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The European CLO market is facing another setback regarding risk retention regulations, this time involving conditional sale agreements.

On Friday (8 August), the European Commission answered a Q&A on a question originally posed in 2021. In short, a certain part of the market — manager-originators — have been using conditional sale agreements, often seen as a more convenient form of seasoning as it was seen to be compliant with regulations.

But the Commission responded that this is not permissible. Essentially, this means conditional sales are dead and forward purchase or sale agreements are the way forward.

CLO managers are now pivoting to align with practices already adopted by the broader market outside of manager-originators. While this transition will require additional time and administrative costs, it primarily impacts manager-originator deals that had been using conditional sale agreements, as many third-party originators (or 50% originators) had already been using forward purchase, or sale agreements.

Is this legally binding?

The very clear answer to the question from the Commission on if a “securitisation special purpose entity (SSPE) enters into a conditional sale agreement will it be classified as the originator and act as an eligible retainer?” was as follows:

According to the definition set out in Article 2 (3) of the (EU) 2017/2402 the originator is an entity which either

(a) itself or through related entities, directly or indirectly, was involved in the original agreement which created the obligations or potential obligations of the debtor or potential debtor giving rise to the exposures being securitised; or

(b) purchases a third party’s exposures on its own account and then securitises them.

If an entity has not purchased the assets but has entered into a conditional sale agreement with the SSPE whereby the entity is obliged to acquire relevant assets from the SSPE, such entity does not qualify as an originator and therefore cannot fulfil the risk retention requirement on this basis.

So, what has the Commission said?

Essentially, if managers have been using a conditional sale agreement as opposed to a forward sale agreement/forward purchase agreement, that is not sufficient to qualify you as an originator. The answer couldn't really be clearer and that leaves some in the market in a difficult position.

“It’s worth noting that the Commission themselves have answered this one which is significant, because they are the rule-making body and the ones who propose the legislation in the first place, which arguably carries more weight than anyone else,” said John Goldfinch, partner at Proskauer.

Single rule book Q&A responses are not legally binding, but the market will sit up and pay attention given this is the voice of the Commission, he added.

Managers find themselves in a tough position because they based their original deal structures on the information available at the time, confident that they had a solid origination strategy in place. They didn't anticipate the need to revisit their decisions based on new information that emerged years later.

But that doesn't seem to be where the CLO market is coalescing around, sources say. Despite a strong argument for sticking with the original interpretation, many managers are now considering remedial actions for existing deals.

It’s important to emphasise that there’s no "grandfathering" of these deals, as the law hasn’t changed. What has happened is that the primary regulatory body has clarified that the market has been incorrectly interpreting the provision all along.

Conditional sale agreements vs forward sale agreements

CLO managers select assets for an SSPE (special purpose entity), which buys these assets directly from the entity (i.e. the manager originator) without them going on the originator’s balance sheet. The SSPE enters into a conditional sale agreement with the originator, which allows the originator to be exposed to the risk of a portion of the assets. The exposure occurs because it must buy these assets back if they default within a certain period e.g, 15 business days.

The originator fulfils its risk retention obligation by holding at least 5% of the nominal value of each tranche sold to the SSPE. Through the conditional sale agreement, the entity is essentially exposed to the credit risk of the assets, similar to if it had bought and then resold the assets itself. This structure ensured that the entity qualifies as an "originator" under the Securitisation Regulation and thus meets the risk retention requirements.

This structure is common in CLOs, where the CLO manager acts as the originator. CLO managers are considered the most appropriate party to retain risk because they are the ones managing the assets and aligning their interests with investors. CLOs typically acquire assets from various counterparties in the open market, and the CLO manager remains the key active party throughout the securitisation process.

A forward purchase agreement, or a forward sale agreement, means you have a sale of every single asset that you are purporting to season. From an accounting perspective, it is sitting on the balance sheet of the originator for the seasoning period (basically 15 business days).

A conditional sale agreement however means the originator will only buy back any asset out of the seasoned portion if it defaults in the seasoning period (which is what the Commission has taken an issue with).

The use of a conditional sale agreement is preferred over direct purchases and sales of assets due to inefficiencies in the loan market. Asset settlements can take a long time, and buying assets directly would create administrative burdens and delays. The conditional structure simplifies the process and avoids the need for consent from counterparties to novate the trades, which can be cumbersome.

It's also important to note that while the Commission has expressed a clear dislike for conditional sale agreements, they haven't explicitly endorsed forward purchase agreements. However, since these are legally distinct concepts, it’s a reasonable assumption that forward purchase agreements could be considered acceptable if conditional sale agreements are not.

Forward purchases involve double trade tickets. This means managers need to document the transfer of assets onto the originator's balance sheet and then onto the issuer’s balance sheet.

Two courses of action

Managers' response will largely depend on how proactive they want to be in addressing the situation.

Some managers will feel compelled to take immediate action on existing deals. The concern being that if they don't, there could be a perception that their deals are non-compliant. This could lead to a ‘non-compliant discount’ being applied to how their notes are traded in the secondary market.

There have been times when the CLO market has been split between compliant and non-compliant deals — a few years ago the basis between triple-A spreads for such deals was as high as 15bps, one source said

For those CLO managers that used a conditional sales agreement for a deal that's priced but not closed, it might be best to “just rip it up” and put in place a forward purchase agreement. In a manager originator deal only 5% of assets get seasoned, so plenty left to play with. If the seasoning period extends beyond the closing date; what’s important is the manager is seen to be trying to resolve the issue which has been dropped on the market with absolutely no notice.

However, the view seems to be that there are two courses of action, and actually, it might make sense to do both.

Proskauer’s Goldfinch tells 9fin there are two ways to qualify as an originator. Limb A origination and limb B origination.

“Limb B origination is what the conditional sale agreement and what the forward purchase agreement are designed to do, which is to put the credit risk of the relevant asset on the balance sheet of the originator for the seasoning period; for its own account is the wording from the legislation. However, there's also a Limb A origination, which is where you are actively involved in negotiating the terms of the particular credit itself,” he explains.

Most market participants believe most the assets that CLOs buy, particularly on a new close is primary origination, so the market is getting it right at the outset. They have been sent certain term sheets, commented on the term sheets and asked for terms of what is proposed to be changed. They could therefore be limb A originators already in respect of almost everything that's taken down at close.

“That of course, only works where you are within the reinvestment period, because a manager needs to sell assets out and then back in again,” he said. “If you are in a static deal, you can't sell assets unless they're credit impaired or credit improved. In most cases, you wouldn't necessarily want to limit yourself to only selling credit impaired or credit improved and thus an amendment may be necessary.”

An alternative to this is if the CLO market goes down a condition 14C route. This would require sending a notice out to noteholders to ask if they can amend the documents because of a regulatory change, allowing them to make that sale purely and only for the purposes of seasoning some assets so that the deal can be bought into compliance (not for any other purpose).

Addressing this will require the involvement of the trustee to ensure compliance with the regulatory changes, however this will be of benefit to noteholders. There is of course a cost and time process that comes with that.

Another cost? Entering into a forward purchasing agreement means you sell several assets, 5% of the portfolio, to the originator, and then get them back again, ideally at the same price. But, a manager must allow for a 15 business day seasoning period, so there is a risk that the pricing does change in that period. That could be a cost to note holders just to bring the deal into compliance.