Securitisation 2013 Guide

General Chapters:1 Documenting Securitisations in Leveraged Finance Transactions Dan Maze & James Burnett,

Latham & Watkins LLP 1

2 CLOs: An Expanding Platform Craig Stein & Paul N. Watterson, Jr., Schulte Roth & Zabel LLP 7

3 US Taxation of Non-US Investors in Securitisation Transactions David Z. Nirenberg, Ashurst LLP 12

4 Debt Trading: A Practical Guide for Buyers and Sellers Paul Severs & Lucy Oddy, Berwin Leighton Paisner LLP 24

5 Cliffhanger: The CMBS Refinancing Challenge Stuart Axford & Colin Tan, Kaye Scholer LLP 30

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DisclaimerThis publication is for general information purposes only. It does not purport to provide comprehensive full legal or other advice.Global Legal Group Ltd. and the contributors accept no responsibility for losses that may arise from reliance upon information contained in this publication.This publication is intended to give an indication of legal issues upon which you may need advice. Full legal advice should be taken from a qualified professional when dealing with specific situations.

Further copies of this book and others in the series can be ordered from the publisher. Please call +44 20 7367 0720

The International Comparative Legal Guide to: Securitisation 2013

Continued Overleaf

Contributing Editor

Mark Nicolaides,Latham & Watkins LLP

Account ManagersBeth Bassett, Dror Levy,Maria Lopez, FlorjanOsmani, Oliver Smith, RorySmith

Sales Support ManagerToni Wyatt

Sub EditorBeatriz ArroyoFiona Canning

Editor Suzie Kidd

Senior EditorPenny Smale

Group Consulting EditorAlan Falach

Group PublisherRichard Firth

Published byGlobal Legal Group Ltd.59 Tanner StreetLondon SE1 3PL, UKTel: +44 20 7367 0720Fax: +44 20 7407 5255Email: [email protected]: www.glgroup.co.uk

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ISBN 978-1-908070-58-6ISSN 1745-7661

Strategic Partners

Country Question and Answer Chapters:6 Argentina Estudio Beccar Varela: Damin F. Beccar Varela & Roberto A. Fortunati 34

7 Australia King & Wood Mallesons: Anne-Marie Neagle & Ian Edmonds-Wilson 44

8 Austria Fellner Wratzfeld & Partners: Markus Fellner 54

9 Brazil Levy & Salomo Advogados: Ana Ceclia Giorgi Manente & Fernando de Azevedo Peraoli 63

10 Canada Torys LLP: Michael Feldman & Jim Hong 73

11 Chile Bofill Mir & lvarez Jana Abogados: Octavio Bofill Genzsch &Daniela Buscaglia Llanos 83

12 China King & Wood Mallesons: Roy Zhang & Ma Feng 92

13 Czech Republic TGC Corporate Lawyers: Jana Stov & Andrea Majerkov 104

14 Denmark Accura Advokatpartnerselskab: Kim Toftgaard & Christian Sahlertz 113

15 England & Wales Weil, Gotshal & Manges: Rupert Wall & Jacky Kelly 123

16 France Freshfields Bruckhaus Deringer LLP: Herv Touraine & Laureen Gauriot 135

17 Germany Cleary Gottlieb Steen & Hamilton LLP: Werner Meier & Michael Kern 146

18 Greece KG Law Firm: Christina Papanikolopoulou & Athina Diamanti 160

19 Hong Kong King & Wood Mallesons: Paul McBride & Michael Capsalis 169

20 India Dave & Girish & Co.: Mona Bhide 180

21 Ireland A&L Goodbody: Peter Walker & Jack Sheehy 190

22 Israel Caspi & Co.: Norman Menachem Feder & Oded Bejarano 201

23 Italy Chiomenti Studio Legale: Francesco Ago & Gregorio Consoli 211

24 Japan Nishimura & Asahi: Hajime Ueno 221

25 Luxembourg Bonn & Schmitt: Alex Schmitt & Andreas Heinzmann 234

26 Mexico Cervantes Sainz, S.C.: Diego Martnez Rueda-Chapital 245

27 Morocco Benzakour Law Firm: Rachid Benzakour 254

28 Netherlands Loyens & Loeff N.V.: Maritte van 't Westeinde & Jan Bart Schober 262

29 Norway Advokatfirmaet Thommessen AS: Berit Stokke & Sigve Braaten 275

30 Panama Patton, Moreno & Asvat: Ivette Elisa Martnez Saenz & Ana Isabel Daz Vallejo 284

31 Poland TGC Corporate Lawyers: Marcin Gruszko & Grzegorz Witczak 294

32 Portugal Vieira de Almeida & Associados: Paula Gomes Freire & Benedita Aires 304

33 Saudi Arabia King & Spalding LLP: Nabil A. Issa 316

34 Scotland Brodies LLP: Bruce Stephen & Marion MacInnes 324

35 Slovakia TGC Corporate Lawyers: Kristna Drbikov & Soa Pindeov 333

The International Comparative Legal Guide to: Securitisation 2013

EDITORIAL

Welcome to the sixth edition of The International Comparative Legal Guideto: Securitisation. This guide provides the international practitioner and in-house counsel with acomprehensive worldwide legal analysis of the laws and regulations ofsecuritisation.It is divided into two main sections:Five general chapters. These are designed to provide readers with acomprehensive overview of key securitisation issues, particularly from theperspective of a multi-jurisdictional transaction.Country question and answer chapters. These provide a broad overview ofcommon issues in securitisation laws and regulations in 36 jurisdictions.All chapters are written by leading securitisation lawyers and industryspecialists and we are extremely grateful for their excellent contributions.Special thanks are reserved for the contributing editor, Mark Nicolaides ofLatham & Watkins LLP, for his invaluable assistance.Global Legal Group hopes that you find this guide practical and interesting.The International Comparative Legal Guide series is also available online atwww.iclg.co.uk.

