Banks contemplating a CLO transaction should be aware of several significant legal issues that need to be considered in structuring a CLO. The rating agencies generally require satisfactory legal opinions addressing these issues.
1. Bankruptcy/True Sale Issues. As is typical for asset-backed securities transactions, the rating agencies will require that the CLO issuer be established as a bankruptcy-remote SPV. The charter documents of the CLO issuer will limit its activities to acquiring loans to be used as collateral, issuing debt and equity securities, entering into contracts with third party service providers such as credit enhancers, and related ancillary activities.
As is the case in most asset-backed securities structures, the rating agencies will usually require a legal opinion to the effect that there has been a "true sale" of the underlying loans from the sponsoring bank to the SPV issuing the CLO debt securities and, if the sponsoring bank retains any interest in the CLO issuer, a "nonconsolidation opinion" to the effect that, in the event of the insolvency of the bank, the assets of CLO issuer will not be consolidated with those of the bank under the "substantive consolidation" doctrine of applicable bankruptcy law. The point of these opinions is to provide comfort that, in the event of the receivership or bankruptcy of the sponsoring bank, the receiver, the bankruptcy trustee or the creditors of the bank will not be able to claim an interest in the loan collateral and thereby defeat or interfere with its value as collateral for the CLO debt securities.
In most jurisdictions, the question of whether loans have been "sold" in a manner that puts them beyond the reach of creditors of the transferor is complex, and requires analysis of all of the facts and circumstances of the transfer. The law firm issuing the true sale and nonconsolidation opinions will examine and analyze all aspects of the structure and proposed operation of the CLO, and typically will deliver a lengthy, "reasoned" opinion to the rating agencies. Most of the true sale issues raised by a CLO structure are the same as those posed by asset securitization structures generally, and do not require separate discussion here. 14
However, there are several "true sale" related issues that are particularly associated with bank CLO structures and that should be considered by any bank contemplating a CLO. These are discussed below:
A. Inclusion of Loan Participations. The loan portfolios of many banks include participation interests in loans originated by themselves or others. In a typical participation, the bank originating a loan will sell a "participation interest", representing a partial ownership interest in the loan to another bank. Typically, the creation and sale of such a participation is done without the agreement of the borrower to be bound by the arrangement, so the borrower remains in contractual privity with only the originating bank. If a bank transferring a participation interest to a CLO issuer or the originating bank (if different) becomes insolvent, there is a concern that, if the participation interest were not truly sold to the CLO issuer, the participation would be deemed by a bankruptcy trustee or receiver to be property of the selling or originating bank's estate, and amounts paid by the borrower to the selling or originating bank would be captured in the insolvent bank's estate, and therefore would be unavailable to support payments on the CLO's debt obligations.
There is no easy solution to this problem. Generally, the perceived risks posed by participations are most easily dealt with in "linked" CLO transactions, in which the bank's credit rating (and thus the likelihood of insolvency) is considered in the rating of the CLO debt obligations. However, in an increasing number of de-linked transactions, including the recent NationsBank CLO, the rating agencies have permitted the inclusion of so-called "100% participation interests" issued by the selling bank in reliance on legal opinions to the effect that the CLO issuer, as holder of the 100% participation interests, had an enforceable ownership or security interest in the related whole loans.15 Banks considering the inclusion of loan participations in a CLO transaction should consult the rating agencies and counsel early in the process to determine the extent to which the participations may be included, and how their inclusion will affect the rating analysis.
B. Set-off Rights. Under long-standing common law and, in some jurisdictions, statutory law, a borrower from a bank may have the right to "set-off" the amount of any deposits of such borrower held by the bank against the amount of the loan. This principle is an example of the doctrine of cancellation of mutual debts, which holds that when two parties owe money to each other, one party may offset his obligation against the amount owed to him, so that only the net amount is owed. While borrowers usually waive their set-off rights as part of standard loan documentation, there is a concern that the waiver may not be effective in all circumstances. Moreover, the FDIC, as receiver of U.S. banks, has been known to permit (and, indeed, encourage) borrowers to offset deposits against their loans, effectively canceling outstanding deposits and thereby reducing the FDIC's liability to repay depositors pursuant to federal deposit insurance. In CLO transactions involving U.S. sponsoring banks, there is a concern that the FDIC has a strong incentive to challenge the true sale characterization of loans or participations transferred to CLO issuers in order to keep such loan assets available to create set-off rights against deposits.
