The European Supervisory Authorities1 (the "ESAs") have published an opinion on 25 March 2021 entitled "ESAs’ Opinion to the European Commission on the Jurisdictional Scope of Application of the Securitisation Regulation"2 (the "Opinion"). The Opinion, which is addressed to the European Commission (the "Commission"), sets out the opinion of the ESAs on the jurisdictional scope of application of the EU Securitisation Regulation3 and is split into two parts: Part 1, in which it considers the application of Articles 5 to 7 and 9 of the EU Securitisation Regulation to securitisations with third country-based entities, and Part 2, in which it considers the application of the EU Securitisation Regulation's provisions to investment fund managers. Market participants should note that the Opinion constitutes a set of views and proposals and is not binding. All references to an "Article" in this legal update are to an Article of the EU Securitisation Regulation and references to entities being in a third country means entities which are not established in the European Union (the "EU").
Scope of the Opinion
Amongst other things, the EU Securitisation Regulation sets out obligations relating to investor due diligence (Article 5), risk retention (Article 6), transparency (Article 7) and credit-granting standards (Article 9) and a ban on resecuritisation (Article 8). It applies to all securitisations entered into from 1 January 2019 as well as transactions entered into prior to that date where there is a new issuance of securities or the creation of a new securitisation position from that date.
The Opinion distinguishes between originators, original lenders, sponsors and securitisation special purpose entities ("SSPEs") in a securitisation, which it refers to as the "sell-side parties", and institutional investors, which it refers to as the "buy-side parties".
The Opinion recognises that the definition of "securitisation" in the EU Securitisation Regulation does not refer to jurisdictional scope and various definitions and provisions do not expressly require that the relevant parties are located in the EU. It cites the following examples: (a) the definition of "sponsor" in Article 2(5) includes reference to a credit institution "located in the Union or not", (b) Article 4 expressly bans the establishment of SSPEs in certain third countries but not others, and (c) Article 5(1) refers to sell-side parties as being "established in the Union" or "in a third country". However, it notes that securitisations with buy-side or sell-side parties located in third countries may give rise to difficulties in the interpretation of Articles 5 to 7 and 9.
The Opinion states that the Commission should issue a statement with interpretative guidance with respect to matters that can be clarified within the text of the EU Securitisation Regulation. Where matters cannot be dealt with in this way the Opinion provides proposals to amend the EU Securitisation Regulation.
It is worth noting that the EU Securitisation Regulation provides that the Commission is required to present a report to the European Parliament and the Council of the European Union by 1 January 2022 on the functioning of the EU Securitisation Regulation, accompanied, if appropriate, by a legislative proposal. The report should consider certain reports to be published by the Joint Committee of the ESAs in relation to various issues relating to the EU Securitisation Regulation and should assess certain aspects of the EU Securitisation Regulation regime.
The Opinion applies only to the EU Securitisation Regulation regime and not the UK regime, which is currently similar, although not identical.4
Separately, the Joint Committee of the ESAs published Q&As on certain cross-sectoral aspects of the EU Securitisation Regulation on 26 March 2021.5 The Q&As provide some clarifications in relation to certain questions relating to Article 7 and also consider certain issues relating to third party verification agents in relation to Capital Requirements Regulation (the "CRR")6 and LCR (liquidity coverage ratio) assessments in connection with the "STS" (simple, transparent and standardised) regime.
Obligations of sell-side parties in relation to risk retention, transparency and credit-granting
The Opinion states that obligations applying to the relevant sell-side parties under Article 6, 7 and 9, which deal with risk retention, transparency and credit-granting, are intended to ensure that the securitisation meets certain structural and quality requirements. Those obligations are mirrored by the obligation on institutional investors to verify certain matters. While Article 5(1)(b) and Article 5(1)(d) of the EU Securitisation Regulation explicitly refer to securitisation parties "established in a third country", and impose verification requirements on EU institutional investors in relation to such parties, Articles 6, 7 and 9 are silent as to the location of the relevant sell-side parties.
Where the transaction has all the sell-side parties in a third country, if the investor verifies that sell-side parties in third countries have not complied with the applicable requirements, or does not carry out the required verification, it may not invest in that securitisation.
However, where a transaction has a mixture of sell-side parties which are located inside and outside of the EU, the Opinion identifies a question of how that transaction would comply with Articles 6, 7 and 9, as the relevant competent authority would have no powers to enforce the compliance of parties located outside the EU. The Opinion therefore confirms the general market understanding that third country entities are not directly subject to Articles 6, 7 and 9.
The Opinion considers two options for how to deal with the application of Articles 6, 7 and 9 in the case of a transaction where there are sell-side parties located both inside and outside the EU. Option 1 is that, similar to a transaction with all the sell-side parties in a third country, Article 6, 7 and 9 would apply indirectly through the investor verification requirements only. Option 2 is that, in addition to the indirect application through the investor verification requirements, a sell-side party located in the EU should be directly responsible for complying with, and would be held accountable for any breach of, Articles 6 and 9 (provided in the case of Article 9 that the EU sell-side party has overall responsibility for setting or applying the credit-granting criteria in relation to exposures to be securitised, as discussed below) and with the main disclosure obligation under Article 7. The ESAs advise that the Commission should clarify which interpretation should apply through interpretative guidance, and state that they favour option 2, given that the inability to hold third-country entities accountable poses practical challenges for the ability of the ESAs and competent authorities to supervise compliance, and the advantages of being able to have a sell-side party that is accountable in addition to the investor verification requirements. However, the Opinion envisages that in the event that the Commission is unable to uphold the option 2 interpretation, the Commission should propose amendments to implement it as part of the review of the EU Securitisation Regulation regime.
The proposals with respect to Article 6, 7 and 9, based on option 2, are discussed in more detail below.
Article 6 requires the originator, original lender or sponsor of a securitisation transaction to retain at least 5% of the material net economic interest in the transaction for the life of the transaction and sets out various methods of complying with this obligation. The Opinion states that "where one or more of the securitisation’s originator, original lender or sponsor are located in a third country, the party or parties among them located in the EU should be the sole responsible for retaining the net economic interest in the transaction". This would mean that the third country sell-side parties would not need to comply.
However, this interpretation poses some significant challenges for some transactions. Under the currently applicable regulatory technical standards relating to risk retention,7 which were put in place under the CRR and which apply until the new regulatory technical standards come into force, where the securitised exposures are created by multiple originators, the retention requirement is required to be fulfilled by each originator, in relation to the proportion of the total securitised exposures for which it is the originator. However, there is a derogation from that provision allowing the retention requirement to be met by a single originator provided that either (a) the originator has established and is managing the programme or securitisation scheme, or (b) the originator has established the programme or securitisation scheme and has contributed over 50 % of the total securitised exposures. There is similar wording in the draft technical standards published by the European Banking Authority (the "EBA") which have not yet been adopted.8 There is no explanation of how the proposed interpretation would work in this context. In many transactions it is concluded that the parent entity in the group is an originator, meeting the requirements for a single originator to hold the retained interest as set out above, and is the most appropriate entity to hold the retained interest. The parties to the transaction may not consider that the EU entity in the transaction would be the most appropriate entity to hold the retained interest in a multi-originator, cross-border transaction and this may have an adverse effect on the ability for such entities to obtain funding through a securitisation transaction. There is also no discussion of how this interpretation should be applied to existing transactions which have already been entered into in reliance on the current rules.
Article 7 of the EU Securitisation Regulation contains transparency obligations requiring the provision of certain specified information to institutional investors, competent authorities, and upon request, to prospective investors (the "Transparency Requirements"). Originators, sponsors and SSPEs must make available all of the underlying documentation that is essential for understanding the transaction, along with a prospectus or, where no prospectus is required, a transaction summary. They are also obliged to provide specified information on the underlying receivables and investor reports, to be provided on the required reporting templates, to report inside information (where this is required to be made public) and to report certain significant events. These transparency obligations are joint obligations on the originator, sponsor and SSPE of the securitisation, who must designate one of them to make the relevant information available.
The Opinion takes the view that by one of the sell-side parties in the EU should be designated as the entity which is responsible for complying with the Transparency Requirements. However, all the other sell-side parties should make that designation, and in addition, should be contractually required to provide the necessary information and documents to the designated reporting entity.
We would assume that, notwithstanding that designation, the reporting entity would be able to delegate its reporting obligations to another party, while still remaining responsible for the reporting. This approach was confirmed in the Q&As published by the European Securities and Markets Authority ("ESMA") and is commonly used in the market.9
Article 9 sets out certain obligations in relation to credit-granting. Originators, sponsors and original lenders are required to apply to exposures to be securitised the same sound and well-defined criteria for credit granting which they apply to non-securitised exposures and the same clearly established processes for approving and where relevant, amending, renewing and refinancing credits. In addition, they must have effective systems in place to apply those criteria and processes in order to ensure that credit-granting is based on a thorough assessment of the obligor’s creditworthiness taking appropriate account of factors relevant to verifying the prospect of the obligor meeting its obligations.
The Opinion recommends that where one or more of the sponsor, originator or original lender are located in a third country, the party or parties located in the EU should be responsible for ensuring that the exposures to be securitised "are applied the credit-granting criteria and subject to the same processes for approving and renewing credits as non-securitised exposures in accordance with Article 9, provided that the securitisation sell-side party located in the EU has overall responsibility for setting or applying the credit-granting criteria on the exposures to be securitised". It is not clear how this would work in practice.
The Opinion also notes that, while Article 9 imposes obligations with respect to credit-granting criteria on the sponsor of a transaction, this is not reflected in the verification obligations for EU institutional investors in Article 5(1)(b). The Opinion suggests that imposing a duty on institutional investors to verify sponsor compliance with this requirement may be burdensome and an inefficient use of investor resources. Nonetheless, it recommends that the Commission investigate the convenience and appropriateness of amending Article 5(1)(b) to include reference to sponsors located in a third country.
Obligations of buy-side parties in relation to due diligence
Under Article 5, institutional investors in a securitisation position are required to verify that there is compliance with the credit granting requirements (under Articles 5(1)(a) and/or (b), as applicable), the risk retention requirements (under Articles 5(1)(c) and/or (d), as applicable), and, where applicable, that the originator, sponsor or SSPE, has, where applicable, made available the information required under Article 7 in accordance with the frequency and modalities provided for in that Article (under Article 5(1)(e)). In addition, they must carry out a due diligence assessment and comply with ongoing monitoring and other requirements.
Verification of transparency requirements
The Opinion notes that while it may be relatively straightforward for institutional investors to verify compliance with the credit-granting and risk retention requirements, verifying compliance with the Transparency Requirements is much more complex.
The Opinion recognises that Article 5(1)(e) is silent as to the location of the transaction parties, but states that the institutional investors' obligation to verify that the originator, sponsor or SSPE has complied with Article 7 may be understood as including third country securitisations, where the party responsible for making the disclosures would be located outside the EU.
The Opinion considers that "it seems very unlikely, or at least very challenging" that EU investors would be able to comply with Article 5(1)(e) of the EU Securitisation Regulation in the context of a third country securitisation, and as a result they would not be able to invest in them.
The ESAs recommend that the Commission should assess the feasibility of incorporating a third country equivalence regime for the Transparency Requirements in relation to third country securitisations, noting that, for third country laws to be regarded as "equivalent", such laws should require the relevant sell-side parties to make available to investors or potential investors:
(a) the same or substantially the same information as required by the Transparency Requirements;
(b) with sufficient frequency (even it such frequency is not exactly the same as under Article 7); and
(c) in the form of disclosure templates of similar quality and granularity as those set out in the relevant technical standards put in place under the EU Securitisation Regulation.
Following advice from ESMA, the Commission could then declare such third country regime to be "equivalent", i.e., the due diligence requirements under Article 5(1)(e) would be satisfied where the institutional investor could verify that the applicable information had been made available in accordance with the transparency requirements under that third country regime.
While this could conceivably work for UK securitisations (where the transparency requirements under Article 7 of the UK Securitisation Regulation and the related technical standards are currently substantially similar to those under the EU Securitisation Regulation regime), concluding that other third country regimes are equivalent could well be challenging as they will not be aligned with the EU securitisation regime, particularly given the Opinion's requirement for there to be disclosure templates with similar quality and granularity.
We would also note that this proposal does not consider at all the possibility that Article 5(1)(e) can be interpreted in a different way. The question of how Article 5(1)(e) should be interpreted has been discussed extensively by market participants, regulators and others for more than two years and, while there is one interpretation that would be that investors are required to verify compliance with Article 7, there is another interpretation which has not been discussed in the Opinion. While the requirements for investor verification set out a different standard with respect to credit-granting and risk retention, depending on where the relevant sell-side entities are located, this is not the case for Article 5(1)(e), and the words "where applicable" suggest that Article is not applicable in all cases. Consequently, there is an argument that, because Article 7 is not directly applicable to non-EU entities, then Article 5(1)(e) would not require the investor to verify compliance with Article 7 with respect to those entities. To date, investors have had to take their own views as to how to interpret those requirements, given the uncertainty and lack of guidance on this point, and some have taken a "substantive compliance" approach.
There is also no mention of the report by the High Level Forum on Capital Markets Union (the "High Level Forum Report"), which was published in June 2020 and set out a number of recommendations for scaling up the EU securitisation market. We discussed the High Level Forum Report in detail in our Legal Update entitled "Recommendations for developing the EU securitisation market – Report by the High Level Forum on Capital Markets Union". The High Level Forum Report proposed that it should be clarified that Article 5(1)(e) of does not apply with respect to third country securitisations, i.e. where the originator, sponsor or SSPE are not established in the EU, and instead that EU-regulated investors would be able to meet their due diligence obligations under Article 5 if they receive sufficient information which is proportionate to the risk profile of the securitisation. While there is some uncertainty about exactly how an EU investor would comply with this, and the extent to which the relevant information would meet those requirements, and while it might not work for all transactions, this approach is likely to be far more preferable to investors and sell-side entities that the proposals in the Opinion.
Third Country Subsidiaries of EU CRR Firms:
The Opinion also considers third country subsidiaries ("Third Country Subsidiaries") of EU credit institutions and investment firms ("EU CRR Firms"), which are consolidated for regulatory capital purposes with their EU parent by operation of Article 14 of the CRR, requiring the EU CRR Firm to ensure compliance by the Third Country Subsidiary with the Article 5 due diligence requirements.
The ESAs consider that there is uncertainty as to whether a Third Country Subsidiary must in practice comply line by line with Article 5 of the EU Securitisation Regulation as if it were an EU investor, and also note that such Third Country Subsidiaries have a much weaker link with the EU resulting in a significant compliance burden on, and competitive disadvantage for, EU groups with operations in third countries when compared with local investors.
The ESAs therefore consider that some alternatives could be provided with respect to compliance by Third Country Subsidiaries. The ESAs suggest that Article 14 of the CRR could be amended in order to allow the EU CRR Firm to ring-fence the relevant Third Country Subsidiary investing in a securitisation from the EU group, where the EU CRR Firm is unable to ensure compliance by its Third Country Subsidiary or where it is deemed to be unduly burdensome. Ring-fencing could be achieved through structural separation of the Third Country Subsidiary from the core EU group to prevent or mitigate potential contagion risk, subject to agreement by the EU CRR Firm's competent authority. To the extent that ring-fencing is not possible, the competent authority could instead impose proportionate investment limits on the Third Country Subsidiary's investments in third country securitisations by reference to the consolidated situation of the EU CRR Firm. If such proposals were implemented, this could be a positive development for EU CRR Firms with significant operations in third country jurisdictions. However, it is not clear at present how it would be achieved and it may present some challenges.
Application to Investment Fund Managers
In the Opinion, the ESAs consider how the EU Securitisation Regulation should apply to third country investment fund managers. The definition of "institutional investor" in the EU Securitisation Regulation includes alternative investment fund managers ("AIFMs"), as defined in the Alternative Investment Fund Managers Directive ("AIFMD")10, that manage and/or market alternative investment funds ("AIFs") in the EU, but it is not clear whether non-EU AIFMs would be caught. The Opinion concludes that they would in principle fall within that definition. It also notes that there is inconsistency with Article 17 of AIFMD and considers how non-EU AIFMs and sub-threshold AIFMs should be supervised.
In addition, the Opinion also notes that while Article 5(5) provides that an institutional investor may give a third party authority to make investment management decisions, and that such third party may be subject to sanctions as a result of failing to fulfil the obligations applicable to the institutional investor, such institutional investor would remain responsible under AIFMD and the UCITS Directive.11 It is also unclear under Article 5(5) whether an institutional investor may give non-EU AIFMs or sub-threshold AIFMs12 the authority to make investment management decisions that might expose it to a securitisation, and the Opinion notes that such permission seems to be inconsistent with Article 6(4)(a) of the AIFMD requiring an additional licence to perform individual portfolio management.
The Opinion recommends a number of amendments and clarifications, including:
- clarification of how the EU Securitisation Regulation applies to non-EU AIFMs;
- changes to the EU Securitisation Regulation and the AIFMD to ensure that non-EU AIFMs comply with the due diligence obligations set out in Article 17 of AIFMD and Article 5 of the EU Securitisation Regulation with respect to those AIFs that they manage and/or market in the EU, in order to ensure an appropriate level of protection for EU investors investing in AIFs marketed by non-EU AIFMs;
- clarification of the EU Securitisation Regulation as to whether non-EU AIFMs marketing and/or managing AIFs in the EU should be regarded as "institutional investors", and therefore subject to the due diligence requirements of Article 5;
- clarification of the securitisation-related rules in the EU Securitisation Regulation and AIFMD, in particular by including a cross-reference in Article 42 of AIFMD to Article 17 of AIFMD and the EU Securitisation Regulation;
- amendments to clarify who the competent authorities are for non-EU AIFMS and for sub-threshold AIFMs and to ensure that they have the relevant enforcement powers as regards those entities;
- changes to the definition of "institutional investor" in the EU Securitisation Regulation, to clarify whether sub-threshold AIFMs fall within such definition and are therefore required to comply with the due diligence requirements of Article 5;
- amendments to Article 5(5) to ensure consistency with AIFMD and the UCITS Directive delegation regimes, and to make it clear that, while Article 5(5) allows third parties to be instructed to comply with the due diligence requirements, this is without prejudice to the requirement that only authorised AIFMs and UCITS13 may perform individual portfolio management services, and authorised AIFMs and UCITs management companies must ensure compliance with AIFMD and the UCITS Directive where portfolio management has been delegated. In addition, it is recommended that the allocation of supervisory responsibilities with respect to managing parties should be clarified; and
- amendment to the definition of "sponsor" in the EU Securitisation Regulation to clarify that sponsors may only delegate to AIFMs authorised in accordance with Article 6(4)(a) of AIFMD and UCITS management companies authorised under Article 6(3)(a) of the UCITS Directive.
While market participants would certainly welcome some clarification as to the jurisdictional scope of the EU Securitisation Regulation, some of the proposals in the Opinion are unclear, and some are likely to come as a surprise. In particular, the risk retention proposals would constitute a change from the way many deals are currently done, in reliance on the regulatory technical standards relating to risk retention, and the proposals relating to transparency will give rise to concerns as to how EU investors can comply with their Article 5 due diligence requirements with respect to third country securitisations. It is essential that a practical solutions are found, in order to ensure that EU investors can continue to invest in securitisations with non-EU entities. Also of concern is the fact that there is no mention of how existing transactions would be dealt with. Market participants should monitor future developments closely and look for opportunities to make their views known.
2 ESAs’ Opinion to the European Commission on the Jurisdictional Scope of Application of the Securitisation Regulation, published on 25 March 2021, available at https://www.eba.europa.eu/sites/default/documents/files/document_library/Publications/Opinions/2021/964573/JC%202021%2016%20-%20ESAs%20Opinion%20on%20Jurisdictional%20Scope%20of%20Application%20of%20the%20Securitisation%20Regulation%20%28003%29.pdf.
3 Regulation (EU) 2017/2402 of the European Parliament and of the Council of 12 December 2017 laying down a general framework for securitisation and creating a specific framework for simple, transparent and standardised securitisation, and amending Directives 2009/65/EC, 2009/138/EC and 2011/61/EU and Regulations (EC) No 1060/2009 and (EU) No 648/2012.
4 For more details of the UK regime, please see our Legal Update – "The Revised Securitisation Regulation Regime in the UK".
5 Joint Committee Q&As relating to the Securitisation Regulation (EU) 2017/2402, available at https://www.eba.europa.eu/sites/default/documents/files/document_library/About%20Us/Governance%20structure/JC/Q%26As/964576/JC%202021%2019%20JCSC%20QAs%20on%20Securitisation%20Regulation.pdf.
6 Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012, as amended.
7 Chapters I, II and III and Article 22 of Commission Delegated Regulation (EU) No 625/2014 of 13 March 2014 supplementing Regulation (EU) No 575/2013 of the European Parliament and of the Council by way of regulatory technical standards specifying the requirements for investor, sponsor, original lenders and originator institutions relating to exposures to transferred credit risk.
8 EBA Final Draft Regulatory Technical Standards Specifying the requirements for originators, sponsors and original lenders relating to risk retention pursuant to Article 6(7) of Regulation (EU) 2017/2402, published on 31 July 2018.
9 See Q5.1.7 and A5.1.7 in Questions and Answers On the Securitisation Regulation, Version 7, updated on 25/02/2021, available at https://www.esma.europa.eu/sites/default/files/esma33-128-563_questions_and_answers_on_securitisation.pdf.
10 Directive 2011/61/EU of the European Parliament and of the Council of 8 June 2011 on Alternative Investment Fund Managers and amending Directives 2003/41/EC and 2009/65/EC and Regulations (EC) No 1060/2009 and (EU) No 1095/2010, as amended.
11 Directive 2009/65/EC of the European Parliament and of the Council of 13 July 2009 on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS), as amended.