Dodd-Frank Risk Retention Rules Raise CMBS Concerns | Practical Law

Dodd-Frank Risk Retention Rules Raise CMBS Concerns | Practical Law

The approaching implementation of risk retention rules under the Dodd-Frank Act is creating uncertainty in the capital markets, contributing to a decline in the volume of CMBS deals and prompting legislators to introduce proposals to relieve some regulatory burdens affecting the industry.

Dodd-Frank Risk Retention Rules Raise CMBS Concerns

Practical Law Legal Update w-001-4926 (Approx. 4 pages)

Dodd-Frank Risk Retention Rules Raise CMBS Concerns

by Practical Law Real Estate
Published on 11 Mar 2016 • USA (National/Federal)
The approaching implementation of risk retention rules under the Dodd-Frank Act is creating uncertainty in the capital markets, contributing to a decline in the volume of CMBS deals and prompting legislators to introduce proposals to relieve some regulatory burdens affecting the industry.
Regulatory oversight of commercial mortgage-back securities (CMBS) tightened significantly after the financial crisis. In response to the crisis, the Securities and Exchange Commission (SEC) and five federal lending and housing agencies amended the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank), imposing additional regulatory burdens on CMBS lenders. The most significant part of the new regulations are the credit risk retention rules slated to go into effect for CMBS on December 24, 2016.

Dodd-Frank Risk Retention Rules

Dodd-Frank led to the promulgation of Regulation 15G of the Securities and Exchange Act of 1934 (15 U.S.C.A. § 78o-11), which requires the sponsor in a CMBS securitization to retain a 5% stake in the credit risk of the underlying commercial real estate asset. The purpose of the regulations is to require CMBS lenders to keep "skin in the game" to prevent the abuses that contributed to the financial crisis.
The rules were finalized on October 22, 2014, but become effective for CMBS transactions on December 24, 2016.

Acceptable Forms of Risk Retention

Sponsors have several options available to satisfy the risk retention obligations. Under the standard risk retention option, the sponsor must retain:
  • 5% of the face value of each class of securities issued in the CMBS transaction.
  • 5% of the fair value of all CMBS securities issued, but only of the most subordinate class of securities.
  • 5% of the value of transaction through a combination of either of the above options.
Sponsors are prohibited from hedging their credit risk in the underlying asset through the use of insurance contracts, letters of credit, or guaranties.
An alternative option allows the sponsor to find up to two B-piece investors willing to assume the risk retention obligation of the sponsor, subject to certain restrictions (see B-Piece Investors).

B-Piece Investors

In a CMBS transaction, the "B-piece" refers to the tranche of the capital stack that is below investment grade. Since the B-piece investors were already investing in the riskier first-loss positions in the securitized pool, they became the logical choice to assume risk retention obligations. Some requirements applicable to the B-piece investor are:
  • The B-piece investors may not be affiliates of any party to the transaction other than the special servicer, investors, or originators or less than 10% of the unpaid principal balance of the securitized assets involved in the transaction.
  • Each B-piece investor's interest must be pari passu so that neither party's losses are subordinate to the other's losses.
  • B-piece investors are required to hold the bonds period of five years. After the holding period, B-piece investors may only sell their bonds to other qualified B-piece investors, which further limits how they can hedge their positions.
The rules leave many questions unanswered about the role of B-piece investors. For instance, sponsors worry if they are responsible for ensuring that B-piece investors comply with the risk retention rules. Sponsors are also concerned about liability for violating the risk retention rules if the B-piece buyer declares bankruptcy and the securities are sold.

Proposed Legislation

On February 2, 2016, the Preserving Access to CRE Capital Act of 2016 was introduced to the House of Representatives (H.R. 4620, 114th Congress (2015-2016)). The bill passed a vote of the House Committee of Financial Services on March 2, 2016. The bill would modify the risk retention requirements for CMBS loans by:
  • Exempting single asset and single borrower transactions.
  • Allowing B-piece investors to hold their interests in a senior/subordinate structure.
  • Expanding the definition of Qualifying Commercial Real Estate.

Practical Implications

Lenders and their counsel should continue to monitor this situation as the December deadline approaches. It is uncertain whether the proposed bill will be signed into law in time and whether the bill will adequately address the concerns of the CMBS industry.
For more information on CMBS financing, see Practice Note, Commercial Mortgage-Backed Securities (CMBS) Finance: Overview and CMBS Loan Negotiation: Borrower's Counsel Checklist.
For general background information on the Dodd-Frank risk retention rules, see Practice Note, ABS Risk Retention under Dodd-Frank.