The rating agencies may address these issues in two ways. First, as is the case with participations, in "linked" structures the rating agencies may factor the risk of the sponsoring bank's insolvency into the rating determination. In addition, with respect to both "linked" and "de-linked" structures, the rating agencies may require the establishment of reserves as part of the CLO structure to provide coverage for borrower and FDIC set-off risk.
C. Application of FIRREA to U.S. Banks. In the U.S., banks and savings associations are generally excluded from the coverage of the federal bankruptcy laws. Rather, depository institutions whose deposits are insured by the Federal Deposit Insurance Corporation (the "FDIC") are subject to the receivership provisions of the Federal Deposit Insurance Act (the "FDI Act"). The FDIC has issued a policy statement indicating that it will not seek to avoid an otherwise legally enforceable and perfected security interest, provided that certain requirements are met. 16 Accordingly, when a U.S. bank or savings institution is the transferor of assets in an asset-backed securities transaction, the rating agencies generally require, in lieu of a "standard" true sale opinion, a so-called "FIRREA opinion" (named after the Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA"), which amended the receivership provisions of the FDI Act) to the effect that the SPV has a perfected security interest in the securitized assets and that, upon the insolvency of the bank, the FDIC, as the receiver of the bank, would respect the security interest therein granted to the SPV. Similarly, the nonconsolidation opinion required when the parent of the CLO issues is an FDIC-insured bank is somewhat more complicated than is the case when the parent is subject to the U.S. bankruptcy laws, and must take into account significant jurisdictional and doctrinal issues regarding the extent of the FDIC's powers with respect to failed banks and their subsidiaries.
D. State Law Receivership Issues. As previously noted, banks and savings associations domiciled in the U.S. are generally excluded from the coverage of the general corporate bankruptcy laws, but are subject to federal receivership laws administered by the FDIC. The banking laws of most states of the U.S. also empower state banking authorities to seize and administer insolvent or grossly mismanaged banks under the their jurisdiction; however, through a combination of federal and state laws, the FDIC is virtually always appointed as the receiver for FDIC-insured banks. State bank receivership laws may also be relevant for state banks since the FDIC, as conservator or receiver of a state chartered bank, has the powers and duties conferred by applicable state law.
State banking laws are of particular importance, however, when the bank entity transferring assets to a CLO is located in the U.S. but is not subject to the FDIC's receivership provisions— principally, where the transferor is a U.S. branch or agency of a foreign bank. In these cases, the powers of the state banking authorities must be scrutinized to determine whether additional steps should be taken to ensure that the transferred loans will be treated as truly sold, will not be substantively consolidated with the assets of the sponsoring bank or its affiliates, and will not otherwise become subject to any extraordinary power of the state banking authorities. In some states—including New York, whose state banking law gives the New York Superintendent of Banks powers similar to the "automatic stay" of the U.S. Bankruptcy Code—these laws may require the use of "two-step" or "two-tier" transfers of assets to effectively remove the transferred assets from the jurisdiction of the state banking authorities. In such structures, the assets are first transferred in a true sale from the selling bank to a separate bankruptcy-remote SPV, which then transfers the assets to the CLO issuer.
2. Perfection Issues. As described above, rating agencies and investors are concerned that transfers of the underlying commercial loans from the sponsoring bank or other loan sellers to the CLO issuer constitute "true sales", such that the CLO issuer obtains the ownership interest in the loans. A similar concern arises with respect to the transfer of the commercial loans from the CLO issuer to the trustee for the CLO trust. In this case, the transfer of the loans is for security purposes only, to provide collateral for CLO debt securities, and the legal objective is to ensure that the CLO trustee will have a perfected security interest in the pledged commercial loans and any related collateral. Both types of transfers (i.e., transfers of outright ownership interests and of security interests) must be undertaken in a manner that ensures that the interest of transferee is "perfected," or generally protected from the claims of other purported owners or transferees of the collateral. This requires the identification of the jurisdiction or jurisdictions whose law applies to the perfection of the security interests. This determination is often a complicated issue in CLO transactions, which typically involve many jurisdictions. Second, the determination requires an analysis of the types of property that make up the commercial loan and related collateral. In fact, these questions are inter-related, as the determination of the property type of the collateral will often determine the jurisdiction whose law governs the perfection of the ownership interest or security interest.
