On May 22, 2013, the European Banking Authority (EBA) published a consultation paper on EU securitization risk retention rules that has changed the market's understanding of how risk retention in the EU operates. The EBA's interpretation could present problems for US investors in, and issuers of, EU managed CLOs, as well as for the European CLO market, which had just begun to recover. The draft regulatory and implementing technical standards (RTS and ITS) on securitization retention rules to which the EBA consultation relates are scheduled to become effective on January 1, 2014.

EU risk retention rules are similar to those proposed under the Dodd-Frank Act (see Practice Note, ABS Risk Retention under Dodd-Frank) in that they require retention by issuer affiliates of 5% of the economic interest of a securitized asset pool. The EBA consultation clarifies that in EU securitizations this credit risk may not be held by a third party, as had been widely believed, even if the interests of that third party are aligned with those of the securitizers. The consultation clarifies that the retained interest must be held by a sponsor or originator of the securitization, which must be an EU investment fund or EU credit institution.

The consult threatens to render noncompliant a number of recent EU CLO transactions that have come to market during the period since implementation of the rules in which third parties, usually equity investors, have retained the 5% interest. These transactions have not yet been grandfathered under the EBA interpretation.

An important element of the EU retention rules is that, rather than penalizing the securitizers themselves, the rules penalize investors in ABS for which the risk retention requirements have not been complied with (including the required investor disclosures), placing the onus on investors to obtain the requisite disclosures and ensure that they invest in compliant ABS. Though these penalties, mostly in the form of additional capital charges, do not apply to non-EU investors, US investors in European managed CLOs issued during the period since implementation of the risk retention rules in January 2011 are at risk of holding noncompliant, illiquid securities.

Further, if the regulation becomes effective as drafted, US CLO collateral managers are unlikely to be eligible to retain the risk under the EBA consult, and therefore unable to issue managed CLOs in the EU, because they:

Collateral managers of most non-CLO EU ABS deals as well as so-called "balance sheet" CLOs are usually the originators of the securitized assets. Therefore, most ABS and balance sheet CLOs would not present a problem under the EBA interpretation of the retention rules.

Many market participants assert that managed CLOs do not follow the originate-to-distribute model that EU and US risk retention rules sought to address, and that these transactions should therefore not be targeted by the retention rules. However, regulators have not only included managed CLOs in the risk retention regime, but this latest development has essentially eliminated their only option for compliance with the EU retention rules.

The draft regulatory and implementing technical standards (RTS and ITS) on securitization retention rules (EBA/CP/2013/14) to which the EBA consultation relates are scheduled to become effective on January 1, 2014. The draft RTS concern the retention of net economic interest and other requirements related to exposures to transferred credit risk under Articles 394, 395, 397 and 398 of the proposed Capital Requirements Regulation (CRR). The draft ITS relate to the convergence of supervisory practices with regard to the implementation of additional risk weights under Article 396 of the CRR and specify the measures to be taken in the event of breach of the obligations in Articles 394, 395 or 398 of the CRR.

In developing these draft RTS and ITS, the EBA has taken into account the guidelines on Article 122a of the Capital Requirements Directive (2006/48/EC and 2006/49/EC) (CRD) that were published in December 2010 (see Legal Update, CEBS Guidelines to Article 122a of the CRD) and the associated questions and answers (Q&A) that were published in September 2011 (see Legal Update, EBA Q&A on Article 122a of the CRD), as well as the changes in the level 1 text of the CRR compared to CRD II (2009/111/EC) and relevant market developments.

The Article 122a CRD rules are currently effective and have been applicable to newly issued securitizations since January 1, 2011. Articles 393-399 CRR (which will replace 122a CRD) will come into force on January 1, 2014. The revised rules are currently under consultation by the EBA. Market participants generally believed regulators would effect a straight switch between CRD and CRR, but the CRR has proposed tweaking the rules in a way which is unfavorable to managed CLOs. Under the CRD, equity investors may assume collateral management responsibilities and hold the retention as a "sponsor." However, this flexibility has been discarded by the CRR, as interpreted by the EBA in the consultation. The new definition of "sponsor" is rarely applicable to any party involved in a managed CLO (which the EBA acknowledges) because most EU CLO managers lack the capital to retain the 5% risk (unlike many US CLO managers). Historically, US managers and arrangers have been active in the managed European CLO market, but as they are not regulated by MiFID or AIMFD they will no longer be able to fill this role. This is problematic for the EU CLO market, which had just begun to revive based on the understanding that the risk retention rules had been finalized and that they permitted third party retention under certain circumstances.

It is not clear if CLOs issued in compliance with Article 122a, which will be replaced by the new rules on January 1, 2014, but which are now not compliant with the CRR will be penalized or grandfathered. Market consensus appears to be that deals issued prior to the publication of the EBA consultation will be exempted but any deals done from late May 2013 onwards will have to comply with the new rules because even though they are not yet effective, the market has been put on notice of the new requirements. More certainty will be provided once the next draft of the regulations are released at the conclusion of the consultation period.

Comments can be made on the consultations until August 22, 2013. The EBA must submit the RTS and ITS to the European Commission by January 1, 2014.

For a discussion of the role of the originator, sponsor, collateral manager and other parties to both US and EU securitization transactions, see Practice Note, Securitization: US Transaction Parties and Documents.