On March 15, 2019, the Japanese Financial Services Agency (the "JFSA") published the final version of its amendment to the regulatory capital requirements relating to investments by certain types of Japanese financial institutions in securitizations. The amendment adds to such regulatory capital requirements (i) a set of due diligence and information collection requirements for investments by Covered Japanese Institutions (as defined below) in securitizations and (ii) a risk retention rule for such investments.1 The amendment will take effect on March 31, 2019. To provide guidance regarding these new regulatory requirements, the JFSA published, together with the final version of the amendment, a series of responses to selected comments that it received with respect to its initial proposal of these regulatory changes2 (the "Responses to Comments")3 as well as a series of answers to frequently asked questions concerning the application of these regulatory changes (the "Answers to FAQs").4 Because we believe that it should not be overly cumbersome for many Covered Japanese Institutions to comply with the due diligence and information collection component of the amendment (based on the current due diligence practices of large Japanese banks and the type and scope of information that is already customarily reported to investors by US securitizations), this Legal Update focuses on the risk retention rule portion of the amendment (the "Japanese Risk Retention Rule").
This Legal Update is intended for originators, sponsors and underwriters of non-Japanese securitizations that are marketed to Japanese investors, although Covered Japanese Institutions and other interested parties may also find this Legal Update helpful.5
The Japanese Risk Retention Rule
The Japanese Risk Retention Rule was adopted in substantially the same form as in the JFSA's initial proposal, except that, in response to questions and comments submitted to the JFSA regarding the applicability of the rule to securitizations whose underlying assets were transferred by a business entity not meeting the definition of "originator" (namely, business entities that were not directly or indirectly involved in the organization of the original assets), the JFSA amended the definition of "original assets" to clarify that assets transferred into a securitization by a party other than the originator are also considered "original assets" for purposes of the rule.6 By so doing, the JFSA eliminated any doubt that securitizations without a classic originator, such as Open Market CLOs,7 are within the scope of the rule. In adopting the Japanese Risk Retention Rule in substantially the same form as in the JFSA's initial proposal, the JFSA elected not to exclude from the rule any particular types of securitizations as such or securitizations from any particular jurisdictions as such and instead sought to address concerns raised by commentators and other interested parties through guidance regarding the application of the rule in its Responses to Comments and Answers to FAQs.8
As adopted, the Japanese Risk Retention Rule requires banks, bank holding companies, credit unions (shinyo kinko), credit cooperatives (shinyo kumiai), labor credit unions (rodo kinko), agricultural credit cooperatives (nogyo kyodo kumiai), ultimate parent companies of large securities companies and certain other financial institutions regulated by the JFSA (collectively, "Covered Japanese Institutions") that invest in "securitization transactions"9 to apply an increased regulatory capital risk weighting—set at three times higher than that otherwise applied to compliant securitization exposures (subject to a risk weight cap of 1,250 percent)—to securitization exposures that they hold, unless such Covered Japanese Institutions can establish either of the following:
- that the "originator" 10 of the applicablesecuritization commits to retain, inhorizontal, vertical or, in some cases, L-shaped form,11 at least 5 percent of thenominal value of the securitizedexposures, or
- that the securitization's "original assets"were not inappropriately originated,12based on the originator's involvement inthe original assets, the quality of theoriginal assets or any other relevantcircumstances.
As was the case in the JFSA's initial proposal, securitization exposures purchased by Covered Japanese Institutions before March 31, 2019 will be grandfathered, but only while they are held by the Covered Japanese Institution that holds them on March 31, 2019. Subsequent purchasers after that date will not benefit from this grandfathering.