While a commercial loan is often perceived from a business standpoint as a single, discrete item of property, from a commercial law standpoint a commercial loan may be characterized as a bundle of related property rights and types, evidenced by a number of agreements and other documents constituting a loan file. The most important loan document, of course, is the promissory note or other agreement by which the borrower agrees to repay the loan. In most cases, this is in fact a promissory note, which constitutes an "instrument" under Article 9 of the Uniform Commercial Code (the "UCC") as in effect in most states of the United States. In some cases, however, the loan may be evidenced by a contract or agreement which does not meet the technical definition of an "instrument", in which case it will likely be viewed as a "general intangible". In the case of most commercial loans, there are a number of ancillary documents and rights, such as security agreements, assignments of leases and rents, guarantees, lock box agreements and the like, most of which are likely to be characterized as general intangibles.
In the United States, perfection of a security interest in an "instrument" is generally accomplished by transferring possession of the instrument to the secured party or its agent. Accordingly, in a CLO transaction in which whole loans, rather than participation interests, constitute the collateral, the underlying promissory notes are required to be physically delivered to the CLO trustee or to a custodian acting on behalf of the trustee. In the United States, perfection of the security interest in the ancillary rights categorized as "general intangibles" is accomplished by filing a so-called "UCC-1 financing statement" with a governmental filing authority in the jurisdiction in which the chief executive office of the debtor (in this case, the CLO issuer) is located.
If, as is often the case, the debtor has connections with more than one jurisdiction and there is therefore a concern that the debtor may be deemed to have a chief executive office in more than one state, UCC-1 filings are made in several jurisdictions. In the event non-U.S. law is determined to govern these perfection issues, an analysis must be made of the applicable commercial law. In most cases, the critical issue under non-U.S. law will be whether the borrower needs to be notified of, or even consent to, the transfer of the security interest to the trustee.
Where loan participation interests, rather than whole commercial loans, are being securitized, the issues become even more complex. In these cases, there will be a desire to obtain a perfected security interest in the related participation agreement, which will most often be characterized as a general intangible, but which may have a related "participation certificate" that could be characterized as an instrument. The rating agencies will usually require an opinion that the CLO trustee has a perfected security interest not only in the participation agreement, but also in the underlying commercial loans. Not surprisingly, these perfection issues are the subject of extensive legal opinions provided at the closing of the CLO transaction.
3. Risk-Based Capital Issues. As discussed above, a likely motivation for many banks to pursue a CLO is to reduce their risk-based capital requirements. Generally speaking, a true sale of a loan portfolio from a bank to a CLO issuer which is not a subsidiary of the bank will result in the loans being removed from the bank's balance sheet for both financial reporting and regulatory accounting purposes. In the case of a straightforward sale of assets with no continuing involvement or responsibility on the part of the selling bank, the removal of the assets from a bank's balance sheet will terminate any regulatory requirement that capital be maintained against such assets. Under the risk-based capital rules in effect in most developed countries, however, a bank may be required to maintain risk-based capital even against assets sold by the bank to a third party if the transferring bank retains or accepts "recourse" with respect to the sold assets. 17
Accordingly, if a bank is undertaking a CLO transaction to reduce its risk-based capital requirement, it must take care to structure the transaction in a manner that eliminates or at least minimizes (in the case of U.S. banks subject to the low-level recourse rule) recourse to the bank. Recourse issues typically arise in bank-sponsored securitization transactions when the sponsoring bank either retains a subordinated interest in the sold loans or an equity interest in the issuer (whether or not evidenced by a security) or provides credit enhancement to the transaction through a guarantee or other credit support obligation.
In a typical CLO transaction, the equity interest in the CLO or an unrated subordinate debt obligation issued by the CLO would be viewed as recourse if retained by the bank or a bank affiliate. Thus, in planning a bank CLO transaction, the sponsoring bank will probably need to satisfy itself that most, if not all, of any subordinated interest in the loan portfolio can be sold economically to unrelated third parties. Structurally, this is usually accomplished by tranching the subordinate interests into senior subordinated interests and a junior subordinated interest, with the senior interests being sold to investors and the junior interest being retained by the bank or its affiliate.
