Introduction and Summary of CMBS Updates
After more than three and a half years since the publication by regulators of the first proposals for credit risk retention, we now have a final rule that has brought with it a myriad of reactions: dissent, relief and perplexity, among others. In the world of commercial mortgage-backed securities (“CMBS”), we have come a long way – for example, since the original proposal resulted in comments from over 10,500 parties and since we wondered how we could ever live with the premium capture cash reserve account mechanism (which was excluded in re-proposed rules last year) – but questions remain and we have work to do before the final rule goes live in about two years.
The final regulations apply to, and have varying impacts on, a wide array of securitization arenas. While the rule poses significant challenges to certain markets such as the collateralized loan obligation (“CLO”) (detailed in Dechert's related OnPoint U.S. Risk Retention Final Rule: Playing it Forward for CLOs), and automobile loan sectors, and while it provides confirmation of relief for other industries such as the residential mortgage-backed securities (“RMBS”) space, most of the smoke has cleared for CMBS as we now look at final regulations that remain largely unchanged from re-proposals a year ago. However, important CMBS updates in the final rule include:
elimination of the “closing date cash flow test” that was viewed as an economic non-starter by industry participants in favor of an optional eligible horizontal cash reserve account;
exclusion of an exemption for stand-alone (single borrower single credit) deals;
retention of the requirement that two “third-party purchasers” (or B-piece buyers) hold the required risk on a pari passu basis;
confirmation of an exemption for “qualified” commercial real estate (“QCRE”) loans but the lack of any significant expansion of the related loan parameters; and
revision of the maximum investor voting quorum from 5% to 20% with respect to removal of the special servicer upon the recommendation of the operating advisor.
With regard to unchanged big-picture concepts found in the 2013 re-proposal, the final regulations still include the following concepts for CMBS: (1) a sponsor may utilize up to two “third-party purchasers” (or B-piece buyers) to satisfy required risk retention; (2) the role of an operating advisor is required if a sponsor utilizes the third-party purchaser option; and (3) any initial third-party purchaser is permitted to transfer the required retention interest to subsequent purchasers (and those purchasers are permitted to make successive transfers) starting five years after the closing of a deal.
In this OnPoint, we provide a brief background of the rule process, we detail the foregoing CMBS considerations as well as the basic risk retention requirements applicable across all asset classes and we estimate where all of this is going for CMBS. In addition, more reading on this topic can be found on Dechert’s blog, Crunched Credit.
Path to the Final Rule and Revisiting Section 15G of Dodd-Frank
On October 21, 2014, the Federal Deposit Insurance Corporation (“FDIC”) approved joint final credit risk retention regulations (the “Final Rule”)1 for asset-backed securities (“ABS”) to implement the related requirements of section 15G (“Section 15G”) of the Securities Exchange Act of 1934 (the “Exchange Act”).2 The FDIC’s approval of the Final Rule was part of a joint rulemaking effort that included the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, the Department of Housing and Urban Development, the Federal Housing Finance Agency and the Securities and Exchange Commission (together with the FDIC, the “Agencies”). Three of the Agencies approved the Final Rule on October 21, 2014 and the remaining Agencies approved it on October 22, 2014.
In 2010, Section 941 (“Section 941”) of the Dodd-Frank Wall Street Reform and Consumer Protection Act created Section 15G of the Exchange Act and generally required the Agencies to jointly prescribe regulations that require (i) a securitizer of ABS to retain at least 5% of the credit risk of any asset that, through the issuance of ABS, is transferred to a third party and (ii) prohibit a securitizer from directly or indirectly hedging or otherwise transferring the required risk retention.3 In furtherance of Section 15G’s mandate, the Agencies originally proposed risk retention requirements in April 2011 (the “Original Proposed Rule”)4 and, after soliciting and receiving comments from the public, published re-proposed requirements in September 2013 (the “Re-Proposed Rule”).5
In the Final Rule, the Agencies adopted much of the Re-Proposed Rule with various changes including concepts included in over 150 unique comment letters. Again, with respect to CMBS, the Agencies made relatively few revisions to the Re-Proposed Rule from 2013; nevertheless, there are new and old concepts deserving of focus, as summarized in our introduction above and described in detail below.