Alan Falach LL.M.Group Consulting EditorGlobal Legal [email protected]

Country Question and Answer Chapters:36 Spain Ura Menndez Abogados, S.L.P.: Ramiro Rivera Romero & Jorge Martn Sainz 342

37 Switzerland Pestalozzi Attorneys at Law Ltd: Oliver Widmer & Urs Klti 356

38 Taiwan Lee and Li, Attorneys-at-Law: Hsin-Lan Hsu & Mark Yu 368

39 Trinidad & Tobago J.D. Sellier + Co.: William David Clarke & Donna-Marie Johnson 379

40 UAE King & Spalding LLP: Rizwan H. Kanji 389

41 USA Latham & Watkins LLP: Lawrence Safran & Kevin T. Fingeret 397

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Chapter 1

Latham & Watkins LLP

Documenting Securitisationsin Leveraged FinanceTransactions

Introduction

Including a receivables securitisation tranche when financing (andrefinancing) highly leveraged businesses that generate tradereceivables has become popular for several reasons. First andforemost, securitisation financings can generally be obtained at amuch lower overall cost to the corporate group. Second,securitisation financings typically do not impose as extensive apackage of operational restrictions on the group compared withthose found in leveraged finance facility agreements. Finally, manycompanies engaged in securitisation transactions claim that it helpsthem improve the efficiency of their underlying business byfocussing management attention on the actual performance ofcustomer relationships (e.g. invoice payment speed and volume ofpost-sale adjustments). In leveraged finance facility agreements and high yield bondindentures, affirmative and negative covenants restrict theoperations of the borrower/issuer and all or certain of its significant(i.e. restricted) subsidiaries in a complex and wide-rangingmanner. This chapter discusses the manner in which suchcovenants would need to be modified in order for a borrower/issuerto be able to enter into a receivables securitisation without needingto obtain specific lender or bondholder consent (which is often acostly and challenging process). Although this chapter describesone set of modifications, there are, of course, various means ofachieving the same objectives and the transaction documentationmust be analysed carefully in each case to determine what exactlyis required. This chapter also discusses some of the key negotiatingissues involved in negotiating and documenting such covenantmodifications.Once appropriate covenant carve-outs permitting a tradereceivables securitisation have been agreed, the securitisation itselfcan then be structured and documented. Each of the countrychapters in the latter part of this guide provides a summary of theissues involved in executing a securitisation in that country.

Typical Transaction Structure

Trade receivables are non-interest bearing corporate obligationstypically payable up to 90 days following invoicing. They arisefollowing the delivery of goods or the rendering of services by acompany to its customers. As long as a receivable is legallyenforceable and not subject to set-off, and satisfies certain othereligibility criteria specific to each transaction, the company towhich the receivable is owing can raise financing against it.One popular form of receivables financing, asset-based lending(ABL), is structured as a loan to a company secured by the

receivables. ABL transactions, although popular, have thedrawback of exposing ABL lenders to all of the risks of theborrowing companys business risks which may lead to thecompanys insolvency and (at least) delays in repayment of theABL lenders.An alternative form of receivables financing, discussed below, is asecuritisation of the receivables. A securitisation involves theoutright sale of receivables by a company to a special purposevehicle (SPV), usually a company but also possibly a partnership orother legal entity. The purchase price of receivables will generallyequal the face amount of the receivables minus, in most cases, asmall discount to cover expected losses on the purchasedreceivables and financing and other costs of the SPV. The purchaseprice will typically be paid in two parts: a non-refundable cashcomponent paid at the time of purchase with financing provided tothe SPV by senior lenders or commercial paper investors, and adeferred component payable out of collections on the receivables.In some jurisdictions the deferred component may need to be paidup front (e.g. to accomplish a true sale under local law), in whichcase the SPV must incur subordinated financing, usually from amember of the selling companys group, to finance that portion ofthe purchase price. The SPV will grant security over thereceivables it acquires and all of its other assets to secure repaymentof the financing incurred by it to fund receivables purchases.The SPV will be structured to have no activities and no liabilities otherthan what is incidental to owning and distributing the proceeds ofcollections of the receivables. The SPV will have no employees oroffices of its own; instead, the SPV will outsource all of its activities tothird parties pursuant to contracts in which the third parties agree notto make claims against the SPV. While the SPV purchaser will oftenbe established as an orphan company, with the shares in thecompany held in a charitable trust, rather than by a member of thetarget group, in certain jurisdictions and depending on the particulardeal structure, it may be necessary to establish an initial purchaser ofreceivables that is incorporated as a member of the group (which maythen on-sell the receivables to an orphan SPV).Collection of the receivables will generally be handled by theselling company or another member of the group pursuant to anoutsourcing contract until agreed trigger events occur, at whichpoint a third party servicer can be activated. By these and othercontractual provisions the SPV is rendered bankruptcy remoteand investors in the securitisation are, as a result, less likely tosuffer the risks of the insolvency of the borrower of thesecuritisation debt.From collections, the SPV will pay various commitment fees,administration fees and interest to its third party suppliers and financeproviders. All payments are made pursuant to payment priority

James Burnett

Dan Maze

1 Published and reproduced with kind permission by Global Legal Group Ltd, London

Latham & Watkins LLP Securitisations in Leveraged Finance

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waterfalls that govern the order in which parties are paid. Typically,there are separate waterfalls for distributions made prior toenforcement and for distributions made after enforcement commences.The structure of a typical trade receivables securitisation transactionis as follows:

Documentation Provisions

In light of the foregoing, we describe below the provisionsnecessary to permit a trade receivables securitisation under typicalleveraged finance documentation. In summary, the relevantdocumentation will need to include several framework definitionsdescribing the general terms of the anticipated securitisationtransaction and several carve-outs from the restrictive covenants towhich the relevant borrower/issuer would otherwise be subject. Weaddress each in turn below.

Descriptive Definitions

The following descriptive definitions will need to be added to therelevant transaction documents to describe what is permitted andthus to provide reference points for the covenant carve-outs whichfollow. These definitions contain various limitations designed tostrike a balance between the interests of the owners of theborrower/issuer, on the one hand, who desire to secure thereceivables financing on the best possible terms, and the interests ofthe senior lenders/bondholders, on the other hand, who do not wantthe terms of the securitisation financing to disrupt the borrowersability to repay their (usually much larger) loans or bonds inaccordance with their terms. The definitions below are of coursenegotiable, and the exact scope of the definitions and relatedprovisions will depend on the circumstances of the particulartransaction and the needs of the particular group. In particular,where a business is contemplating alternate structures to a tradereceivables securitisation, such as a factoring transaction, certainslight modifications may be necessary to one or more of thedefinitions and related provisions described below.The definitions below are tailored for a high yield indenture, butthey can easily be modified for a senior facility agreement ifdesired.Qualified Receivables Financing means any financing pursuantto which the Issuer or any of its Restricted Subsidiaries may sell,convey or otherwise transfer to any other Person or grant a securityinterest in, any accounts receivable (and related assets) in anaggregate principal amount equivalent to the Fair Market Value ofsuch accounts receivable (and related assets) of the Issuer or any ofits Restricted Subsidiaries; provided that (a) the covenants, eventsof default and other provisions applicable to such financing shall becustomary for such transactions and shall be on market terms (asdetermined in good faith by the Issuers Board of Directors) at thetime such financing is entered into, (b) the interest rate applicableto such financing shall be a market interest rate (as determined in