4A Tax Issues. The most important objectives in a CLO transaction related to taxation are (i) to avoid any potential tax impairment of the securitization vehicle itself (i.e., to prevent the risk of any imposition of a vehicle-level tax, including any withholding tax, even though it might be refundable) and (ii) to maximize tax neutrality (i.e., to minimize or eliminate any incremental tax costs in implementing and maintaining the CLO structure by comparison to an "on-balance sheet" financing). Tax neutrality requires minimization or elimination of (i) taxation of the transfer of the collateral as a "sale" upon funding of the vehicle, (ii) adverse tax consequences with respect to payments from the vehicle to investors or the sponsoring bank, (iii) adverse peripheral effects upon the tax calculations of the overall non-securitization operations of the sponsoring bank, and (iv) significant administrative burdens. Achievement of these objectives typically requires intense analysis in the initial stages of structuring the transaction.
The most favorable tax structure depends on numerous variables, including (a) with respect to the loan portfolio, the booking location, situs of the borrowers, and nature of the security for the loans (e.g., real estate vs. non-real estate), (b) the nature and extent of the ramp-up or reinvestment period, if any, (c) the legal status and residency of the sponsor (e.g., domestic bank vs. branch of non-U.S. bank) and, to some extent, of the investors, (d) the relationship among (and degree of subordination of) the securities to be issued by the CLO issuer, (e) whether or not the sponsor can retain the residual (in the form of debt or otherwise) or must market it in whole or in part to investors, and (f) the administrative flexibility of the sponsoring bank. Although there are foreign marketing advantages for an offshore (typically Cayman Islands) CLO issuer and recent tax legislation has made such an issuer more administrable, traditional constraints which have remained unchanged may challenge the use of an offshore issuer in given circumstances. Alternative domestic structures include a limited liability company ("LLC"), a "financial asset securitization investment trust" ("FASIT") or, in limited circumstances, a "real estate mortgage investment conduit" ("REMIC") or real estate investment trust ("REIT"). All the circumstances must be considered in the determination of the optimum tax structure.
5A Securities Law Issues. Bank CLO transactions raise a number of issues under U.S. securities laws. 18The principal U.S. securities law issues are discussed below:
Ai Securities Act of 1933. The U.S. Securities Act of 1933, as amended (the "1933 Act"), generally requires the registration of public securities offerings with the U.S. Securities and Exchange Commission (the "SEC"), and imposes disclosure obligations (and related statutory liabilities for non-compliance) on issuers and underwriters. Most bank CLO offerings to date have been structured to take advantage of exemptions from the registration requirements of the 1933 Act, generally pursuant to the exemptions provided by Regulation D and Rule 144A (for certain private placements) and Regulation S (for offshore offerings to non-U.S. persons). These non-public forms of distribution have been used to reduce exposure to securities law liability, to avoid difficult SEC disclosure requirements and to provide a basis for further exemptions under the Investment Company Act of 1940, as amended (the "1940 Act"), discussed below.
Bi Investment Company Act of 1940. The 1940 Act generally applies to "investment companies" — that is, companies whose business is investing in securities, such as mutual funds. Since loans fall within the definition of "securities" for many federal securities law purposes, a CLO issuer could be viewed as an investment company subject to the 1940 Act if an exemption were not available. Investment companies subject to the 1940 Act are subject to a number of burdensome and costly restrictions regarding reporting requirements, limitations on borrowings, corporate governance and other matters, and issuers of CLOs and other types of asset-backed securities typically structure their transactions to fall within 1940 Act exemptions whenever possible. At least three 1940 Act exemptions are frequently used in CLO transactions:
- Section 3(c)(1): This section, which was included in the 1940 Act as originally enacted, excludes from the definition of "investment company" any company "whose outstanding securities (other than short-term paper) are beneficially owned by not more than 100 persons and which is not making and does not presently propose to make a public offering of its securities." One advantage in certain contexts of Section 3(c)(1) over the other exemptions described below is that there is no requirement that the investors have a minimum financial capacity or level of investment experience. However, this advantage is of little importance in the CLO market in its present state of development, since CLO investors are almost always very substantial, financially sophisticated institutions. The principal disadvantage of Section 3(c)(1), of course, is that it imposes a rather strict limitation on the ability of investors to sell off partial positions and thus severely limits the liquidity of the trading market for such securities. Moreover, the difficulty of tracking the number of beneficial owners imposes a practical constraint on the usefulness of this exemption.