The Final Rule will apply to new-issue CMBS deals starting two years after its publication in the Federal Register.
Basic Risk Retention Requirement
5% Retention of Eligible Vertical Interest or Eligible Horizontal Residual Interest
The Final Rule requires that a sponsor6 of a securitization (or its majority-owned affiliate7) retain a 5% economic interest in the credit risk of the securitized assets. If there is more than one sponsor of the deal, each sponsor is responsible to ensure that at least one sponsor (or its majority-owned affiliate) retains the required credit risk.8 The required risk retention obligation can be satisfied by holding:
a single vertical security or an interest in each class of ABS issued by the securitization (in either case, an “Eligible Vertical Interest” or “EVI”);
an eligible horizontal residual interest (i.e., first loss, subordinate tranche) equal to 5% of the fair value of all ABS issued (an “EHRI”); or
any combination of an EVI and an EHRI so long as the sum of the percentage of the EVI and the fair value of the EHRI is at least equal to 5%.9
Measurement and Disclosure by Sponsor of Fair Value of Eligible Horizontal Residual Interest
With respect to the retention of an EHRI, the Final Rule requires that “the amount of the interest must equal at least 5 percent of the fair value of all ABS interests in the issuing entity issued as a part of the securitization transaction, determined using a fair value measurement framework under GAAP” (i.e., U.S. generally accepted accounting principles).10 The Final Rule deviates from the Re-Proposed Rule of 2013 by not requiring a fair value measurement for an Eligible Vertical Interest.11 In addition, the Final Rule revised the definition of “ABS Interests” to exclude residual REMIC interests from the calculation of fair value.12
The Final Rule requires written disclosure to potential investors with regard to the measurement of fair value of any EHRI (i) prior to the sale of the related ABS and (ii) after the closing of the related securitization.13 At a reasonable period of time prior to the sale of the ABS, a sponsor is required to disclose:
the fair value (expressed as a percentage of the fair value of all classes of ABS interests issued) and the dollar amount of the EHRI expected to be retained by the sponsor at the closing of the transaction or, if specific prices, sizes or interest rates of each tranche are not yet available, a range of fair values of the EHRI expected to be retained by the sponsor at the closing of the transaction;
the material terms of the EHRI;
the valuation methodology used to calculate the fair values or range of fair values of all classes of ABS interests, including the EHRI; and
all key inputs and assumptions or a comprehensive description of key inputs and assumptions (including discount rates, default rates, loss given default, prepayment rates and other metrics) used to calculate the fair value or range or fair values of all classes of ABS interests, including the EHRI expected to be retained, which data is required to include, at a minimum, descriptions of all inputs and assumptions that could have a material impact on the fair value calculation or would be material to a prospective investor’s ability to evaluate the sponsor’s fair value calculations.14
In addition, at a reasonable time after the closing of the securitization, a sponsor is required to disclose:
the actual fair value (expressed as a percentage of the fair value of all classes of ABS interests issued) and the dollar amount of the EHRI retained by the sponsor based on actual pricing, tranche sizes and interest rates;
the fair value (expressed as a percentage of the fair value of all classes of ABS interests issued) of the EHRI that the sponsor is required to retain according to the Final Rule; and
any material differences between the methodologies actually used to calculate fair value at the closing of the securitization and those disclosed prior to the sale of the ABS.15
Option - Eligible Horizontal Cash Reserve Account
As an alternative to retaining all or any part of an Eligible Horizontal Residual Interest, a sponsor may establish and fund in cash, at the closing of the securitization, an eligible horizontal cash reserve account, held with a trustee for the benefit of the issuing entity, in an amount equal to the fair value of the related EHRI or any part of it.16 While the Re-Proposed Rule from 2013 called for U.S. Treasuries and comparable investments in foreign currencies, the Final Rule limits permitted investments in the reserve account to cash and cash equivalents.17 Also, in another deviation from the Re-Proposed Rule, the Final Rule allows for funds in the cash reserve account to be used not only (i) for satisfaction of payments on ABS interests if there is a shortfall with respect to amounts due on any ABS interests but also (ii) for the payment of critical deal-party expenses of the trust unrelated to credit risk but for which the issuing entity has insufficient funds so long as such expenses, in the absence of available funds on deposit in the cash reserve account, would have otherwise been paid prior to any payments to ABS interests and such expenses are not paid to any parties affiliated with the sponsor.18