good faith by the Issuers Board of Directors) at the time suchfinancing is entered into and (c) such financing shall be non-recourse to the Issuer or any of its Restricted Subsidiaries except toa limited extent customary for such transactions.Receivable means a right to receive payment arising from a saleor lease of goods or services by a Person pursuant to anarrangement with another Person pursuant to which such otherPerson is obligated to pay for goods or services under terms thatpermit the purchase of such goods and services on credit, asdetermined on the basis of applicable generally acceptedaccounting principles. Receivables Assets means any assets that are or will be thesubject of a Qualified Receivables Financing.Receivables Fees means distributions or payments made directlyor by means of discounts with respect to any participation interestissued or sold in connection with, and other fees paid to a Personthat is not a Restricted Subsidiary in connection with, any QualifiedReceivables Financing.Receivables Repurchase Obligation means:(a) any obligation of a seller of receivables in a Qualified

Receivables Financing to repurchase receivables arising asa result of a breach of a representation, warranty orcovenant or otherwise, including as a result of a receivableor portion thereof becoming subject to any asserted defense,dispute, off-set or counterclaim of any kind as a result of anyaction taken by, any failure to take action by or any otherevent relating to the seller; and

(b) any right of a seller of receivables in a Qualified ReceivablesFinance to repurchase defaulted receivables in order toobtain any VAT bad debt relief or similar benefit.

Receivables Subsidiary means a Subsidiary of the Issuer thatengages in no activities other than in connection with a QualifiedReceivables Financing and that is designated by the Board ofDirectors of the Issuer as a Receivables Subsidiary:(a) no portion of the Indebtedness or any other obligations

(contingent or otherwise) of which (i) is guaranteed by theIssuer or any other Restricted Subsidiary of the Issuer(excluding guarantees of obligations (other than theprincipal of, and interest on, Indebtedness) pursuant toStandard Securitisation Undertakings), (ii) is recourse to orobligates the Issuer or any other Restricted Subsidiary of theIssuer in any way other than pursuant to StandardSecuritisation Undertakings, or (iii) subjects any property orasset of the Issuer or any other Restricted Subsidiary of theIssuer, directly or indirectly, contingently or otherwise, to thesatisfaction thereof, (other than accounts receivable andrelated assets as provided in the definition of QualifiedReceivables Financing) other than pursuant to StandardSecuritisation Undertakings;

(b) with which neither the Issuer nor any other RestrictedSubsidiary of the Issuer has any contract, agreement,arrangement or understanding other than on terms which theIssuer reasonably believes to be no less favorable to theIssuer or such Restricted Subsidiary than those that might beobtained at the time from Persons that are not Affiliates ofthe Issuer; and

(c) to which neither the Issuer nor any other RestrictedSubsidiary of the Issuer has any obligation to maintain orpreserve such Subsidiarys financial condition or cause suchSubsidiary to achieve certain levels of operating results.

Any such designation by the Board of Directors of the Issuer shallbe evidenced to the Trustee by filing with the Trustee a copy of theresolution of the Board of Directors of the Issuer giving effect tosuch designation and an Officers Certificate certifying that suchdesignation complied with the foregoing conditions.


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Standard Securitisation Undertakings means representations,warranties, covenants, indemnities and guarantees of performanceentered into by the Issuer or any Subsidiary of the Issuer which theIssuer has determined in good faith to be customary in aReceivables Financing, including those relating to the servicing ofthe assets of a Receivables Subsidiary, it being understood that anyReceivables Repurchase Obligation shall be deemed to be aStandard Securitisation Undertaking.

Qualified Receivables Financing Criteria

In addition to the descriptive definitions above, the documentationmay also set out certain criteria which the Qualified ReceivablesFinancing would have to meet in order to be permitted. Thesecriteria will often be transaction specific or relate to certaincommercial terms, in which case they may not be needed inaddition to the requirements for market or customary provisionsalready incorporated into the descriptive definitions above (seeKey Issues below). However, if required, these may include:

minimum credit ratings (for underlying debt or the securitiesissued pursuant to the securitisation);conditions as to who may arrange the securitisation;notification obligations in respect of the main commercialterms; requirement to ensure representations, warranties,undertakings and events of defaults/early amortisation eventsare no more onerous than the senior financing; and/orother economic terms (e.g. a cap on the weighted averagecost of interest and third party credit enhancement payable).

Covenant Carve-outs

In a typical senior facility agreement or high yield indenture, thesecuritisation transaction must be carved out of several covenants,described in further detail below. In summary, carve-outs will needto be created for the following restrictive covenants:

Asset sales/disposals.Indebtedness.Liens/negative pledge.Restricted payments.Limitations on restrictions on distributions from restrictedsubsidiaries.Affiliate transactions/arms length terms.Financial covenants (in the case of facility debt only).

Limitation on asset sales/disposalsTypically in a leveraged facility agreement, the relevant borrowermay not, and may not permit any of its subsidiaries to, sell, lease,transfer or otherwise dispose of assets (other than up to a certainpermitted value), except in the ordinary of course of trading orsubject to certain other limited exceptions. Similarly, in a typicalhigh yield indenture, the issuer may not, and may not permit any ofits restricted subsidiaries to make any direct or indirect sale, lease(other than an operating lease entered into in the ordinary course ofbusiness), transfer, issuance or other disposition, of shares of capitalstock of a subsidiary (other than directors qualifying shares),property or other assets (referred to collectively as an AssetDisposition), unless the proceeds of such disposition are applied inaccordance with the indenture (which will regulate how the netdisposal proceeds must be invested).In connection with a Qualified Receivables Transaction the relevantborrower and its restricted subsidiaries will sell receivables andthose sales would otherwise be caught by such a restriction. Thus,