- Section 3(c)(7): This section, which became effective in 1997, excludes from the definition of investment company any company, "the outstanding securities of which are owned exclusively by persons who, at the time of acquisition of such securities, are qualified purchasers, and which is not making and does not at that time propose to make a public offering of such securities." The term "qualified purchasers," in turn, is defined to include individuals who own at least $5 million in investments, certain companies that own at least $5 million in investments, certain trusts, and, subject to certain exceptions, "qualified institutional buyers" ("QIBs") as defined in Rule 144A. While Section 3(c)(7) imposes financial capacity and sophistication requirements that are not present in Section 3(c)(1), it represents a significant liberalization with respect to the potential size of the investor group. Since the number of prospective investors is not limited under Section 3(c)(7), the use of Section 3(c)(7) may be expected to increase the liquidity of the market for CLO securities.
- Rule 3a-7. Rule 3a-7 under the 1940 Act, adopted in 1992, excludes from the definition of "investment company" any company that issues non-redeemable investment grade, fixed income securities that entitle holders to receive payments that depend primarily on the cash flow from a pool of financial assets. The Rule further permits, subject to certain conditions, the sale of non-investment grade fixed income securities to certain types of accredited investors as defined in Regulation D under the 1933 Act and the sale of any securities to QIBs. Where the requirements of Rule 3a-7 are met, it is the most flexible exemption with respect to the nature of the offering because it effectively permits public offerings of at least the investment grade debt securities of a CLO. Moreover, even non-investment grade fixed income securities may be sold to "accredited investors," generally a broader category than the more restrictive "qualified purchaser" category permitted under Section 3(c)(7). This latter advantage provides greater flexibility in the initial offering of the securities since the issuer does not need to comply with the onerous private placement restrictions of the federal securities laws, and it also permits secondary trading with fewer restrictions than under other possible exemptions.
Unfortunately, however, Rule 3a-7 also embodies a significant disadvantage as compared to the other possible exemptions. Specifically, the Rule imposes several restrictions on the ability of the portfolio manager to engage in trading activities with respect to the CLO's assets, including most importantly a prohibition on acquiring or disposing of assets for the primary purpose of recognizing gains or decreasing losses resulting from market value changes. These trading restrictions limit the utility of the Rule 3a-7 exemption in CLO transactions in which active management of the CLO's asset portfolio is contemplated.
6A ERISA Issues A thorough discussion of the application of the Employee Retirement Income Security Act of 1974, as amended ("ERISA") to securitization transactions in general, and to CLOs in particular, is beyond the scope of this article. 19 However, it should be noted that CLO transactions may give rise to a number of possible "prohibited transactions" under ERISA if securities are sold to plans because of the application of ERISA to the CLO issuer and its underlying loans or other assets. Moreover, the U.S. Department of Labor has not issued any generally applicable exemption for CLOs similar to the exemptions it has issued with respect to certain other types of asset-backed securities. Accordingly, each CLO structure must be analyzed to determine the applicability of ERISA and its exemptions to prospective investors. In general, debt securities issued by a CLO issuer will not pose difficult ERISA issues so long as the debt is highly rated and does not have substantial equity features. On the other hand, equity interests in a CLO issuer are not entitled to any generally applicable ERISA exemption, and offerings of CLO equity securities typically either prohibit or substantially limit investments by U.S. pension plans.
Implementing A Bank CLO Transaction
1A Professional Team Members. Structuring and completing a bank CLO is, particularly in the case of the initial transaction undertaken by a sponsoring bank, a significant undertaking requiring the attention of bank management and staff as well as numerous service providers. Usually, the effort will be coordinated by the investment bank that proposes to act as underwriter or placement agent in placing the CLO securities with investors (sometimes referred to in this discussion as the "structuring agent"). The sponsoring bank's outside law firm will also play a critical role in structuring and documenting the transaction and in ensuring that the legal opinions required by the rating agencies and investors can be provided. Other service providers necessary to complete a CLO may include a portfolio manager, credit enhancers, accountants, a trustee, a custodian, a paying agent and a collateral agent.