Option - Allocation of Risk Retention to Originators
The Final Rule retains the option included in the Re-Proposed Rule to have eligible originators share the risk retention obligation.19 A sponsor is permitted to offset the amount of its risk retention requirements by the amount of eligible interests acquired by an originator. An originator is eligible to take a portion of the retention obligation if:
the originator acquires and retains at least 20% of the aggregate risk required to be retained by the sponsor; and
the ratio of the percentage of eligible interests retained by the originator to the percentage of the eligible interests required to be retained by the sponsor does not exceed the ratio of the balance of the assets originated by such originator to the balance of all assets in the securitization.20
The Agencies sought to “ensure that an originator retains risk in an amount significant enough to function as an actual incentive for the originator to monitor the quality of all the securitized assets (and to which it would retain some credit risk exposure).”21 Also, an eligible originator is required to acquire and retain eligible interests, with respect to risk across the entire pool of assets, in the same manner and proportion as those acquired and retained by the sponsor. Lastly, the Final Rule obliges a sponsor to disclose the nature of any originator allocation and to monitor compliance by each originator that is allocated a portion of the risk retention.22
Basic Transfer, Hedging and Financing Restrictions
The Final Rule, confirming the approach of the Re-Proposed Rule, generally prohibits a sponsor from transferring its eligible interests to any person other than to its majority-owned affiliate (and back to the sponsor), and such majority-owned affiliate is only permitted to hold the eligible interest so long as it remains a majority-owned affiliate of the sponsor.23
Other concepts tracked from the Re-Proposed Rule to the Final Rule are restrictions on hedging and financing of eligible interests. The Final Rule prohibits a retaining sponsor and its affiliates, as well as the issuing entity, from purchasing or selling a security or other financial instrument and from entering into an agreement, derivative or other position with any person if:
the payments are “materially related to the credit risk of one or more particular ABS interests” that the sponsor (or its majority-owned affiliate) is required to retain; or
the security, instrument, agreement, derivative or position “in any way reduces or limits the financial exposure” of the retaining sponsor (or its majority-owned affiliate) to the credit risk of one or more of the particular ABS interests that the sponsor (or its majority-owned affiliate) is required to retain.24
However, the Final Rule exempts certain hedging activities, including interest rate hedging, foreign exchange hedging and certain transactions that are based on an index of instruments that include ABS.25 Finally, a sponsor is generally prohibited from financing eligible interests, but a sponsor (or its affiliate) may pledge eligible interests as collateral for an obligation if such obligation is fully recourse to the sponsor (or its affiliate).26
Basic Retention Period
Similar to the Re-Proposed Rule, the Final Rule provides that a sponsor’s risk retention obligation will be satisfied upon retention until the latest of “(1) the date on which the total unpaid principal balance of the securitized assets that collateralize the securitization is reduced to 33 percent of the original unpaid principal balance (if applicable) as of the date of the cut-off date of the securitization, (2) the date on which the total unpaid principal obligations under the ABS interests issued in the securitization is reduced to 33 percent of the original unpaid principal obligations at the closing of the securitization transaction, or (3) two years after the date of the closing of the securitization transaction.”27
No Participation Interests, Companion Loans or Third-Party Credit Support
The Final Rule did not adopt an expansion of the form of risk retention to permit the use of pari passu and subordinate participation interests or companion loans. In addition, the Final Rule does not allow the use of third-party credit support (such as insurance policies, guarantees or letters of credit) or overcollateralization to satisfy the retention requirements.