the relevant documentation should contain an explicit carve-out,typically in the case of a high yield indenture from the definition ofAsset Disposition, along the following lines:(--) sales or dispositions of receivables in connection with anyQualified Receivables Financing;A similar carve-out can be included in the restrictive covenantrelating to disposals in a loan facility agreement, or in the definitionof Permitted Disposal or Permitted Transaction, whereapplicable.Limitation on indebtednessIn a leveraged facility agreement the relevant borrower group isoften greatly restricted in its ability to incur third-party financialindebtedness other than in the ordinary course of its trade (again,often subject to a permitted debt basket and certain other limitedexceptions). In a high yield indenture, the issuer and its restrictedsubsidiaries are normally restricted from incurring indebtednessother than ratio debt (e.g. when the fixed charge or leverage ratioof the group is at or below a specified level), subject to limitedexceptions. In a high yield indenture, the term Indebtednesstypically covers a wide variety of obligations. A receivables subsidiary in connection with a qualified receivablestransaction will incur various payment obligations that wouldotherwise be caught by such a restriction, particularly if thefinancing is raised in the form of a secured loan made to thereceivables subsidiary. Thus, if a borrower/issuer desires to retainthe ability to continue to obtain funding under a receivablessecuritisation even if the leverage of the group is too high to permitthe incurrence of third-party financings (or if the permitted debtbasket is insufficient), the relevant documentation should containan explicit carve-out from the indebtedness restrictive covenantalong the following lines:(--) indebtedness incurred by a Receivables Subsidiary in aQualified Receivables Financing;Alternatively, one could exclude the securitisation transaction fromthe definition of Indebtedness directly:The term Indebtedness shall not include . . . (--) obligations andcontingent obligations under or in respect of Qualified ReceivablesFinancings.It should be noted that an exclusion from Indebtedness may havean impact on other provisions such as the cross default or financialcovenants so it should therefore be considered carefully in each ofthe different contexts in which it would apply (see also FinancialCovenants below).Subject to the same considerations, a similar carve-out can beincluded in the restrictive covenant relating to the incurrence ofFinancial Indebtedness in a loan facility agreement, or in thedefinition of Permitted Financial Indebtedness or PermittedTransaction, where applicable.Mandatory prepayment of other debt from the proceeds ofsecuritisationsIn a leveraged facility agreement, the carve-outs from disposals andIndebtedness described above may be subject to a cap, abovewhich any such amounts are either prohibited absolutely or subjectto mandatory prepayment of other debt. Whether, and to whatextent, the proceeds of securitisations should be used to prepay debtcan often be heavily negotiated. The business may wish to use suchproceeds for general working capital purposes while lenders wouldbe concerned at the additional indebtedness incurred by a borrowergroup which may already be highly leveraged.If some form of mandatory prepayment is agreed, this will often belimited to the initial proceeds of the securitisation so that theborrower is not required to keep prepaying as new receivables




replace existing receivables. A simple way to incorporate this intothe loan documentation would be to carve out ongoing proceedsfrom the proceeds which are required to be prepaid:Excluded Qualified Receivables Financing Proceeds means anyproceeds of a Qualified Receivables Financing to the extent suchproceeds arise in relation to receivables which replace maturingreceivables under that or another Qualified Receivables Financing; Qualified Receivables Financing Proceeds means the proceedsof any Qualified Receivables Financing received by any member ofthe Group except for Excluded Qualified Receivables FinancingProceeds and after deducting:(a) fees, costs and expenses in relation to such Qualified

Receivables Financing which are incurred by any member ofthe Group to persons who are not members of the Group; and

(b) any Tax incurred or required to be paid by any member of theGroup in connection with such Qualified ReceivablesFinancing (as reasonably determined by the relevantmember of the Group, on the basis of existing rates andtaking into account of available credit, deduction orallowance) or the transfer thereof intra-Group,

to the extent they exceed, in aggregate for the Group, [--] in anyfinancial year.Limitation on liens/negative pledgeIn a leveraged facility agreement, the borrower and other membersof the group will be restricted from creating or permitting to subsistany security interest over any of their assets, other than as arisingby operation of law or in the ordinary course of trade (again oftensubject to a permitted security basket and certain other limitedexceptions). Similarly, in a typical high yield indenture, an issuermay not, and may not permit any of its restricted subsidiaries to,incur or suffer to exist, directly or indirectly, any mortgage, pledge,security interest, encumbrance, lien or charge of any kind(including any conditional sale or other title retention agreement orlease in the nature thereof) upon any of its property or assets,whenever acquired, or any interest therein or any income or profitstherefrom (referred to collectively as Liens), unless such Liensalso secure the high yield debt (either on a senior or equal basis,depending on the nature of the other secured debt). As withleveraged loan facilities, typically, there is a carve-out forPermitted Liens that provide certain limited exceptions.A receivables subsidiary in connection with a qualified receivablestransaction will grant or incur various Liens in favour of theproviders of the securitisation financing that would otherwise becaught by the restriction, particularly if the financing is raised in theform of a secured loan made to the receivables subsidiary. Thus, therelevant documentation should contain an explicit carve-out fromthe Lien restriction, along the lines of one or more paragraphs addedto the definition of Permitted Lien:(--) Liens on Receivables Assets Incurred in connection with aQualified Receivables Financing; and(--) Liens securing Indebtedness or other obligations of aReceivables Subsidiary;A similar carve-out can be included in the negative pledge in a loanfacility agreement, or in the definition of Permitted Security orPermitted Transaction, where applicable.Limitation on restricted payments Typically, in a leveraged facility agreement, the borrower and itssubsidiaries may not make payments and distributions out of therestricted group to the equity holders or in respect of subordinatedshareholder debt. Similarly, in a typical high yield indenture, anissuer may not, and may not permit any of its restricted subsidiariesto, make various payments to its equity holders, including any

