Introduction

On May 12, 2020, the Federal Reserve Board of Governors (the “Fed”) and the Federal Reserve Bank of New York (the “FRBNY”) released an updated term sheet (the “New Term Sheet”) and Frequently Asked Questions (the “TALF FAQs”) for the reestablishment of the Term Asset-Backed Securities Loan Facility (“TALF”) program. The New Term Sheet supersedes the term sheet released by the Fed on April 9, 2020 (the “April Term Sheet”).¹ The New Term Sheet and the TALF FAQs include positive developments, but also raise additional concerns and more questions. In some cases, the Fed and the FRBNY added guidance that specific rules will come and were silent on other questions.

The April Term Sheet introduced some significant flaws to the TALF program, in particular the definitions of and requirements applicable to eligible issuers and Eligible Borrowers (as defined below) that we highlighted in our previous OnPoint discussing the April Term Sheet. Yesterday’s Fed announcement largely addresses those issues but creates some additional concerns of its own, arising from the TALF FAQs. In particular, the borrower certification (“Borrower Certification”) requirements of a qualifying Eligible Borrower remain opaque at best. Specifically, the Eligible Borrower is required to certify that it cannot receive adequate credit accommodations from other sources and must certify that it is not insolvent. How that requirement is applied to newly formed investment funds/vehicles is currently unclear.

Positive Developments

Eligible Borrowers
After receiving considerable commentary and concern, the Fed provided generally positive guidance on the definition of eligible borrower (the “Eligible Borrowers”). The New Term Sheet defines Eligible Borrowers to “include businesses that (a) are created or organized in the United States or under the laws of the united States, (b) have significant operations in and a majority of their employees based in the United States, and (c) maintain an account relationship with a primary dealer.” The TALF FAQs make clear that an externally managed investment fund can also be an Eligible Borrower, provided that “the investment manager must have significant operations in and a majority of its employees based in the United States,” without requiring that the investment fund itself have “significant operations and a majority of its employees based in the United States.”

Eligible Issuers
Responding positively to market concerns that it would have rendered the program unusable, the Fed removed the requirement that issuers have significant operations and a majority of their employees in the U.S. This update allows for the TALF assets to coincide with generally accepted standards within the industry for special purpose entities (“SPEs”) to issue the related securities. In addition, CLO issuers are now permitted to be domiciled in the Cayman Islands, in accordance with standard market practice, as long as they are managed by a collateral manager with significant operations and a majority of their employees in the U.S.

Eligible Collateral
The New Term Sheet clarified that “newly issued” underlying credit exposures include leveraged loans, auto loans, student loans, SBA loans and equipment receivables originated on or after January 1, 2019. CLO industry professionals in particular had raised concerns that the inability to include recently-issued loans in TALF-eligible CLOs would make it practically impossible to assemble a portfolio in time to take advantage of the TALF program before it expired in September, and this change amounts to a significant positive development for CLO market participants wishing to take advantage of TALF. The TALF FAQs also clarified that eligible collateral can be on a borrower’s balance sheet, so long as such borrower acquired such collateral in arms-length secondary market transactions within 30 days prior to the relevant loan subscription date.

Additional Concerns

Eligible Borrowers
The Fed added additional guidance that restricts foreign government participation in the program, including by limiting foreign government participation in a TALF investment fund to no more than 10% of any outstanding class of the fund’s securities (any investor who owns 10% or more, a “Material Investor”) as well as limiting the equity ownership of the investment adviser in a similar manner.

Eligible Issuer Domicile & Collateral Location
Under the New Term Sheet, “all or substantially all” of the assets backing the securities must be originated by U.S. entities (in the case of ABS), have a lead arranger or co-arranger that is U.S. domiciled (in the case of CLOs), must be provided to U.S. domiciled obligors (in the case of ABS and CLOs) or must be backed by “real property located in the United States or one of its territories” (in the case of CMBS).²

Eligible Collateral Matters
The Fed made no change to the requirement that the CMBS backed by commercial mortgages must be issued prior to March 23, 2020, and on or after March 23, 2020 for all other eligible collateral that may be financed by the program. Further, although relatively unsurprising, eligible collateral cannot be backed by loans originated or securitized by the Eligible Borrower or an affiliate.

