On October 10, 2022, the European Commission (the Commission) issued its report (the Report) on various aspects of the EU Securitization Regulation (EUSR).
This Sidley Update addresses a specific issue raised by the Report in relation to reporting requirements that may significantly affect new U.S. securitizations — including traditional securitizations of all asset classes, collateralized loan obligations, single-family residential securitizations, and bilateral loan facilities structured as securitizations. In particular, in light of the Report, European Union (EU) investors may now require additional reporting by U.S. sponsors, and may consider themselves unable to invest if such reporting is not available.
This is an evolving issue, with further developments expected, and there is not yet an established market position in certain areas. However, the potential impact is immediate, and this Sidley Update considers the implications as things currently stand.
Summary of Key Issues
SCOPE AND APPLICATION OF EUROPEAN RISK-RETENTION RULES
The European risk-retention rules are imposed by the EUSR (for EU investors) and the UKSR (for UK investors). The objectives and requirements of the EUSR and the UKSR are aligned in many respects, but there are certain differences between them (and those are relevant in the context of the developments discussed in this Sidley Update).
Neither the EUSR nor the UKSR applies directly to U.S. (or other non-UK/non-EU) sponsors, lenders, collateral managers, originators, or issuers. However, both the EUSR and the UKSR impose certain restrictions on EU/UK institutional investors, such that they are not permitted to invest in any securitization — including a U.S. securitization — unless they can verify that the requirements of the EUSR or the UKSR (including as to risk-retention and reporting, as described below) are satisfied. Consequently, in practice, certain aspects of the EUSR and the UKSR have extraterritorial effect, and in a U.S. securitization intended to attract EU/UK investors, it will be necessary for the sponsor (or another appropriate party) to commit to take certain actions in accordance with these requirements.
Each of the EUSR and the UKSR prohibits investment in a securitization unless the investor can verify that the sponsor (or another appropriate party) will hold a 5% retained interest in the transaction in accordance with one of the methods prescribed by the EUSR/UKSR (e.g., a first-loss piece or a vertical slice).
The position in regards to reporting is more complex.
Article 7 Reporting
The EUSR and the UKSR each establish a regime commonly known as “Article 7 reporting.” This requires the originator, sponsor, and issuer of a securitization to make certain documents and information available to investors, regulators, and (on request) potential investors. The required documents include asset-level reports and investor reports, to be provided on a quarterly basis (or monthly, for asset-backed commercial paper).
Under each regime, template forms are prescribed for the purposes of these reports. In the case of asset-level reports, the templates differ according to the nature of the securitized assets (e.g., corporate loans, residential mortgages, or auto loans). In all cases, the templates comprise a large number of mandatory data fields. The asset-level reports require the inclusion of data by reference to each individual asset. It is generally understood that in many cases, generating the required reports in the form of the prescribed templates would be a challenging and burdensome obligation. However, the other elements of Article 7 reporting, such as providing information on the transaction documents or notification of significant events affecting the securitization, generally should not be particularly onerous.
Requirements for EU Institutional Investors
The EUSR provides that an institutional investor (generally defined to mean EU regulated financial institutions and occupational pension funds) must not invest in a securitization unless it can verify that the sponsor (or another appropriate party — but, for convenience, we will refer only to sponsors) will deliver Article 7 reporting. However, because of some perceived ambiguity in the drafting, there has — to date — been uncertainty as to whether such EU investors must receive Article 7 reporting in the context of U.S. securitizations (or other non-EU securitizations). In the absence of guidance clarifying the legislation, it has been common to see non-EU securitizations that have not provided for Article 7 reporting (in particular, they have not required reports to be delivered in the form of the prescribed templates), and EU investors generally seem to have been comfortable investing on that basis.
Requirements for UK Institutional Investors
The UKSR differs, on this point, from the EUSR in that the former is explicit in stating that the corresponding reporting requirement under the UKSR does apply in respect of non-UK securitizations. However, the terms of the requirement itself are also different under the UKSR: it comprises a prohibition on UK institutional investors investing in non-UK (including U.S.) securitizations unless they receive reporting “substantially the same as” would be required by Article 7 of the UKSR. The precise meaning of the “substantially the same” condition is not clear, but it appears to leave investors with a degree of flexibility in what they should obtain from sponsors.
Reporting in U.S. Securitizations
It has been rare to see securitizations in which a U.S. sponsor has agreed to report in accordance with Article 7 of the EUSR and the UKSR. This is partly because it would likely be challenging for the sponsor (or other parties) to generate reports in the form of the Article 7 prescribed templates. It is also partly because to date, in many cases, EU and UK investors have taken the view that they do not require Article 7 reporting.