dividends or distributions on or in respect of capital stock, orpurchases, redemptions, retirements or other acquisitions for valueof any capital stock, or principal payments on, or purchases,repurchases, redemptions, defeasances or other acquisitions orretirements for value of, prior to scheduled maturity, scheduledrepayments or scheduled sinking fund payments, any subordinatedindebtedness (as such term may be defined).A receivables subsidiary in connection with a qualified receivablesfinancing will need to pay various fees that may be caught by thisrestriction. Thus, the relevant documentation should contain anexplicit carve-out from the restricted payment covenant, along thefollowing lines:(--) payment of any Receivables Fees and purchases of ReceivablesAssets pursuant to a Receivables Repurchase Obligation inconnection with a Qualified Receivables Financing;A similar carve-out can be included in the restrictive covenantsrelating to dividends and restricted payments in a loan facilityagreement, or in the definition of Permitted Distribution orPermitted Transaction, where applicable.Limitation on restrictions on distributions from restrictedsubsidiariesIn a typical high yield indenture, issuer may not permit any of itsrestricted subsidiaries to create or otherwise cause or permit to existor to become effective any consensual encumbrance or consensualrestriction on the ability of any restricted subsidiary to make variousrestricted payments, make loans, and otherwise make transfers ofassets or property to such borrower/issuer.A receivables subsidiary in connection with a qualified receivablesfinancing will have restrictions placed on its ability to distributecash to parties in the form of payment priority waterfalls thatwould otherwise usually be caught by such a restriction. Thus, therelevant document should contain an explicit carve-out from thelimitation on restrictions on distributions, etc., along the followinglines:(--) restrictions effected in connection with a Qualified ReceivablesFinancing that, in the good faith determination of an Officer or theBoard of Directors of the Issuer, are necessary or advisable to effectsuch Qualified Receivables Financing;Limitation on affiliate transactions/arms length termsTypically, in a leveraged facility agreement, the borrower and itssubsidiaries will not be allowed to enter into transactions other thanon an arms length basis. Similarly, in a typical high yieldindenture, an issuer may not, and may not permit any of itsrestricted subsidiaries to, enter into or conduct any transaction orseries of related transactions (including the purchase, sale, lease orexchange of any property or the rendering of any service) with anyaffiliate unless such transaction is on arms length terms.Depending on the value of such transaction, an issuer may berequired to get a fairness opinion from an independent financialadviser or similar evidencing that the terms are not materially lessfavorable to the issuer (or to the relevant restricted subsidiary) aswould be achieved on an arms length transaction with a third party.A receivables subsidiary in connection with a qualified receivablestransaction will need to engage in multiple affiliate transactionsbecause it will purchase Receivables from other members of theGroup on an on-going basis and a variety of contractual obligationswill arise in connection with such purchases. While the terms ofsuch financing may be structured to qualify as a true sale, and be onarms length terms, the potential requirement to obtain a fairnessopinion from an independent financial adviser in connection witheach such transaction is an additional burden that the business willwant to avoid, and the indenture will therefore need to contain an


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explicit carve-out from the restriction on affiliate transactions,along the following lines:(--) any transaction between or among the Issuer and anyRestricted Subsidiary (or entity that becomes a RestrictedSubsidiary as a result of such transaction), or between or amongRestricted Subsidiaries or any Receivables Subsidiary, effected aspart of a Qualified Receivables Financing;A similar carve-out can be included in the restrictive covenantrelating to arms length transactions in a loan facility agreement, orin the definition of Permitted Transaction, where applicable.Financial CovenantsIn addition to the carve-outs described above, the parties will alsoneed to consider carefully whether the activities of the borrower andits subsidiaries in connection with Qualified ReceivablesFinancings may impact the testing of financial covenants in aleveraged facility agreement. Although high yield indentures willtypically not contain maintenance covenant, the testing of financialratios is still important for the purposes of determining whether aparticular action may be taken by an issuer or a restricted subsidiaryunder the high yield indenture at a particular time, or indeed todetermine whether a subsidiary must be designated as a restrictedsubsidiary in the first place.In a high yield indenture, important carve-outs can be accomplishedby excluding the effects of the securitisation financing from twokey definitions (to the extent not already excluded):Consolidated EBITDA for any period means, withoutduplication, the Consolidated Net Income for such period, plus thefollowing to the extent deducted in calculating such ConsolidatedNet Income (1) Consolidated Interest Expense and ReceivablesFees; (--) . . .Consolidated Interest Expense means, for any period (in eachcase, determined on the basis of UK GAAP), the consolidated netinterest income/expense of the Issuer and its RestrictedSubsidiaries, whether paid or accrued, plus or including (withoutduplication) . . . Notwithstanding any of the foregoing,Consolidated Interest Expense shall not include (i) . . . (--) anycommissions, discounts, yield and other fees and charges related toa Qualified Receivables Financing.The treatment of financial covenant definitions in a leveragedfacility agreement is complex, and care should be taken to ensurethat the treatment of receivables securitisations in the variousrelated definitions is consistent with the base case model used to setthe financial covenant levels and with the applicable accountingtreatments. Examples of definitions which should take into accountreceivables securitisations include, the definitions of Borrowings,Finance Charges and Debt Service.

Key Issues

Should an early amortisation of the securitisation facility constitutea cross-acceleration or cross-default to the leveraged financefacility or high yield bonds?Leveraged finance facility agreements typically contain a clauseproviding that the loans can be declared to be repayableimmediately should an event of default occur with respect to somethird party debt or should such third party debt become payablebefore its scheduled maturity. High yield bond indentures containa similar provision, but only triggered upon a payment defaultunder or acceleration of the third-party debt. A receivablessecuritisation financing can be structured so that there is no debt,and therefore no events of default or acceleration can occur.Instead, receivables financings enter into so-called early