Final Rule Victory – Elimination of Closing Date Cash Flow Test
The Final Rule eliminates the closing date cash flow test for Eligible Horizontal Residual Interests that was included in the Re-Proposed Rule. A derivative of the premium capture cash reserve account mechanism included in the Original Proposed Rule, the closing date cash flow test was considered by the industry to be unworkable in the CMBS space. The test would have permitted risk retention by way of an EHRI only if the sponsor calculated and certified that, for each payment date:
the ratio of (i) the fair value of cash flows projected as of the transaction’s closing date to be paid to the holder of the ERHI through the related payment date to (ii) the fair value of all cash flows projected as of the transaction’s closing date to be paid to the holder of an EHRI through the maturity of the EHRI would not exceed
the ratio of (i) the amount of principal projected as of the transaction’s closing date to be paid on all ABS interests through the related payment to (ii) the aggregate principal amount of all ABS interests issued in the transaction.28
By doing away with the test, the Final Rule offers a significant benefit to the CMBS market (and other markets) by removing what may have been a categorical bar on the ability of a CMBS sponsor to meet risk retention requirements through the acquisition of an EHRI by a traditional B-buyer (i.e., third-party purchaser).
Final Rule – Specific Updates for CMBS
Multiple Third-Party Purchasers Must Take Pari Passu Interests
Despite industry comments to the contrary, the Final Rule retains the restriction that satisfaction of a sponsor’s risk retention requirement by two third-party purchasers (or B-piece buyers) is effected only if the eligible interests of such purchasers are pari passu with each other.29 In the preamble to the Final Rule, the Agencies indicate “that allowing the third-party purchasers to satisfy the risk retention requirement through a senior-subordinated structure would significantly dilute the effectiveness of the risk retention requirement.”30
No Exemption for Stand-Alone Securitizations
The Final Rule does not create a categorical exemption from risk retention requirements for single borrower single credit (“SBSC”) deals, as the Agencies “have not concluded that SBSC transactions as a category are of sufficiently low risk to warrant a special exemption from risk retention.”31 In explaining this conclusion, the Agencies point to, among other factors, the lack of diversification across property types that characterizes SBSC deals, “which potentially concentrates and increases credit risk as compared with a diversified CMBS securitization.”32 Accordingly, a stand-alone securitization is generally required to satisfy basic risk retention requirements, subject to the availability of any benefits provided, for example, by the specific CMBS provisions or QCRE loan parameters. Given that the QCRE exemption was the subject of limited expansion in the Final Rule, as detailed below, the flexibility provided by it is probably not enough to have a meaningful impact in the real world of stand-alone securitizations.
