues in this regard and the real disincentives to securitise created by the application of non-principles based disclosure requirements to private and/or bilateral transactions.  It is not clear what is intended to come of ESMA’s work under article 8b to define private and/or bilateral transactions and to identify an appropriate disclosure and reporting standard for these arrangements.

Lastly, it should be noted that questions arise with respect to the templates to be used for loan-level reporting under the re-cast requirements.  Provision is made for corresponding regulatory technical standards to be made to specify the information required to be disclosed by the originator, sponsor and SSPE, including standardised templates. While use of the European Central Bank templates as permitted under article 8b would be acceptable until the new technical standards are finalised, it is not clear that consistent disclosures will be acceptable in the longer term.  Given that key matters relating to article 8b and the acceptable compliance standards thereunder (including the standardised templates to be used for reporting purposes) were only agreed and confirmed by the EU authorities last year, it is rather discouraging to think that this may need to be debated again in the context of the STS regulation.

Common foundation criteria for identifying STS securitisations

Significantly, the STS regulation also includes proposals to create common foundation criteria for identifying STS securitisations.  In particular, the regulation includes proposals for the criteria for true sale “long-term” and “short-term” securitisations.  For these purposes, short-term securitisation is intended to mean ABCP programmes and underlying transactions.  The proposals do not include criteria for synthetic securitisations but the explanatory memorandum indicates that the Commission will reflect further on these arrangements and possibly seek to develop standards in the future.

The introduction of proposals to create common foundation criteria for STS securitisations is supported by market participants in general.  A harmonised standard is preferable to the piecemeal approach which European authorities seemed at risk of pursuing given the overlapping but slightly different standards adopted under the Solvency II Directive and the LCR.  More generally, this work is strongly supported given that the STS initiative represents an opportunity for more balanced EU regulatory treatment for certain securitisations.  If structured properly, the hope is that the new framework will make securitisation more attractive for both issuers and investors.  As a result, the STS framework is a key pillar of the CMU-securitisation workstream related to reviving the securitisation markets.

While the foundation criteria included in today’s proposals are improved in certain respects from those included in recent related consultation materials, aspects of such criteria remain unclear and/or disproportionately onerous.  The proposed standards do not reflect certain key comments raised by market participants.  It was already understood based on previous consultations that the criteria were (unfortunately) likely to exclude CMBS, managed CLOs and synthetic transactions in general but the worry is that a much wider range of other common securitisation arrangements may also be (possibly unintentionally) excluded and/or that the position of these other arrangements may not be sufficiently certain.  Heightened concerns arise under the proposals in respect of existing transactions as well given that the criteria would require certain non-market standard provisions to be included in the transaction documents and it may not be possible to build these provisions into existing arrangements, particularly term deals.  In addition, notwithstanding that it appears to be intended that existing transactions should remain subject to the current retention regime (rather than the re-cast requirements) a technical adjustment is not made to reflect this in the STS criteria.

Based on a preliminary review of today’s proposals, it appears that issues persist under the proposed criteria for long-term securitisations with respect to (i) the restriction on defaulted assets and assets involving credit impaired obligors given uncertainty under the proposed definitions for these purposes and the lack of provision for adjustment based on the nature of the specific credit involved, (ii) the required standards with respect to borrower creditworthiness assessments which do not reflect the simplicity, transparency and/or level of standardisation of a transaction and instead go to credit quality, (iii) the requirement for certain transfer perfection events that do not reflect existing transaction terms and (iv) requirements for the information required under the re-cast disclosure requirements (discussed above) to be available (in final or draft form) prior to pricing.

While it is helpful that the legislative proposals include provisions relating to ABCP in keeping with the EBA’s recommendations on STS earlier this year and fix previous known issues in such recommendations, there are certain remaining concerns under the draft criteria.  In particular, greater flexibility provided under the ABCP underlying transactions criteria with respect to the maturity of underlying assets represents an improvement (moving from a one year limit to a requirement referring to a remaining weighted average life of two years and a residual maturity for individual underlying assets of not longer than three years), but probably not a full fix and other key issues have not been addressed.  For example, through the cross-application of certain long-term securitisation criteria, extensive disclosure requirements (including loan-level reporting and data on static and dynamic historical default and loss performance for substantially similar assets) would apply in respect of underlying transactions, which would be problematic.