amortisation pursuant to which the receivables collections thatwould normally have been paid to the borrowers group to acquirenew receivables is paid instead to the provider of the receivablesfinancing. The commercial risk to lenders and bondholders should an earlyamortisation event occur is that the cut-off of funds could cause asudden and severe liquidity crisis at the borrowers group. Thus,subject to a materiality threshold below which the parties agree thatthe sudden loss of liquidity is not material, cross-default and cross-acceleration triggers in leveraged finance facilities and high yieldbond indentures should be tripped if an early amortisation eventoccurs under a receivables financing facility.How might the non-renewal of the securitisation program affect theleveraged loans and the high yield bonds?For historical reasons, most securitisation facilities must berenewed every year by the receivables funding providers. Theleveraged loans and high yield bonds, on the other hand, have farlonger maturities. The non-renewal of a securitisation facility priorto the maturity of the leveraged loans and high yield bonds cancause a liquidity crisis at the borrowers group in the same manneras any early amortisation event, and should be picked up in theleveraged finance and high yield documentation in a comparablemanner. Should there be any limits to the size of the securitisation facility?If so, how should those limits be defined?By its nature, a securitisation financing removes the most liquidassets of a borrower group the short term cash payments owing tothe group from its customers from the reach of the leveragedlenders and high yield bondholders. Moreover, the amount of newreceivables financing raised will never equal the full face value ofthe receivables sold, because the receivables financing providerswill advance funds on the basis of some advance rate or subjectto certain reserves which result in the new funding equalling 75per cent to 80 per cent of the full face value of the receivables atbest. On the other hand, a receivables financing delivers to theborrower group, the lenders and bondholders alike the benefits oflower-cost funding and liquidity. Where the balance between thesetwo competing factors should be struck is for negotiation among theparties, but some balance in the form of a limit to the overall size ofthe receivables facility seems appropriate.Should a limit be agreed, the residual question is how that limitshould be defined. There are two main options. The limit can bedefined by reference to the total outstanding value at any point intime of receivables sold, or it can be defined by reference to thetotal receivables financing raised. The disadvantage of the latterapproach is that it rewards receivables financings with pooradvance rates. If a receivables financing has an advance rate of 80per cent, 500 million face value of receivables is needed to raise400 million of financing. On the other hand, if a receivablesfinancing has an advance rate of only 50 per cent, 800 million facevalue of receivables is needed to raise the same 400 million offinancing. In the latter example, the leverage lenders and high yieldbondholders lose more receivables for little or no additional cost orliquidity benefit.Should ineligible receivables be sold?This issue functions commercially in much the same manner as theadvance rate issue discussed immediately above. As summarised atthe beginning of this chapter, receivables funding providers onlyadvance funds against receivables that satisfy certain specifiedeligibility standards. That requirement, however, does not meanthat the ineligible receivables are any less likely to be paid or thatthey have actual payment rates that are any less sound comparedwith eligible receivables. However, the advance rate against an


Dan Maze

Latham & Watkins LLP99 BishopsgateLondon EC2M 3XFUnited Kingdom

Tel: +44 20 7710 1000Fax: +44 20 7374 4460Email: [email protected]: www.lw.com

Dan Maze is a Finance partner in the London office of Latham &Watkins. He has a wide range of experience in leveraged financetransactions, investment-grade acquisition facilities, restructuringsand workouts and emerging markets financings.

James Burnett

Latham & Watkins LLP99 BishopsgateLondon EC2M 3XFUnited Kingdom

Tel: +44 20 7710 1810Fax: +44 20 7374 4460Email: [email protected]: www.lw.com

James Burnett is a capital markets associate in the London officeof Latham & Watkins. His practice includes representinginvestment banking firms, private equity firms, and companies inpublic and private debt and equity offerings, bridge loans,acquisition financing and liability management transactions, witha particular emphasis on issuances of high yield debt securitiesand leveraged transactions.

Latham & Watkins is a global law firm with approximately 2,000 attorneys in 31 offices, including Abu Dhabi, Barcelona, Beijing,Boston, Brussels, Chicago, Doha, Dubai, Frankfurt, Hamburg, Hong Kong, Houston, London, Los Angeles, Madrid, Milan,Moscow, Munich, New Jersey, New York, Orange County, Paris, Riyadh, Rome, San Diego, San Francisco, Shanghai, SiliconValley, Singapore, Tokyo and Washington, D.C. For more information on Latham & Watkins, please visit the Web site atwww.lw.com.



ineligible receivable is 0 per cent and, as a result, including them inthe pool of sold receivables will reduce the effective overalladvance rate against the pool, with the adverse impact for lendersand bondholders described above. Accordingly, if ineligiblereceivables constitute any meaningful percentage of a groups totalreceivables, it makes sense to require that ineligible receivables beexcluded from the receivables financing.Should proceeds raised under the securitisation facility be used torepay debt?The required and permitted use of proceeds of a securitisationfinancing is always a key point of negotiation. The outcome of thosenegotiations will depend upon many diverse factors, includingwhether the groups liquidity needs are met by one of the leveragedloan facilities and whether the borrowers group can bear the higheroverall debt burden should no debt repayment be required.

Should the lenders/bondholders regulate the specific terms of thesecuritisation?Sponsors prefer that the receivables financing carve-outs permit anyprogramme which a responsible officer of the borrower determinesin good faith is on market terms which is in the aggregateeconomically fair and reasonable to the borrower/issuer and thegroup. This approach is, in general, the correct one. As indicatedabove, however, certain issues are sufficiently important for theparties to agree upon in advance. Beyond these and possibly ahandful of additional issues, neither lenders nor bondholders shouldhave the right specifically to approve the documentation of thereceivables financing facility.

Conclusion

In summary, with very little modification to the standard leveragedloan or high yield documentation, a trade receivables securitisationfinancing can easily be added as part of a leveraged buy-outfinancing or refinancing, thereby providing financing directly to therelevant corporate group on comparatively favourable terms.



Chapter 2

Schulte Roth & Zabel LLP

CLOs: An ExpandingPlatform

At the beginning of 2011, the collateralised loan obligation(CLO) market was poised to make a comeback. In TheInternational Comparative Legal Guide to: Securitisation 2011chapter we authored entitled On the CLO Horizon RegulationsExpected to Impact CLOs (the CLO Regulations Chapter) wediscussed the new or proposed regulations that might affect thegrowth of the CLO market. Moreover in 2011, we did, in fact, seea modest revival of CLOs. New issuance for the year totaledapproximately $12.3 billion. In The International ComparativeLegal Guide to: Securitisation 2012 we authored a chapter entitledNew Structural Features for Collateralised Loan Obligationswhich discussed the structural changes being made to the governingdocuments for a post-financial crisis CLO, which has becomeknown as CLO 2.0. Those changes helped foster the growth in theCLO market last year, when new issuance reached approximately$55 billion. Industry participants are predicting that new issuancein 2013 will exceed that level and reach $65 billion to $75 billionand, in fact, issuance so far in 2013 is on a pace that would exceedthat amount. 2013 will also see an expansion of the CLO marketinto new asset classes and new markets, and a return of theEuropean CLO. However, there continue to be regulatory andmarket challenges for CLOs.