Not Many Changes to QCRE Loan Exemption
The Final Rule retains the Original Proposed Rule’s and the Re-Proposed Rule’s inclusion of a framework for exempting transactions, with little movement from the Re-Proposed Rule’s criteria for exemptions applicable to CMBS transactions. Like the Re-Proposed Rule, the Final Rule exempts a loan that meets the following conditions and thus qualifies as a QCRE loan: (i) the loan has a debt service coverage ratio of (a) 1.25x, if it is a qualifying multifamily loan, (b) 1.50x, if it is qualifying leased loan or (c) 1.70x, if it is any other commercial real estate loan; (ii) the loan has an amortization term of no more than 25 years or, if it is a multifamily loan, 30 years; (iii) the loan has an LTV of no more than 65% and, if the related collateral also secures a junior lien, a combined LTV of no more than 70%; (iv) the loan has an interest rate that is fixed or is fully convertible to a fixed rate; and (v) the loan has no interest-only period.33 Representing perhaps the most significant deviation from the Re-Proposed Rule’s QCRE loan regime, the Final Rule slightly expands the scope of loans that may qualify as QCRE loans to include loans secured by improved land if the related borrower owns the fee interest in the land and the land is leased to a third party who owns all improvements on the land.34 With little expansion of the parameters for QCRE loans, we remain unconvinced that the Final Rule’s exemption for QCRE loans will offer significant relief to CMBS issuers on a pool-wide basis. We note, however, that the exemption could provide relief to a securitization of a blended pool of assets as a blended pool’s risk retention requirement is reduced by the proportion of the unpaid principal balance of the QCRE loans to the total unpaid principal balance of the pool, capped at 50%.35
Increase of Voting Quorum for Replacement of Special Servicer
The Final Rule departs from the Re-Proposed Rule with respect to the maximum allowed voting quorum related to taking an affirmative investor vote in support of the operating advisor’s recommendation to replace the special servicer. The Re-Proposed Rule included a threshold of 5% based of the outstanding principal balance of all ABS interests in the issuing entity,36 and the Final Rule responded to industry comments by increasing this maximum to 20%.37 The Final Rule also introduces an additional restriction on the quorum’s composition, requiring that it include at least three holders of ABS interests that are not affiliated with each other.38
Final Rule – General CMBS Provisions
The Final Rule follows the Re-Proposed Rule by similarly containing an option specific to CMBS transactions whereby the related sponsor can satisfy risk retention requirements through or in combination with one or two third-party purchasers or B-piece buyers. Largely paralleling the market role of B-piece buyers in CMBS transactions, the Final Rule allows up to two third-party purchasers to take pari passu Eligible Horizontal Residual Interests to satisfy some or all of the sponsor’s risk retention requirements so long as certain conditions are met, including:
the securitization is collateralized solely by commercial real estate loans or servicing assets;
no third-party purchaser receives any financing, directly or indirectly, for the acquisition of its EHRI from any person that is a party (or an affiliate of any party) to the securitization, and each third-party purchaser pays cash for its EHRI;
each third-party purchaser conducts an independent review of the credit risk of each securitized asset prior to the sale of the ABS (including, at a minimum, a review of underwriting standards, collateral and expected cash flows);
no third-party purchaser is affiliated to any party to the securitization transaction, except for investors, the special servicer and originators of assets constituting less than 10% of the cut-off date balance of the securitized assets;
incorporation in the related transaction documents of the role of the operating advisor (as described below); and
each third-party purchaser complies with specific transfer, hedging and financing restrictions (as described below).39
Operating Trust Advisor
With respect to any transaction for which a sponsor utilizes the third-party purchaser option to satisfy in whole or in part the required retention obligation, the related transaction documents must provide for:
the appointment of an operating advisor that is not affiliated with other parties to the transaction, does not have any financial interest in the transaction other than its fees from its function as operating advisor and is required to act in the best interest of, and for the benefit of, investors as a collective whole;
standards with respect to the operating advisor’s experience, expertise and financial strength to fulfill its duties under the transaction documents;
the terms of the operating advisor’s compensation;
the requirement that the special servicer consult with the operating advisor in connection with any material decision relating to its servicing of the assets once the EHRI has been reduced by principal payments, realized losses and appraisal reduction amounts to a principal balance of 25% or less of its initial principal balance;
adequate and timely access by the operating advisor to information and reports necessary to fulfill its duties, including the operating advisor’s obligation to review the special servicer’s actions, all reports provided by the special servicer to the issuing entity or any holder of ABS interests and the special servicer’s calculations;
the operating advisor’s obligation to issue periodic reports to investors and the issuing entity describing the operating advisor’s good faith assessment of whether the special servicer is operating in compliance with any servicing standard required under the transaction documents and which standards the operating advisor believes that the special servicer has failed to observe; and
the operating advisor’s right to recommend that the special servicer be replaced upon the affirmative vote of investors (subject to the voting quorum requirements revised in the Final Rule, as detailed above).40
The Original Proposed Rule provided for an operating advisor role that would have direct special servicer oversight rights for the entirety of the transaction’s term.41 The Final Rule departs from this prior formulation, favoring requirements that more closely conform to market CMBS 2.0/3.0 structures.