The JFSA's Responses to Selected Comments and Answers to FAQs
The Responses to Comments and Answers to FAQs that were published by the JFSA together with the final Japanese Risk Retention Rule provide additional guidance, among other things, with respect to (1) the application of the rule to securitizations that are exempted from risk retention pursuant to the risk retention requirements of one or more other jurisdictions, (2) the application of the rule to securitizations that are structured to comply with the risk retention requirements of one or more other jurisdictions (e.g., securitizations that comply with the US risk retention rules and/or the EU risk retention requirements), (3) instances where the original assets can be deemed not to have been inadequately originated, including based on compliance with risk retention methods other than those prescribed by the rule, (4) the factors that Covered Japanese Institutions should consider when determining, based on an analysis of a securitization's original assets, that such original assets have not been inadequately originated and (5) when and how to confirm compliance with the rule's retention requirements. We next discuss the guidance that the JFSA provided with respect to each of these matters.
1 The final amendment is available (in Japanese) here: https://www.fsa.go.jp/news/30/ginkou/20190315-1/09.pdf.
2 The JFSA published its initial proposal to amend the regulatory capital requirements relating to investments by Covered Japanese Institutions in securitizations in December 2018. The JFSA's initial proposal is available (in Japanese) here: https://www.fsa.go.jp/news/30/ginkou/20181228_3/01.pdf.
3 The JFSA's Responses to Comments are available (in Japanese) here: https://www.fsa.go.jp/news/30/ginkou/20190315-1/02.pdf.
4 The JFSA's Answers to FAQs are available (in Japanese) here: https://www.fsa.go.jp/news/30/ginkou/20190315-1/42.pdf.
5 Important Notice: This Legal Update describes new Japanese regulations whose interpretation is ultimately a matter of Japanese law. Nothing in this Legal Update should be construed as legal advice concerning Japanese law. Furthermore, the new regulations and related guidance were all published in Japanese and this Legal Update is based on an unofficial translation of the regulations and selected guidance. Finally, as is the case with all regulations, we expect that deference will be given to the JFSA, as the drafter and enforcer of these regulations, with respect to their interpretation.
6 See responses nos. 41 and 44 in Responses to Comments.
7 The term "Open Market CLO" is used herein as defined in the decision of the U.S. Court of Appeals for the District of Columbia Circuit in the legal action captioned The Loan Syndications and Trading Association v Securities and Exchange Commission and Board of Governors of the Federal Reserve System, No. 1:16-cv-0065.
8 See responses nos. 31 and 41 in Responses to Comments.
9 "Securitization Transaction" is defined in Article 1 of the JFSA's capital adequacy criteria pursuant to Article 14-2 of the Banking Act and generally includes any transaction in which the credit risk associated with an underlying exposure/pool of exposures is tranched into two or more senior/subordinated exposures and all or a part of such tranched exposures are transferred to one or more third parties. This is similar to EU risk retention, which is also keyed off of tranching for purposes of covered transactions, and different from US risk retention, which applies to asset-backed securities as defined in the Securities Exchange Act of 1934, as amended.
10 "Originator" is defined in Article 1 of the JFSA's capital adequacy criteria pursuant to Article 14-2 of the Banking Act, as (i) an institution involved in the origination of underlying assets directly or indirectly; or (ii) a sponsor of an ABCP conduit or other similar program that acquires exposures from third parties.
11 Under the Japanese Risk Retention Rule, (i) eligible vertical retention interest means a pro rata portion of each tranche of securitization exposures, the total of which is equal to or greater than 5 percent of the total exposure of the securitized assets, (ii) eligible horizontal retention interest means an amount of the first loss tranche equal to or greater than 5 percent of the total exposure of the securitized assets and (iii) eligible L-shaped retention interest, which is only permitted if the most junior tranche in the applicable securitization is less than 5 percent of the total exposure of the securitized assets, means all of the first loss tranche and a pro rata portion of the more senior tranches. Regardless of the form or retention, the retained interest needs to be retained for as long as investor interests remain outstanding.
12 We note that the direct translation of the JFSA's language concerning the creation of the original assets is the "formation" of such assets (as opposed to "origination"). However, because the creation of financial assets is commonly referred to in the United States as "origination," we refer to the creation of the original assets in this Legal Update as the "origination" of such assets.
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