TYPICAL POSITION IN U.S. SECURITIZATIONS TO DATE
U.S. securitizations have generally taken one of the following two positions with regard to the EUSR and the UKSR:
- In securitizations usually referred to as “non-compliant” securitizations, no action of any kind is taken specifically to enable compliance by EU or UK investors with their obligations under the EUSR or the UKSR (in particular, while the sponsor may retain an interest for purposes of the U.S. risk-retention regime under Regulation RR, neither it nor any other transaction party commits to retain an interest, or to report, in accordance with the EUSR or the UKSR); or
- In securitizations often known as “EU-lite,” the sponsor or another appropriate party commits to hold a retained interest in accordance with the EUSR and the UKSR, but neither it nor any other transaction party undertakes to provide anything by way of Article 7 reporting.
In each case (assuming there is an offering document), there is express disclosure describing the position being taken and the related risks for investors.
EUROPEAN COMMISSION REPORT
As noted above, on October 10, 2022, the Commission issued the Report. Among other things, the Report addressed the perceived ambiguity noted above with regard to the requirement for Article 7 reporting. In that regard, the Commission:
- Acknowledged that to date, there have been differing interpretations of the relevant requirements of the EUSR, and that EU investors have been investing in non-EU securitizations without receiving full Article 7 reporting;
- Provided interpretative guidance to the effect that EU investors should not invest in non-EU securitizations unless there is full Article 7 reporting (i.e., including reporting in the form of the prescribed templates); and
- Recognized that a requirement for full Article 7 reporting in non-EU securitizations “… de facto excludes EU institutional investors from investing in certain third-country securitisations,” and places EU investors at a competitive disadvantage in the securitization market.
To be clear, the terms of the EUSR have not been amended, and the apparent ambiguity in its drafting remains, but there is now an authoritative interpretation of the relevant text, to the effect that it prohibits an EU investor holding an interest in a securitization in any jurisdiction unless there is full Article 7 reporting.
The Report relates only to the EUSR and does not apply to the UKSR.
POTENTIAL IMPACT OF GUIDANCE ON NEW U.S. SECURITIZATIONS
The extent of the impact of the Report for U.S. securitizations could depend on the position relevant EU investors take, because it is for those investors to determine whether they are in a position to comply with their obligations under the EUSR — including whether they will receive the reporting they require. Each individual investor should make its own assessment as to what it requires by way of covenants from the sponsor, and in principle, different investors (and their advisers) might take different positions.
That said, while a range of opinions have been expressed by market participants as to the implications of the Report, there appears to be a widely-held view that:
- As things stand, in light of the Report, it would be difficult for an EU investor to demonstrate that it is in strict compliance with the EUSR if it acquires an investment in a securitization without receiving full Article 7 reporting; and
- Accordingly, pending further developments (as to which, see below), in many cases, EU investors are likely to consider themselves unable to invest in U.S. securitizations — whether upon issuance or in the secondary market.
In general, at this stage, we would expect those structuring new U.S. securitizations to be weighing the options noted below. The following assumes that the sponsor has an established issuance program and is considering whether to maintain, or change, its usual approach, but the discussion of the issues is equally relevant to a first-time sponsor.
Continue to Structure as Non-compliant Securitization
A sponsor that has previously issued non-compliant securitizations can continue to take that approach, and need make no change.
Switch from EU-lite to Non-compliant Securitization
Sponsors that might otherwise have structured their securitizations as EU-lite may decide to switch to non-compliant securitizations.
This would be on the basis that even if they were to commit to retain an interest in accordance with the EUSR (which would involve binding themselves to hold the retained interest for the life of the transaction and incurring the associated costs), in many cases, EU investors would be likely to consider themselves unable to invest, given the absence of Article 7 reporting.
Changing to a non-compliant position would entail altering the transaction structure so that there is no commitment to hold a retained interest in accordance with the EUSR, and (where relevant) amending the disclosure to state that no steps are being taken for purposes of compliance with the EUSR. The usual approach in a non-compliant securitization would be also to take no action with regard to the UKSR.
The result would be that both EU and UK investors would be expected not to invest in the transaction.
Continue to Structure as EU-lite
Alternatively, sponsors may opt to continue with an EU-lite structure, committing to hold a retained interest in accordance with the EUSR and the UKSR while taking no action on Article 7 reporting. A number of U.S. securitizations have been issued on this basis since the Report was published.
As noted above, it seems likely that, in many cases — despite the risk retention — EU investors would consider themselves unable to invest in such a securitization, given the absence of Article 7 reporting. However, there could be a number of reasons for maintaining the EU-lite approach. For example:
- The sponsor may be envisaging that if UK investors have invested in prior securitizations, they would continue to do so (given that, as noted above, the Report applies only to the EUSR and EU investors); or
- It may be anticipating that there will be further legal or market developments, such that EU investors that currently would not invest because of concerns as to compliance with Article 7 reporting requirements will again consider themselves to be permitted to invest.