Five Year Retention Period for Third-Party Purchaser(s)
Departing from the requirement in the Original Proposed Rule that an eligible interest be held for the life of the transaction, the Final Rule permits a third-party purchaser or B-piece buyer to transfer its interest beginning five years after the closing of the transaction to a third-party purchaser that satisfies the conditions applicable to an initial third-party purchaser. In addition, the Final Rule permits any number of subsequent transfers of the eligible interest at any time to a transferee that also satisfies the conditions applicable to an initial third-party purchaser.42
Transfers, Hedging and Financing Permitted for CMBS upon Defeasance of All Loans
Although the basic requirements for transfers, hedging and financing of eligible interests (as described above) apply to the CMBS context and retention by any third-party purchaser (as also described above), the Final Rule includes a carveout that removes those prohibitions with respect to retention by any third-party purchaser so long as each commercial real estate loan “that serves as collateral for outstanding ABS interests has been defeased.”43 We question whether this qualification will have any meaningful impact in the CMBS space.
Disclosure by Sponsor of Risk Retention by Third-Party Purchaser(s)
Similar to the Re-Proposed Rule of 2013 and analogous to the disclosure provisions with respect to basic risk retention requirements, the Final Rule requires a sponsor to provide the following information to investors prior to the sale of ABS:
name and form of organization of each initial third-party purchaser acquiring an eligible interest;
a description of each initial third-party purchaser’s experience in investing in CMBS;
any other material information regarding the initial third-party purchaser in light of the circumstances;
the fair value (expressed as a percentage of the fair value of all classes of ABS interests issued) and the dollar amount of the EHRI expected to be retained by the third-party purchaser at the closing of the transaction as well as the purchase price to paid for the EHRI;
the fair value (expressed as a percentage of the fair value of all classes of ABS interests issued) and the dollar amount of the EHRI that the sponsor is required to retain according to the Final Rule;
a description of the material terms of the EHRI;
representations and warranties with respect to the assets, a schedule of any assets determined not to comply with such representations and warranties and any compensating factors; and
the name and form of organization of the operating advisor, a description of how the operating advisor role satisfies requirements set forth in the Final Rule and the terms of the operating advisor’s compensation.
A new disclosure requirement included in the Final Rule provides that investors must be provided with a “description of any material conflict of interest or material potential conflict of interest between the Operating Advisor and any other party to the transaction[.]”44
Duty of Sponsor to Monitor Risk Retention by Third-Party Purchaser
The Final Rule obliges a sponsor to monitor compliance by each third-party purchaser (or B-piece buyer) that is allocated a portion of the risk retention.45
Post-Adoption Interpretation and Guidance
In what might be an acknowledgment of the difficulty of fully accounting for today’s and tomorrow’s securitization landscape, especially given the volume of outstanding questions regarding final regulations that do not include specific remedial provisions but that confer broad enforcement authority, the Final Rule grants the Agencies ongoing authority to provide post-adoption interpretation and guidance and to grant exemptions to any securitization transaction as the Agencies “determine may be appropriate in the public interest and for the protection of investors.”46 Despite this provision for ongoing guidance and review, the Final Rule provides scarce detail on the terms that are to govern the Agencies’ case-by-case evaluation.
CMBS and the Final Rule
Following is our “cheat” chart detailing certain CMBS provisions/exemptions from the Final Rule and their impact on current CMBS structures: