The UK's vote to leave the EU has raised questions across the financial markets and answers are only beginning to trickle through. For CLO (Collateralised Loan Obligation) market participants – and UK-based collateral managers in particular – the biggest legal concerns are regulatory, mainly around MiFID authorisation and risk retention. For the moment, the best bet for CLOs is probably to wait and see. This stems partly from the fact that the Brexit referendum on 23 June 2016 has no legal effect. So while the political landscape has transformed almost beyond recognition, the legal landscape remains unchanged.
In terms of MiFID, authorisations may be required for some CLOs depending on the jurisdictions involved and the structure of the transaction, because discretionary investment services can trigger licensing requirements in the place of ‘delivery’ of the service. As a result, CLOs with a bond bucket will need an appropriately MiFID-authorised manager if the SPV is incorporated in a jurisdiction which treats the management as taking place in the jurisdiction of the customer (being the SPV in this scenario).
For example, local authorisation has historically been required in the Netherlands, while Ireland – the other major CLO jurisdiction in the EU – has treated management as being carried on in the location of the manager. Until now, UK managers have been able to rely on passporting their UK authorisation under EU single market rules, but this may not continue following the UK's exit from the European Union.
But basing CLO issuers in Ireland is no panacea. It is possible that the differences between the Irish and Dutch regimes will not persist for very long. The introduction of MiFID2 in January 2018 will bring with it a cross-border regime which allows firms from ‘equivalent’ non-EU jurisdictions to provide services into the EU under a registration system. If the UK is held to be such an ‘equivalent’ non-EU jurisdiction, then the regulatory position in the Netherlands and Ireland for access by UK firms could become the same.
There are also other options available to UK managers of CLOs with Dutch SPVs, such as the Dutch third-country regime currently used by US collateral managers or sub-delegation of management to an appropriately authorised entity in the continuing EU.
Accordingly, it seems best at this stage to wait and see how the regulatory landscape continues to develop and reassess once the picture is a bit clearer.
In respect of risk retention, the issue arises because many CLOs are structured to rely on a MiFID-authorised ‘sponsor’ to hold the risk retention. Again, once the UK leaves the EU, there is no guarantee that this sponsor status will be able to be retained. Failure to comply with the risk retention rules would make new CLOs virtually unmarketable within the EU and cause serious problems with demand, liquidity and volatility for existing CLOs.
One possible solution would be to structure new CLOs to use an ‘originator’ retention structure. Originators are not required to have any particular regulatory status and some CLOs already use this structure. However, use of this route raises difficult questions, for example around the proportion of assets the manager would need to ‘originate’, and the length of time the manager must hold those assets. Most managers are likely to prefer to avoid these questions – and to continue using the more ‘natural’ sponsor route if at all possible.
For existing transactions, it would not be possible to transition to an originator structure, even where the sponsor was also an ‘originator’ at the time the transaction was established. Because the EU risk retention rules are based around the idea that investors will diligence the retention structure before investing, changes are permitted only in exceptional circumstances. While Brexit is certainly exceptional it is likely that, from a legal point of view, appropriate exceptional circumstances will only exist once Brexit takes effect. It would be premature – and probably inconsistent with existing risk retention rules – to try to make an adjustment now. In a limited number of cases existing transactions may also be able to take advantage of rules permitting risk retention on a consolidated basis.
All of that said, passporting and/or grandfathering rules that may be included in the eventual Brexit arrangement may in any case obviate the need for adjustments. Once again, then, the ‘wait and see’ approach seems wise.
This post is a summary of a Briefing note that can be found here.