Under the ABCP programme level criteria, consistent with comments provided previously by market participants, concerns arise given that all transactions within an ABCP programme would be required to satisfy the STS requirements for underlying transactions, that call options and extension clauses would be restricted and, once again, that extensive disclosure obligations would apply.  Unless fixed, the issues on the ABCP side risk the establishment of a regime for short-term securitisations that does not work in practice.  An effective exclusion of ABCP arrangements from the STS framework would compromise the success of the initiative in general, as a meaningful portion of the market would be outside scope and likely to reduce further in size.

Leaving aside the criteria themselves, it should be noted that the identification of common foundation criteria for STS securitisations also gives rise to the key issue of compliance verification; that is, who should determine, and take responsibility for, whether or not a transaction is compliant with the criteria for STS.  This issue has been subject to extensive discussion and debate in Europe, with a range of views being put forward.  The available options in this regard refer to the involvement of regulatory authorities (through the labelling of transactions or the licensing of entities to provide such a label) or independent third parties (such as the Prime Collateralised Securities (PCS) initiative), as well as so-called “self-attestation” by originators and corresponding due diligence by investors.  For most market participants, the priority with respect to verification has been to ensure that the pursued process is practical, efficient and certain for both originators and investors.  Many consider that this process is most likely to be successfully achieved through the appointment by the authorities of one or more third parties to issue certifications with a corresponding (but manageable) due diligence obligation on investors.

As expected, the Commission has not formally endorsed third party involvement in the verification process and has instead indicated that self-attestation combined with appropriate due diligence should be required.  No restriction is put on assistance from third parties behind the scenes, but the proposals make it clear that responsibility for determinations would sit with originators, sponsors and SSPEs and, to a lesser extent, investors.  Unfortunately, no provision is made for guidance on the criteria (through technical standards or some kind of Q&A tool), which may make it difficult for market participants to comfortably take views on points of interpretation as questions arise.

Under the legislative proposals, where the STS designation is sought to be used in respect of a transaction, the originator, sponsor and SSPE would be required to jointly declare that the relevant transaction meets the STS requirements and to provide notification of this to ESMA and the relevant competent authority.  Notifications would be published on ESMA’s website and would be accessible to market participants.  In turn, institutional investors would need to assess whether a transaction meets the STS requirements as part of their due diligence obligations, although, as noted above, “appropriate reliance” could be placed on the STS notification provided to ESMA by the originator, sponsor and SSPE.  The originator, sponsor and SSPE would be required to designate amongst themselves one entity to act as the first point of contact for investors and competent authorities, although all three entities would remain responsible for the notified information.

It is perhaps not surprising that the Commission has opted not to pursue a verification option based on formal involvement by the regulatory authorities and/or an independent third party entity given previous indications from the authorities that they had concerns with these options given perceived moral hazard and external overreliance issues.  The selected self-attestation option also raises questions, however, particularly given persisting concerns that the criteria are not sufficiently clear in a number of respects.  It remains to be seen whether originators and sponsors would be sufficiently comfortable attesting that transactions are compliant with the requirements based on today’s proposals.  In addition, questions arise under the proposals in respect of the emphasis placed on SSPEs in the process (i.e. the requirement for such entities to participate in the joint declaration) given that such entities may not be established such that they can efficiently make an independent assessment in this regard.

Lastly, it should be noted that the sanctions proposed to potentially apply in the event of breach of the requirements (discussed below) may dissuade market participants from pursuing the STS designation in respect of their transactions and accepting responsibility in this regard.  The consequences of “getting it wrong” are significant and arguably disproportionate.

Supervision and enforcement

The draft STS regulation includes various provisions relating to supervision and enforcement.  In particular, provisions are included with respect to designating the competent authorities to ensure compliance by relevant entities, with power being provided for member states to designate one or more competent authorities for unregulated entities.  Provisions are also included to specify the supervisory, investigatory and sanctioning powers held by such authorities.

With respect to sanctions, the legislative proposals refer to various actions which may be taken by authorities in respect of originators, sponsors, original lenders and SSPEs for breach of the risk retention, disclosure and STS notification related requirements.  Amongst other things, the relevant provisions refer to the right of member states to impose criminal sanctions and possible administrative sanctions, including fines of at least EUR 5 million or, in the case of legal persons, up to 10% of total annual turnover.  Express provision is made for the application of sanctions to members of the management body of relevant entities and “to other individuals who under national law are responsible for infringement”.