Return of the European CLO

Unlike the United States, where the recovery in the leveraged loanmarket continues and the pace of new CLO issuances continues toincrease, Europe has seen no significant CLO activity since thecredit crisis. However, the European market appears to be slowlypicking up, with one transaction successfully pricing in February2013 and others in the pipeline. If these offerings are successful,industry participants estimate that in 2013 we could see from 3billion to 5 billion of new CLO issuance, increasing to 5 billionto 7 billion in 2014.The European CLO market faces significant hurdles on the way torecovery. The relative scarcity of leveraged loans in the Europeanprimary market has made it more difficult for prospective CLOmanagers to assemble marketable portfolios of loans. TheEuropean institutional loan market has fallen from pre-credit crisislevels to a 2012 low of 150 billion in new issuances, and pre-creditcrisis European CLOs are reaching the end of their reinvestmentperiods. As these CLOs begin to unwind, and pre-credit crisis loansbegin to come due (between now and 2015), the conditions are inplace for strong demand for new financing.A second hurdle is Article 122a of the European Unions CapitalRequirements Directive (Article 122a). Article 122as five percent risk retention requirement (discussed below) is a potentially

impossible burden for less-well-capitalised managers. The firstEuropean CLO to price in 2013 is reported to have complied withthis risk retention requirement by arranging for a structured creditfund to hold the equity.Unlike in the U.S. market, where 2013 CLOs have employedleverage equal to as much as ten times the equity tranche, the newwave of European CLOs are expected to be significantly lessleveraged. Concentration limitations and portfolio criteria areexpected to be broadly in line with current CLO 2.0 standards in theUnited States, except that collateral obligations must be Euro-denominated.

Emerging Market CLOs

Issuance of CLOs that invest in emerging market (EM) leveragedloans and debt securities came to a halt in 2008. 2012 saw thesuccessful offering of the first post-credit crisis CLO that investsprimarily in leveraged loans and debt issued by EM borrowers. Thenotes issued by this CLO generally had higher spreads thancomparable CLOs issued to invest in U.S. leveraged loans, and theleverage was lower.The portfolio requirements for this new EM CLO and for others thatare following in its wake are similar to the current CLO 2.0 criteriafor U.S. CLOs as a result of rating agency methodology andinvestor preferences. Obligations are U.S. Dollar-denominated, andmost of the portfolio is required to be first-priority senior securedloans. Unlike in earlier EM CLOs, the amount of EM sovereignobligations that new EM CLOs can buy is more limited (ten percent in a recent CLO) and hedging is limited to interest rate hedgesand short credit default swaps on obligations owned by the CLO.The concentration limitations are structured to provide significantflexibility to invest in most of the major EM markets. There arealso substantial non-EM buckets to permit the CLO to acquirecollateral if suitable EM collateral is not available. Other CLOs focused on EM debt markets are appearing in the market,but there remain significant obstacles. Bloomberg recently reportedthat prices for non-investment-grade EM debt are at their highest levelin seven years. The demand for quality EM debt may makeassembling CLO portfolios more challenging. If these CLOs willmake extensive investments in loans and debt securities that are notdenominated in U.S. Dollars, it will be necessary to issue liabilities inother currencies or confront the hedging issues discussed below.

High-Yield CBOs

One of the early structured credit products, known as acollateralised bond obligation (CBO), invested primarily in high-

Paul N. Watterson, Jr.

Craig Stein


Schulte Roth & Zabel LLP CLOs: An Expanding Platform


yield bonds, and pre-credit crisis CLOs often had the capacity toinvest a large portion of the portfolio in high-yield bonds.However, CLO 2.0 transactions have limited high-yield bonds tofive per cent to ten per cent of the portfolio. Recently, managershave begun early-stage marketing of hybrid CLO/CBOs whichwould have the capacity to invest a majority of the portfolio in high-yield bonds. A few recent CLOs have permitted a larger portion(e.g., 40 per cent) of the portfolio to be invested in high-yield bondsthan the typical five per cent to ten per cent limit. The challenges to a revival of CBOs include the losses thatinvestors experienced on some pre-credit crisis CBOs, and thedifferences in terms (interest rate, maturity, covenants, security andseniority) between a typical senior secured loan and a typical high-yield bond. CLOs that invest in high-yield bonds are unlikely toqualify for the exemption from the U.S. risk retention requirements(discussed below), and are more likely to need to enter into hedginginstruments (also discussed below). The revival of CLOs thatinvest in high-yield bonds is being facilitated by the increasing useof floating rates on high-yield bonds, the increased issuance ofsenior secured bonds and the greater acceptance by CLO investorsof covenant lite (cov lite) terms (which are often found in high-yield bond indentures).

CRE CDOs

Pre-credit crisis Commercial Real Estate CDOs (known as CRECDOs) invested in many different kinds of assets, includingCMBS, commercial mortgages of varying quality and seniority, Bnotes, loan participations, and even tranches of other CRE CDOs.Beginning in 2012 and continuing in 2013, established players inthe commercial mortgage market have begun to remake the CRECDO as a specialty commercial real estate product focusing onproven, but sometimes more risky, segments of the CRE market. Sponsors of CRE CDO 2.0 transactions prefer to call theirofferings a CRE resecuritisation or a mortgage CLO. Thesetransactions also have been structured to more closely resembleCLO transactions, rather than pre-credit crisis CRE CDOs.In 2012, the first of the CRE CDO 2.0 transactions (marketed as amortgage collateralised loan obligation) was offered by asubsidiary of a real estate investment trust. Others have followed,and still more are in marketing. The terms have generally beenmore conservative than in pre-credit crisis CRE CDOs. Forexample, one transaction was fully ramped at closing, and theportfolio criteria limited its assets solely to whole loans and seniorparticipations secured by multi-family properties. Another CRECDO consisted of a static portfolio primarily consisting ofmezzanine and B-note positions.CRE CDOs can play an important role if they remain focused onsectors of the commercial mortgage market that are not currentlywell-served by CMBS.

Challenges for CLOs in 2013

Sourcing Collateral

Although market insiders predict a robust market for CLOofferings, even CLOs that primarily invest in senior secured loansto U.S. borrowers face challenges. One of the main challenges thisyear is sourcing collateral with a yield sufficient for the equityinvestors in a CLO to receive an attractive return after interest ispaid on the senior notes.1 Due to the growth in the CLO market andother market trends (such as the growth of retail investor-oriented

loan funds), spreads on leveraged loans in the United States havedeclined. Unless the spread on senior CLO notes continues totighten, the equity returns may not be high enough to attractinvestors. In addition, maintenance covenants in new creditagreements have fallen by the wayside, forcing CLOs to investmore in cov lite loans. This has resulted in increases in theconcentration limit on cov lite loans in CLO indentures andredefinition of what is a cov lite loan to more closely reflect currentloan market practices.

