EBA Consultation Paper Raises Concerns for CLOs

The European Banking Authority (EBA) published a consultation paper on draft technical standards relating to the implementation of CRD IV on 22 May 2013. The consultation paper can be found here.

Of particular concern to participants in the CLO market are the provisions on the risk retention requirements originally set out in Article 122a of CRD II (Directive 2006/48/EC), now Articles 394-399 of the Capital Requirements Regulation (CRR).

It had been expected that the technical standards would closely follow the Guidelines to Article 122a in December 2010 (Guidelines). However, several key paragraphs of the Guidelines have not been included in the draft technical standards, notably paragraphs 25 and 26, which deal with retaining parties where there is no clear originator, sponsor or original lender to retain a 5% economic interest.

Recent CLOs have relied on paragraphs 25 and 26 of the Guidelines to have the 5% economic interest retained by a subordinated investor who was involved in structuring the transaction and selecting the exposures. Since these provisions have not been incorporated into the draft technical standards, it is far from clear whether this will continue to be a solution to the retention requirement or whether third parties will effectively be barred from performing the risk retention requirement.

The consultation paper states that the widening of the definition of “sponsor” in the CRR, to include investment firms as well as credit institutions, should allow CLO asset managers that are investment firms to act as the retaining entity. However the consultation paper also acknowledges that many CLO asset managers will face capital constraints on acting as retainer. The consultation paper concludes “this could potentially translate in the long term into a modification of the currently existing managed CLO model”. In our view, the provisions of the draft technical standards could potentially stifle the nascent return of the European CLO market recently signaled by the Cairn CLO III and ALME 2013-1 transactions.

We are also concerned that the consultation paper does not mention grandfathering provisions for current CLOs issued in reliance upon the Guidelines. The implication is that CLOs structured in reliance on the Guidelines will be assessed on the technical standards, rather than the Guidelines.

The EBA has requested comments on the consultation paper by 22 August 2013. We understand that the EBA will organize an open public hearing on the proposals for 22 July 2013. We would encourage all interested clients to respond to the questions raised by the EBA in the consultation paper.