The specified sanctions raise concerns given that areas of uncertainty exist under the legislative proposals, meaning that the compliance position may not be clear in a number of cases under the risk retention, disclosure and/or STS notification requirements.  Given that possible criminal sanctions and other seemingly very harsh consequences may arise as a result of a breach, originators and sponsors may be effectively discouraged from using securitisation, particularly when taking into account that similar requirements and consequences do not arise in connection with the use of other funding tools and products such as covered bonds.  Moreover, as the benefits of STS securitisation treatment remain unclear in part (e.g. under Solvency II and the LCR), it may be difficult for market participants to conclude that risks of non-compliance in connection with use of the STS designation are outweighed.

While the legislative proposals refer to and identify the relevant competent authorities in respect of investors for purposes of the due diligence requirements, the specific sanctions which may be applied in respect of these entities are not clear based on the drafting.

In acknowledgement of the fact that different competent authorities may have jurisdiction and power to assess the compliance position under the various requirements and may come to different conclusions in this regard, the STS regulation includes provisions intended to facilitate cooperation and exchange of information with respect to infringements.  Amongst other things, the provisions provide for the settlement of disagreements between competent authorities by the joint committee of the European Supervisory Authorities if necessary and for the development of corresponding technical standards to specify required cooperation procedures.  While it is helpful that the need for coordination and a backstop settlement process is acknowledged in the proposals, the process as proposed seems unlikely to provide for timely resolution, meaning that liquidity issues may arise in circumstances where any single relevant competent authority questions the compliance position of a transaction under any of the requirements.

Miscellaneous amendments to other legal acts

As a final matter, the STS regulation provides for certain amendments to other legal acts.  While a number of these amendments are of a tidying up or consistency nature, certain changes provided for with respect to EMIR are worth noting.

Under the relevant provisions, adjusted application of the clearing and collateral posting requirements under EMIR is contemplated in the case of swaps entered into by securitisation vehicles in connection with a securitisation (and also for swaps entered into by covered bond entities in connection with a covered bond) where certain conditions are met.  Market participants have long made the case for relief from the clearing and collateral posting requirements for securitisation swaps (and covered bond swaps, which was accepted and expressly provided for in EMIR).

While it is positive that the STS regulation includes provision for relief, it appears that under each of the clearing and margin requirements this would only be available in the case of swaps entered into in connection with STS securitisations and not for securitisation swaps more generally.  This limitation seems misguided given that the rationale for greater flexibility in the case of usual structured finance swaps applies across the board and not just in the case of STS securitisations.  While the STS framework provides an appropriate basis for preferential treatment in certain contexts, swaps regulation is less conducive to this.  It is hoped that this point may be made through the advocacy process in connection with the STS regulation and that broader relief will be provided.

CRR amendment regulation

As noted above, today’s proposals also include a regulation focused on amending the CRR to implement the revised securitisation framework adopted by the Basel Committee and to provide for recalibrated regulatory capital treatment under the implemented framework for certain STS securitisation positions. Provision is made for transitional application of the revised regime in respect of existing positions.

With respect to the implementation of the revised securitisation framework, the CRR amendment regulation provides for an important adjustment to the Basel Committee’s standards.  By way of background, the Basel framework imposes a set hierarchy of calculation approaches which broadly requires a firm to use a specified Internal Ratings Based Approach (SEC-IRBA) or, if the firm is unable to use that approach, to use a specified External Ratings Based Approach (SEC-ERBA) if permitted by the authorities in the relevant jurisdiction or, if the SEC-ERBA is not feasible, to use a specified Standardised Approach (SEC-SA).  As the names suggest, the SEC-IRBA and the SEC-SA are formula-based approaches whereas the SEC-ERBA is an approach based on external credit assessments provided by credit rating agencies.  Concerns have been raised by European market participants about this hierarchy given that EU banks are unlikely to be able to use the SEC-IRBA in respect of non-own name transactions due to the asset data required for the main pool capital input (KIRB), meaning that such banks would be required to use the SEC-ERBA.  External ratings-based approaches for calculating securitisation regulatory capital requirements have been criticised by market participants in general and the SEC-ERBA gives rise to heightened issues in Europe given the effective rating caps linked to sovereign rating levels applied by the rating agencies.

Helpfully, in response to these concerns, the CRR amendment regulation would permit firms to deviate from the approaches hierarchy in certain circumstances.  In particular, institutions would be permitted to use the SEC-SA approach instead of the SEC-ERBA in relation to a securitisation “where the risk-weighted exposure amounts resulting from the application of the SEC-ERBA is not commensurate to the credit risk embedded in the exposures underlying the securitisation” and subject to notice being provided to the competent authority.  This flexibility represents a significant improvement in today’s legislative proposals as compared to recent leaked documents.

With respect to the recalibrated treatment for certain STS securitisations, the legislative proposals largely follow the recommendations put forward by the EBA earlier this year.  In keeping with this, the proposals would require satisfaction of the STS foundation criteria and also certain additional “building block” requirements.  For example, for securitisation positions other than those relating to an ABCP programme, the additional requirements refer to, amongst other things, the assets having been originated in accordance with specified sound credit granting criteria, an asset size restriction, a maximum 100% LTV restriction for residential mortgage loan backed transactions and the assets meeting certain credit risk related requirements at the time of inclusion in the securitisation.

Also in line with the EBA’s recommendations, it is proposed that positions in STS securitisations satisfying these additional requirements should benefit from better regulatory capital treatment through adjustments to the parameters under each of the SEC-IRBA and SEC-SA approaches, modifications to the applicable risk weights under the look-up table for the SEC-ERBA approach and a lower risk weight floor of 10% for senior positions.  The adjustments which apply under the formula-based approaches are regarded by market participants to be particularly helpful and, as a result, the flexibility proposed to be provided for deviation from the approaches hierarchy (meaning that firms may not be required to use the SEC-ERBA and can instead use the formula-based approach of the SEC-SA in the circumstances described above) is likely to be regarded by market participants as one of the highlights in today’s proposals.

Further consideration of the detailed provisions included in the CRR amendment regulation will be required over the coming period to identify any technical issues.

Next steps

Today’s legislative proposals on the STS regulation and the CRR amendment regulation have now been submitted to the European Parliament and Council.  As noted above, the proposals are not law at this point and remain subject to political discussion and debate through the usual EU legislative procedure.  This procedure is unlikely to be concluded before the third quarter of 2016 at the earliest.

While there has been some talk of the EU authorities trying to “fast-track” the legislative proposals, it is not clear that this will be possible in practice.  As we have sought to highlight in this eAlert, the proposals are welcomed in general and represent an improvement on previous positions but further work is required to land a bullseye.  Timely action is required to address the current issues facing portions of the European securitisation markets but this should not come at the cost of compromising the success of the revised regime.

Given that the proposals have been put forward in the form of European regulations, no corresponding national measures would be required in member states to implement the measures.  That said, as noted above, the proposals expressly refer to the making of various corresponding acts, including technical standards to further specify the retention, disclosure and STS notification requirements.  In addition, full implementation of the CMU action plan item related to reviving the securitisation markets will require certain follow-up actions, including amendments to Solvency II and the LCR.

Interestingly, the legislative proposals include provisions which expressly encourage “market participants and their professional associations” to “continue working on further standardising market practices, and in particular the standardisation of documentation”.  The proposals also note that the Commission will carefully monitor and report on the work of market participants in this regard.

Other CMU workstreams to note

In addition to reviving the securitisation markets, the CMU action plan refers to other workstreams which are relevant from a structured finance perspective.  For example, other areas of focus include:

  • supporting bank financing to the wider economy through consulting on an EU-wide framework for covered bonds – with a consultation paper being published today on this (linked here);
  • supporting infrastructure investment through adjustment of the treatment of relevant positions under Solvency II – with legislative proposals being published today on this (linked here);
  • strengthening access to public markets through modernisation of the Prospectus Directive – with plans to publish concrete proposals for amendments in November 2015; and
  • improving market infrastructure for cross-border investing through consulting, and proposing final rules, on uniform provisions to determine third party effectiveness in connection with the assignment of claims – with plans for final rules to be published by the end of 2017.

We are working through all of the materials published today and encourage interested clients to get in touch with any questions or comments.

Salim Nathoo +44 2030882838
Partner, London salim.nathoo@allenovery.com
Angela Clist +44 2030882437
Partner, London angela.clist@allenovery.com
Tim Conduit +44 2030882066
Partner, London tim.conduit@allenovery.com
Vanessa Hardman +44 2030884362
Partner, London vanessa.hardman@allenovery.com
Christian Lambie +44 2030882472
Partner, London christian.lambie@allenovery.com
Lucy Oddy +44(0)20 3088 4454
Partner, London lucy.oddy@allenovery.com
Sally Onions +44 2030883584
Partner, London sally.onions@allenovery.com
Franz Ranero +44 2030882424
Partner, London franz.ranero@allenovery.com
Nicole Rhodes +44 2030884408
PSL Counsel, London nicole.rhodes@allenovery.com

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© Allen & Overy LLP 2019. This document is for general guidance only and does not constitute definitive advice.

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© Allen & Overy LLP 2019 This document is for general guidance only and does not constitute definitive advice.
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