In such a case, it may be that even if the prospect of there being EU or UK investors is remote, the sponsor considers the incremental burden and costs of holding a retained interest in accordance with the EUSR and the UKSR to be insignificant. This may be the case, for example, where the sponsor will be holding the retained interest in any event, for purposes of Regulation RR and/or the Japanese risk retention requirements or for other reasons.
Recent EU-lite securitizations have tended to include additional disclosure in the offering document, to note the publication of the Report and to highlight that no action is being taken on Article 7 reporting.
Implement Article 7 Reporting
The final option would be for the sponsor to consider committing to provide Article 7 reporting.
For most sponsors, this would likely be a very significant undertaking, requiring a considerable investment of time and expense. It remains to be seen to what extent sponsors may adopt this approach.
While the Commission expressly recognized that its guidance in the Report, confirming the requirement for full Article 7 reporting in non-EU securitizations, has adverse implications for EU investors, there is no proposal to amend the requirements of the EUSR so that Article 7 reporting would not be required in such cases. However, the anticipated adverse effects of the Report may be mitigated by certain future developments, as follows.
Proposed New Reporting Template
The Commission has instructed the European Securities and Markets Authority (ESMA) to devise a simplified form of Article 7 reporting for all securitizations, and the Commission notes in the Report that this simplification might help mitigate the impact for EU investors of its guidance on Article 7 reporting.
In particular, ESMA is required to produce a new reporting template for use in private securitizations (which are, essentially, all securitizations except those listed on the main markets of the EU exchanges — so, very many U.S. securitizations are private securitizations in this sense). The Commission’s intention is that for private securitizations, this new template would replace all the existing asset-specific templates. The Commission’s focus appears to be on ensuring the provision of information that EU regulators might require in order to monitor the securitization market generally (as opposed to requiring the disclosure of granular loan-by-loan data). On that basis, it appears that the new template could be much briefer and simpler than the current forms.
If the proposed new template is more straightforward, then, in general, it should be easier for U.S. sponsors to complete. This, in turn, may mean that U.S. sponsors are able to commit to Article 7 reporting, such that EU investors that currently would not invest because of concerns as to compliance with Article 7 reporting requirements will again consider themselves to be permitted to invest.
No details of the format or required content of the proposed new template have been released. ESMA has begun work on its review, but there is no published timetable for the development and implementation of the new template. Experience would suggest that this process could take 18 months or more.
Possible Regulatory Relief or Clarification
The Commission’s statement as to the planned introduction of the new private securitizations template has prompted discussion in the market as to whether this may influence the stance of EU regulators with regard to enforcement of the EUSR. In particular, there is a question whether regulators may allow flexibility for EU investors to continue to invest in private securitizations without receiving Article 7 reporting in the form of the current templates, during the period from publication of the Report until implementation of the new template.
To be clear, the Commission has made no reference to the prospect of any such regulatory relief, and we are not aware of any regulator’s having made any statement in this regard.
However, the thinking is that as the Report recognized that there has been an established practice of EU investors not requiring reporting on the existing templates, and there is now a clear expectation that within (say) 18–24 months those templates will not be required at all in private securitizations, it may be considered disproportionate to enforce strictly the current requirements at this stage.
We understand that certain trade associations are seeking clarification from the relevant EU authorities on this issue (and on other points not relevant to this Sidley Update). It is not known how they will respond to this request. However, given the Commission’s express acknowledgment in the Report of the adverse implications for EU investors of the requirement for full Article 7 reporting, and its observation that the proposed simplified template may mitigate those issues, it is not certain that any interim relief will be granted (or any further guidance published).
UKSR Article 7 Reporting
Separately, for completeness, we note that the UK authorities also are proposing to devise a simplified form of Article 7 reporting under the UKSR. Similarly, however, no further details are available at this stage.
Whilst it is possible that some EU investors may take a different view, it seems that, in light of the Report, in many cases, EU investors are likely to consider themselves unable to invest in U.S. securitizations that do not provide for full Article 7 reporting (i.e., including use of the prescribed templates).
The position may be subject to further change, particularly if the relevant authorities grant regulatory relief, or publish further guidance, such that EU investors are permitted to invest in non-EU securitizations without full Article 7 reporting until the proposed simplified reporting template is implemented.
In any event, once the new template takes effect, EU investors and U.S. sponsors will need to reassess their respective positions. However, the expectation is that at that stage, it may then be practicable for U.S. sponsors to report on the basis of that template (as well as to satisfy the other elements of Article 7 reporting), such that EU investors that currently would not invest because of concerns as to compliance with Article 7 reporting requirements will again consider themselves to be able to comply with their obligation to verify that they receive full Article 7 reporting, and so permitted to invest in those U.S. securitizations.
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