Limit on Redemption Rights
The TALF FAQs include a new outright prohibition on ABS that include a redemption option exercisable prior to three years after the disbursement date of the related TALF loan (other than a customary clean-up call), or at any time the ABS is owned by the Fed. This marks a change from the 2009 TALF program, under which the Fed would consider accepting a redemption option exercisable at par. It also constitutes a significant impediment for the CLO market, where equity investors typically rely on a right to refinance or redeem the rated securities after a two-year (or shorter) non-call period to take advantage of changing market conditions.

Public Disclosures
In the interest of transparency, the Fed provided guidelines on disclosure policies for participants in the TALF program. On a monthly basis, the Fed will publicly disclose information relating to the TALF, including information identifying (i) each borrower and other participants in the TALF facility, (ii) each Material Investor of a borrower, (iii) the amount borrowed by each borrower, (iv) the interest rate paid by each borrower, (v) types and amounts of ABS collateral pledged by each borrower and (vi) overall costs, revenues and other fees for the facility. Although not necessarily “bad” from a public policy perspective, the added scrutiny may have the effect of limiting the universe of investors who are willing to invest in Eligible Borrowers.

CLO TALF Loans will use SOFR as the reference rate
The use of SOFR as the reference rate for a TALF loan related to CLOs will continue to be problematic for the broader CLO market. It is anticipated that newly issued CLOs will largely continue to utilize three month LIBOR as the reference rate. While not insurmountable, market participants will have to contend with basis mismatch risk between any pledged CLOs and the related TALF loan.

Borrower Certification
The TALF FAQs provide that an Eligible Borrower will be required to certify that it is (i) unable to secure adequate credit accommodations from other banking institutions and (ii) not insolvent. It is unclear at this time how Eligible Borrowers are to interpret this provision in light of the circumstances in which they have been created. For example, will an Eligible Borrower have to first request similar leverage from one or more financial institutions for similar ABS investments? This seems unlikely but the TALF FAQs do not distinguish between what an Eligible Borrower must do versus a broader market based perspective. Further, any such certification must take into account pricing relative to a “well-functioning market,” which is not a clear, objective standard. Although the TALF FAQs allude to further clarification in the forthcoming Borrower Certifications, there can be no assurance that these questions will be resolved entirely. Finally, it should be noted that each Eligible Borrower also must certify that it is in compliance with the conflicts of interest requirements of section 4019 of the Coronavirus, Aid, Relief and Economic Security Act, which broadly relates to members of the administration, Congress and their relatives.

The Unknown

Known Unknowns
Despite the additional guidance, the Fed and the FRBNY left a number of aspects of the program to be determined in a future release, including:

1. The date the form Master Loan and Security Agreement will be released;
2. The date the TALF will become operational;
3. The eligible collateral review processes and related documentation needed to provide to TALF Agents;
4. The issuer certifications, auditor assurances and SBA documentation for newly-issued ABS;
5. The loan subscriptions and closing processes; and
6. The operational mechanics such as issuer considerations, eligible collateral monitors and agents other than TALF Agents.

Unknown Unknowns
The Fed could still change the term sheet again, and as we have seen with prior guidance and releases, the Fed reserves the right to make adjustments to the program at any time. The Fed has indicated that it is constantly reviewing activity in the market to determine whether credit is available and we expect the Fed to take additional action in the future if necessary. Specifically, the marketplace had been full of speculation that the list of eligible collateral would grow to include additional asset classes, including residential mortgages, additional consumer debt products, and additional types of CMBS. This expansion may be under consideration by the Fed, but they did not explicitly state the extent to which such asset classes are under consideration.

Further Updates and Commentary

The Fed’s newest revisions and clarifications give both potential borrowers and investors a clearer view of the mechanics of the TALF program. Dechert will continue to monitor all developments relating to TALF, and will continue to provide in depth analysis on the specific changes to particular asset classes and other issues relating to both issuers and investors.

Footnotes

1) (see full description of the Fed’s announcement of the TALF program, in the March 2020 Dechert OnPoint - Federal Reserve Establishes Term Asset-Backed Securities Loan Facility (TALF); see also, Dechert’s commentary on the April Term Sheet, in the April 2020 Dechert OnPoint - Federal Reserve Releases May Term Sheet on the Term Asset-Backed Securities Loan Facility (TALF)).

2) As described in the TALF FAQ, “all or substantially all” is 95% or more of the dollar amount of the underlying assets. https://www.newyorkfed.org/markets/term-asset-backed-securities-loan-facility/term-asset-backed-securities-loan-facility-faq