Vedder Thinking | Articles EU Risk Retention Undertakings in U.S. General Equipment ABS: Evolving Market Practice
For companies seeking to finance general equipment assets via asset backed securitization (ABS) instruments, risk retention has become an important consideration. In response to the latest financial crisis, both the U.S. and the EU adopted regulations mandating that ABS issuers retain credit risk in such transactions. U.S. companies desiring to market ABS instruments in the EU must be cognizant of the EU risk retention rules, including certain key differences from the U.S. risk retention regime. This article discusses certain of these differences and the evolution of compliance approaches used in the market to date.
Under the European Capital Requirements Regulation1 (the EU CRR), a securitization is compliant where the originator, the sponsor or the original lender agrees to retain, during the life of the transaction, a “material net economic interest” of not less than 5 percent of the credit risk.2 Unlike the credit risk retention rules enacted under the Dodd-Frank Act,3 the EU CRR holds the investor, rather than the issuer, liable for non-compliance.4 To ensure the originator or sponsor of the ABS maintains this position following closing, the EU CRR prohibits selling, transferring or hedging any of the retained interest during the life of the securitization.
A European credit institution or investment firm5 investing in an ABS will avoid non-compliance penalties by demonstrating that (i) it has undertaken certain due diligence in respect of its investment position, the underlying assets and the relevant sponsor and (ii) the sponsor has explicitly disclosed to the investor that it will retain, on an ongoing basis, a net economic interest of not less than 5 percent in respect of certain tranches or asset exposures.6 An EU investor satisfies the due diligence requirements by demonstrating a “comprehensive and thorough understanding” of the securitization and having implemented formal policies and procedures commensurate with their investment risk.7 This means the EU investor comprehends:
- the net economic interest retained by the originator;
- the risk characteristics of the notes the investor plans to purchase;
- the risk characteristics of the loans or leases that are being securitized;
- the reputation and loss experience of previous securitizations issued by the originator; and
- the transaction structure that could have a material impact on the performance of the securities, such as cashflow structures, liquidity and credit enhancements and events of default.
The EU CRR also requires EU investors to review their compliance at least annually.
EU investors rely heavily on undertakings from the sponsor to maintain a comprehensive understanding of the securitization and as a means of obtaining evidentiary support of compliance. U.S. companies have generally followed one of two approaches with respect to these undertakings depending on their marketing needs. U.S. companies not needing to market to EU investors have acknowledged the requirements imposed by the EU CRR, but neither undertook to provide the information necessary for EU investors to satisfy the due diligence and monitoring requirements nor made any representations regarding the regulatory compliance of their investment in the securitization.
On the other hand, U.S. companies needing to attract EU investors have provided robust undertakings regarding their risk retention position and ongoing compliance. These undertakings included, among others:
- (i) to retain, on an ongoing basis, a material net economic interest of not less than 5 percent transaction credit risk, without exception;
- (ii) not to sell, hedge or otherwise mitigate the retained credit risk;
- (iii) to take further action and provide further information as required to satisfy the EU CRR;
- (iv) to confirm in writing continuing compliance with (i) and (ii) on a monthly basis and at certain other times; and
- (v) to promptly notify investors if for any reason (A) the risk retainer ceases to hold the required 5 percent retention, (B) the risk retainer fails to comply with the undertakings set out in (ii) or (iii) in any way or (C) any of the representations with respect to the EU CRR contained in the underlying transaction documents failed to be true on any date.
Consequently, in such situations the balance of risk between the investor and the issuer tipped in favor of the investor.
Recently, however, this balance has begun to shift in the opposite direction, as U.S. companies have been able to chip away at these undertakings and still successfully market ABS instruments in the EU. First, there was in practice an implied obligation for issuers to top-up their risk retention to maintain the 5 percent interest during the life of the transaction without exception. However, in recent transactions issuers have mitigated this obligation. Specifically, in the event losses under the underlying contracts cause the retained interest to drop below the 5 percent threshold, issuers have successfully introduced language permitting the risk retention percentage to drop so long as the losses are absorbed by the issuer’s first loss position in the retained risk.
Similarly, issuers have obtained carve-outs allowing for decreased retention obligations resulting from amendments to the EU CRR. For instance, if the EU CRR, by way of amendment, repeal or otherwise, decreases the retention requirement from 5 percent, the issuer could decrease its retention obligation accordingly without running afoul of its undertaking. Conversely, issuers have resisted obligations to increase the retained interest if required by amendments to the EU CRR. As a consequence, the monthly confirmations given by these issuers no longer cover undertaking (i). Instead, the issuers only undertake to disclose the current level of retention, whether 5 percent or lower.
With respect to undertaking (iii), issuers have been able to eliminate the obligation to take further action, which correlates somewhat to the elimination of the top-up obligation, and have also limited their obligation to provide further information. With respect to the latter, they have agreed to provide such information only upon an investor’s reasonable request and only if it is not subject to any duties of confidentiality.
Finally, the notification obligations set forth in undertaking (v) appear to be disappearing entirely. In some ways this is a natural consequence of the other changes discussed above. For instance, undertaking (v)(A) is no longer relevant if the issuer has the ability to hold less than the required 5 percent under certain circumstances. Undertaking (v)(B) arguably has become unnecessary because of the monthly confirmation of undertaking (ii) and the limitations on undertaking (iii) discussed above. With respect to undertaking (v)(C), its absence seems simply to be a risk investors are willing to bear in light of current market conditions for U.S.-issued ABS instruments.
In conclusion, the evolution of EU risk retention undertakings has allowed U.S. companies to limit their obligations and exposure while still successfully marketing ABS instruments to EU investors. Whether this shift and success will continue will likely be a function of the risk appetite of the underwriters, banks and credit institutions involved in these transactions. In the near term, this almost certainly will be driven (for better or worse) by the continued market “frothiness” for U.S. ABS instruments around the globe.
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1 Regulation (EU) No. 575/2013, effective January 1, 2014.
2 EU CRR, Article 405. Similar to the United States, the EU CRR provides for (i) vertical retention of 5 percent of the face value of each class of instruments, (ii) horizontal retention of 5 percent of the first loss position of the entire securitization or (iii) a combination of the two.
3 Section 15G of the Securities and Exchange Act of 1934, as amended, as added by section 941 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.
4 EU CRR, Article 405.
5 EU CRR, Part One, Title I, Article 4. The EU CRR defines (i) a “credit institution” as an “undertaking the business of which is to take deposits or other repayable funds from the public and to grant credits for its own account” and (ii) an “investment firm,” by reference to Article 4(1) of Directive 2014/65/EU, as “any legal person whose regular occupation or business is the provision of one or more investment services to third parties and/or the performance of one or more investment activities on a professional basis.”
6 EU CRR, Article 406.
7 EU CRR, Article 406.