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House Bill Would Broaden US CLO Risk Retention Exception
Practical Law Legal Update w-001-0318 (Approx. 4 pages)
House Bill Would Broaden US CLO Risk Retention Exception
by Practical Law Finance
| Published on 29 Sep 2017 • USA (National/Federal) |
Congressmen Andy Barr (R-KY) and David Scott (D-GA) introduced H.R. 4166, designed to ease risk retention requirements on US CLO managers that organize qualified collateralized loan obligations (QCLOs).
Update: On September 14, 2017, the Barr-Scott bill was re-introduced as H.R. 3772. This 2017 version of the QCLO bill is, according to the LSTA, “almost identical” to the 2016 version, with a slight amendment to the retention structure. For more information, see the LSTA’s press release on the bill. Note that on March 2, 2016, the 2016 version of the Barr-Scott bill (H.R. 4166) passed the House Financial Services Committee, but the bill never made it to the full House for a vote.
Under final Dodd-Frank risk retention rules, CLO managers will be required to purchase and retain five percent of the fair value of any collateralized loan obligation (CLO) they initiate for the life of the transaction by either retaining a:
- Vertical interest.
- Horizontal interest.
- Hybrid interest consisting of a combination of the above.
The bill proposes that for QCLOs, this requirement would be reduced to five percent of the transaction's equity rather than the fair value of the CLO.
For further detail on the final risk retention rules, see Practice Note, ABS Risk Retention under Dodd-Frank.
Barr-Scott reflects the proposal submitted by the LSTA, along with SFIG and SIFMA, to federal regulators in January 2014. Additionally, the LSTA continues to pursue relief for CLO managers from Dodd-Frank risk retention requirements via a lawsuit it filed against the Federal Reserve and the SEC on November 10, 2014 in the US Court of Appeals for the District of Columbia. (see Legal Update, LSTA Sues Federal Regulators over Risk Retention Rules for CLOs). Oral arguments are scheduled for February 5, 2016.
For a CLO to qualify as a QCLO, it must meet the following criteria:
- The asset quality tests require the CLO to purchase high quality leveraged loans that have a low expected loss. To meet this criteria:
- CLOs must invest at least 90% in cash and senior secured loans to companies (and only those that are subject to an annual audit);
- CLOs may not purchase ABS interests, derivatives, loans in default, margin stock, or equity convertible notes;
- loans must be held by three or more investors or lenders unaffiliated with the CLO manager; and
- no more than 60% of the loans included in the collateral pool may be covenant lite loans.
- CLOs must have a diverse portfolio and must ensure that the collateral pool includes no more than:
- 3.5% of its aggregate value from any one loan; or
- 15% of its value from any one industry.
- Minimum capital structure requirements. The value of the equity of the QCLO must equal at least eight percent of the face value of all of the assets in the CLO's collateral pool.
- The CLO must be subject to interest coverage and overcollateralization (OC) tests that divert cash to pay down the notes in case the portfolio underperforms.
- The CLO must ensure an alignment of interests between the CLO manager and its investors. The following protections would be required:
- the QCLO must be an "Open Market CLO," not a balance sheet CLO (for details on this distinction, see Legal Update, LSTA Requests CLO Exemption from Dodd-Frank ABS Risk Retention Rules);
- equity investors must have the ability to remove the manager for cause;
- the majority of the manager's fees must be subordinated to payment of principal and interest on the rated CLO notes;
- the manager must purchase and retain five percent of the CLO's equity tranche;
- the manager has only limited discretionary trading authority; and
- US CLO holders must be qualified investors.
- Reporting and disclosure requirement. The manager of a QCLO is required to provide a monthly report including the following information:
- A list of all assets included in the CLO asset pool, as well as information on each asset including the obligor's name, CUSIP, interest rate, maturity date, type of asset and market price where available;
- the aggregate balance, adjusted collateral principal amount, and percentage of adjusted collateral represented by each name in the portfolio;
- details regarding each OC and interest coverage test and the status of each;
- all purchases, repayments, and sales of assets from the collateral pool; and
- the identity of each defaulted asset in the portfolio.
- The manager of a QCLO must be an SEC-registered investment advisor.