2A Structuring and Documenting the CLO Transaction. The investment bank designated as the structuring agent will usually assume the lead role in structuring the transaction. It will analyze the projected cash flows from the pool of underlying loans, and attempt to "carve" the aggregate cash flows into specific bond classes, or "tranches", that are designed to meet the then current desires of prospective investors with respect to yield, weighted average life and credit quality, among other characteristics. If one of the sponsoring bank's motivations is to reduce its risk-based capital requirement, the structuring agent will have to take care to minimize the size of any subordinated debt securities or equity interests to be retained by the bank or its affiliates. The structuring agent will work closely with the rating agencies to ensure that the securities formulated by the structuring agent will qualify for the desired ratings.
The transaction documentation for a bank CLO is conceptually the same as that for any other asset-backed securitization, but in practice may be somewhat more extensive because of the complexity of transferring large loan assets and the typical presence of multi-jurisdictional legal issues. One important document will be the offering memorandum describing the CLO debt securities and, if they are to be sold, the CLO issuer's equity securities. The offering memorandum will include detailed information regarding the transaction structure and the underlying commercial loans. This document may be prepared by either the sponsoring bank's counsel or the structuring agent's counsel, but all principal parties will of necessity be heavily involved in its preparation and review. A firm of independent accountants (which may be the sponsoring bank's regular outside accountants or, if different, the accounting firm that undertook the loan file due diligence) will be required to deliver a "comfort letter" confirming the statistical data that is shown in the offering memorandum.
The transaction documents will also include the corporate documentation required to establish the CLO issuer as an SPV, and the various asset transfer and servicing agreements required to administer the CLO trust and securities. These will include an asset purchase or contribution agreement by which the sponsoring bank will transfer the commercial loans to the CLO issuer, an indenture governing the terms of the CLO debt securities, a servicing agreement, and numerous other ancillary documents. Responsibility for drafting these documents will most likely be divided between counsel for the sponsoring bank and the counsel for the structuring agent, but, as with the offering memorandum, all of the principal parties will need to closely review and comment on the draft documents. For the actual closing, numerous assignments, consents and other documents will need to be prepared and executed to effectuate the actual transfer of loan assets to the CLO issuer.
As should be evident from much of the preceding discussion, the consummation of any CLO transaction will require the delivery of a number of legal opinions regarding, among other things, the structure of the transaction, the proper organization and legal status of the CLO issuer, trustee and other related parties, the tax consequences of the transaction, the effectiveness of the various transfers of commercial loans and related property, the perfection of security interests in the commercial loans and related property, and compliance with applicable securities law. If, as is almost always the case, the commercial loans were originated in or made to borrowers in different jurisdictions and/or the securities are being offered in more than one jurisdiction, lawyers from several or many jurisdictions will be involved in providing the required legal opinions.
While the delivery of the legal opinions is technically an event that occurs at closing, the required legal opinions need to be considered from the earliest planning stages of the CLO transaction, and the ability of the various lawyers involved to give the required opinions will often drive structuring decisions and key provisions of the operative documents. Obviously, the involvement of a number of different lawyers and law firms from the early stages of a transaction can give rise to substantial expense. To minimize this expense, it is important that a CLO issuer or sponsor involve lawyers who are familiar with securitization transactions generally and CLO transactions in particular.
3A Due Diligence. A major difference between a CLO and a CBO is the level of due diligence generally required with respect to the loan portfolio. While a CBO is typically collateralized by bonds with easily verifiable payment and credit characteristics, a CLO is usually collateralized by a large number of individual loans with non-uniform loan terms, each of which may have been modified or have a history of legal problems or complications. As discussed above, the rating agencies will either perform limited due diligence itself or rely on the more extensive due diligence undertaken by other deal participants. Similarly, the structuring agent and the sponsoring bank's counsel will want to ensure that all relevant facts about the loans are gathered, considered in structuring the transaction, and adequately disclosed to prospective investors. The loan file due diligence will generally be performed by a professional due diligence firm or the due diligence unit of an accounting firm. The items to be reviewed will include the following:
AiConfirmation of Payment Terms. The due diligence firm will review each file to confirm that the payment amounts, payment dates, interest rates, maturity dates and other key payment terms of each loan conform to the data in the computer records provided by the sponsoring bank to the rating agencies and the structuring agent. Of course, these terms are central to projecting the cash flows from the transaction which, in turn, drive many structuring decisions.
BiFunding Schedule. The due diligence firm will confirm that all funds have been disbursed under each loan or, if they have not been disbursed, will so note so that provision may be made to assure that any future funding obligations are satisfied.
CiPrepayment Provisions. The due diligence firm will review each loan for any relevant prepayment penalty, yield maintenance or other similar provision that could impact cash flows and the likelihood of a loan pre-paying, so that such factors may be considered in structuring the transaction and making disclosures to investors regarding the rate at which loans are likely to be repaid.
DiTransfer Provisions. The due diligence firm will review the loan documents and any loan participation agreements for restrictions on the ability of the selling bank to transfer the related loan or participation interest that could impair the bank's ability to assign the loan to the CLO issuer. The presence of such restrictions could give rise to a requirement of obtaining the consent of the borrower or of other loan participants to the transfer or, at a minimum, a disclosure to the prospective investors regarding the consequences of not obtaining such consent.
EiEnvironmental Issues. The due diligence firm will review the loan files for any indication that the loan presents any environmental issues which could interfere with the borrower's ability to repay the loan or create liability for the owner of the loan.
FiLender Liability. The due diligence firm will review the loan files for any evidence that the sponsoring bank could be subject to a lender liability claim by the borrower which could result in a right of offset by the borrower against the loan, or which could result in the CLO issuer being drawn into litigation regarding the lender liability issue.
GiServicing Issues. The due diligence firm will review the file for any evidence of improper servicing any other problems with the loan.
Considering the benefits that CLOs can provide to both sponsoring banks and investors, the CLO market will almost certainly continue to grow and evolve. Banks that enter the market early in this process may have a competitive advantage over those who wait.
This article presents a very general overview of bank CLOs. Actual transactions vary considerably with respect to structure and asset types. Banks interested in pursuing CLOs should contact an experienced investment bank or law firm for additional information on this important new securitization tool.
- Kenneth E. Kohler is a partner in the Los Angeles office of Mayer, Brown & Platt, a Chicago-based multinational law firm. Mr. Kohler received his law degree from Yale Law School and his undergraduate degree from the University of California at Berkeley. His practice is concentrated in the areas of asset-backed securities and mortgage-backed securities for bank, thrift and mortgage banking clients.
- The author gratefully acknowledges the assistance of Jean S. Chin, Laura A. DeFelice, Mary C. Fontaine, Thomas R. Hood, J. Paul Forrester, Thomas S. Kiriakos, Jason H. P. Kravitt, Leninne Occhino and George A. Pecoulas, all partners of Mayer, Brown & Platt, and Jon Van Gorp, an associate of Mayer, Brown & Platt, in preparing and reviewing this article.
- While the R.O.S.E. Funding transaction is generally cited as the first of the current generation of bank CLOs, the history of such transactions can be traced to the seminal FRENDS B.V. securitization of portfolio LBO loans sponsored by Continental Bank in 1988.
- Moody's Investors Service, Inc., "CBO/CLO 1997 Review/1998 Outlook: The Market Becomes a Fixture," January 30, 1998.
- CLOs are often classified as either "arbitrage CLOs" or "balance sheet CLOs." In an arbitrage CLO, the sponsoring entity takes advantage of a favorable market opportunity to purchase a loan portfolio for the specific purpose of undertaking a CLO generating a profit from the differential between the yield on the loans and the yield on the CLO securities, as well as fees. In a balance sheet CLO, the sponsoring bank typically uses loans already on its balance sheet, and undertakes the transaction principally to achieve one or more of the portfolio management objectives discussed below under "Benefits to Banks of CLOs." Most bank CLOs to date have been balance sheet CLOs and, unless the context suggests otherwise, the discussion in this article is focused on balance sheet CLOs.
- Although this is the typical structure, many recent CLOs have contemplated issuances of senior and subordinated debt over time as the CLO vehicle "ramps up" and invests in the loan collateral, usually over a one-year period. In contrast, a minority of CBO transactions have been structured as "market value" transactions, in which the repayment and rating of the debt securities is based on the value for which the collateral can be liquidated, and some recent hybrid transactions have employed both "cash flow" and "market value" features.
- The Basle Committee on Banking Supervision is a committee of banking supervisory authorities which was established by the central bank governors of the so-called "Group of Ten" countries in 1975. It consists of senior representatives of bank supervisory authorities and central banks from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, Netherlands, Sweden, Switzerland, United Kingdom and the United States. It usually meets at the Bank for International Settlements in Basle, Switzerland.
- Under the risk-based capital guidelines, banks and bank holding companies must maintain capital of 8% against their risk-weighted assets. Most assets are weighted at 100%; however, certain classes of assets deemed less risky than general assets, such as obligations issued or guaranteed by certain government or government-sponsored entities, are weighted at 50%, 20% or 0% of their face amounts, depending upon their perceived riskiness. Commercial loans are generally assigned a risk-weight of 100%, and therefore command the full 8% risk-based capital requirement.
- Under this rule, established pursuant to 12 U.S.C. §4808, the risk-based capital requirement for recourse cannot exceed the amount a bank is contractually obligated to fund.
- If the bank retains servicing responsibilities or is the collateral manager/portfolio adviser, the underwriter and/or bondholders may require that it retain a certain minimum percentage of the subordinate debt as a performance incentive.
- For example, U.S. national banks are subject to lending limits set forth in 12 U.S.C.§84 (1997).
- The principal rating agencies active in the U.S. and global markets are Duff & Phelps Credit Rating Co. ("DCR"), Fitch IBCA, Inc. ("Fitch"), Moody's Investors Service, Inc. ("Moody's), and Standard & Poor's Ratings Services, a division of McGraw-Hill Companies, Inc. ("Standard & Poor's).
- See, e.g., "Cash Flow CBO/CLO Transaction Rating Criteria: 1996 Update" (Standard & Poor's, Nov. 1996) and "CBO/CLO Update: Market Innovations" (Standard & Poor's, Feb. 1998); "CBO/CLO 1997 Review/1998 Outlook: The Market Becomes a Fixture" (Moody's, Jan. 1998); "CBO/CLO Rating Criteria" (Fitch, Mar. 1997); and "DCR Criteria for Rating Cash Flow and Market Value CBOs/CLOs" (DCR, Sept. 1997).
- For an in-depth discussion of true sale and nonconsolidation issues, see Kravitt, Securitization of Financial Assets (2d ed.), Chapter 5 (Aspen Law & Business, 1998). See, "Bank Collateralized Loan Obligations: An Overview" (Fitch, Dec. 18, 1997).
- Statement of Policy Regarding Treatment of Security Interests After Appointment of the Federal Deposit Insurance Corporation as Conservator or Receiver, 58 Fed. Reg. 16833 (1993).
- In the U.S., the principal federal bank regulatory agencies—the Office of the Comptroller of the Currency (the "OCC"), the Board of Governors of the Federal Reserve System (the "FRB"), the FDIC and the Office of Thrift Supervision (the "OTS")—have each adopted similar, but not identical, risk-based capital rules. These rules were developed by such banking agencies in concert, acting through an umbrella group, the Federal Financial Institutions Examination Council (the "FFIEC"), which, in turn, modeled its approach on the Basle Accord described above.
- As many bank CLO offerings are global in scope, the securities registration and disclosure laws of many jurisdictions may apply to any given offering. Counsel representing sponsoring banks CLOs will likely need to consult with local law firms to ensure securities law compliance in all relevant jurisdictions. For a thorough discussion of the ERISA issues applicable to asset-backed securities, see Kravitt, Securitization of Financial Assets (2d ed.), Chapter 17 (Aspen Law & Business, 1998)
Copyright (c) 1998 Mayer, Brown & Platt. This Mayer, Brown & Platt publication provides information and comments on legal issues and developments of interest to our clients and friends. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.