Risk Retention

The Dodd-Frank Wall Street Reform and Consumer Protection Act(the Dodd-Frank Act) mandated the U.S. Securities and ExchangeCommission (SEC) and Federal banking agencies (theAgencies and, together with the SEC, the Joint Regulators) toadopt regulations requiring the sponsor of a securitisation to retainnot less than five per cent of the aggregate credit risk. In March2011, the Joint Regulators issued proposed rules (the CRRProposal) to implement the risk retention requirement. TheAgencies proposed that CLOs would be subject to the risk retentionrequirement and concluded that the collateral manager should beviewed as the sponsor which must retain at least five per cent ofthe risk. (Alternatively, lenders which originated a significantpercentage of the loans could retain the risk.) The only CLOs thatthe Agencies proposed to exempt from this requirement would beones that invested only in commercial loans that met very strictunderwriting standards and satisfied other conditions summarisedin our CLO Regulations Chapter. Several industry organisations, including the AmericanSecuritization Forum (ASF) and the Loan Syndications andTrading Association (LSTA) submitted comments to theregulators, asking them to reconsider whether CLOs should besubject to risk retention. The LSTA asserted that, as a matter ofstatutory interpretation, managers of CLOs that purchasesyndicated commercial loans in the open market are not subject torisk retention requirements because their activities do not meet thedefinition of securitiser in section 941 of the Dodd-Frank Act.The ASF argued that risk retention was not needed in the CLOmarket to avoid the originate to distribute problem that afflictedother types of pre-credit crisis securitisations, because the managerof a CLO rarely originates the loans purchased by a CLO;moreover, the management fee structure used in most CLOs alignsthe interests of the CLO manager with the interests of investors,because the manager subordinates part of its fee to payments on thesenior notes and receives a private equity-style incentive fee onlyafter the equity investors have achieved a specified return on theirinvestments. Both the LSTA and the ASF asked that, if theregulators conclude that risk retention applies to CLOs, they shouldexempt from risk retention any CLO that meets specified criteria;however, they pointed out that no CLO could meet the criteria foran exempt CLO set forth in the CRR Proposal. The LSTAssuggested criteria included the following: the portfolio must belimited to corporate credit obligations, cash and temporary liquidityinvestments, 90 per cent of which must be senior securedsyndicated loans; purchases in an initial commercial loansyndication transaction would be limited to circumstances wheremultiple financial institutions can acquire loans through thesyndication process; underlying obligors must be commercialborrowers; no asset-backed securities; no synthetic assets;managers must be registered investment advisers; andcompensation to the manager must be structured to align its interestwith the CLO investors.


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As of the date of this writing, the proposed rule has not beenfinalised. The recent adoption of a rule defining a qualifiedmortgage by the Consumer Financial Protection Bureau wasexpected to lead to regulatory action on the CRR Proposal.However, this is now in doubt because the director of the Bureau,Richard Cordray, was appointed by President Barack Obamawithout U.S. Senate confirmation during the Senates recess, and afederal appeals court ruled that the presidents recess appointmentsto the National Labor Relations Board which were made at thesame time as Mr. Cordrays appointment were unconstitutional.Article 122a applies to new securitisations, including CLOs, whichissued securities after 31 December 2010.2 Article 122a imposes asignificant capital charge on securitisation securities acquired by aEuropean Economic Area (EEA) regulated credit institution,unless the originator, sponsor or original lender of the securitisationhas disclosed to the EEA-regulated credit institution that it willretain, for the life of the transaction, a net economic interest of notless than five per cent of specified credit risk tranches. As of thedate of this writing, most CLOs have not complied with Article122a. However, a few CLOs that invest in U.S. loans havecomplied with Article 122a, and as discussed above new EuropeanCLOs in the market are planning to comply. Article 122A permitsa third-party equity investor in the CLO to retain the risk if it isinvolved in structuring the transaction and selecting the assets, aswell as being involved in any material changes to the transaction.The equity investor may be a fund, provided that it is not a fundwhich is controlled by, or managed by, the investment manager ofthe CLO.

Foreign Account Tax Compliance Act

On 17 January 2013, the U.S. Treasury issued final regulations thatprovide guidance on Sections 1471 through 1474 of the U.S.Internal Revenue Code of 1986, as amended (commonly referred toas the FATCA). FATCA generally requires foreign financialinstitutions (FFIs), including CLOs, to enter into informationsharing agreements with the U.S. Internal Revenue Service (theIRS) and report certain information about their U.S. accounts tothe IRS on an annual basis in order to avoid a 30 per centwithholding on certain U.S.-connected payments (including U.S.source interests and gross sale proceeds from the disposition of U.S.debt obligations). The final regulations provide that FATCAwithholdings will not apply to any U.S. debt obligationsoutstanding on 1 January 2014, unless such obligations arematerially modified after that date, and treat certain entities inexistence on 31 December 2011 as deemed-compliant FFIs through31 December 2016 if, among other things, the organisationaldocuments do not permit amendments without the agreement of allof such entitys holders. However, because most CLOs require onlya two-third majority for consent, among other reasons, thistemporary relief is unlikely to provide much respite to pre-FATCACLOs, absent further guidance from the IRS. The U.S. Treasury isdeveloping an alternative approach for FFIs resident in a countrythat has entered into an intergovernmental agreement (IGA) withthe United States. The United States and the Cayman Islands areworking together on an IGA, but it is unclear whether, and when, aUnited States and Cayman Islands IGA will be put in place and howsuch an IGA would impact CLOs.

Volcker Rule

Section 619 of the Dodd-Frank Act (commonly referred to as theVolcker Rule) prohibits a banking entity from acquiring orretaining an equity, partnership, or other ownership interest in, or

sponsoring, any hedge fund or private equity fund. The termshedge fund and private equity fund include any issuer that doesnot register with the SEC as an investment company under the U.S.Investment Company Act of 1940 (the Investment Company Act)based on the exceptions in Section 3(c)(1) or Section 3(c)(7)thereof, and any similar fund. Most (but not all) CLOs have beenstructured as 3(c)(7) vehicles, which limit investors (or, in thecase of CLOs domiciled outside of the United States, U.S.investors) to qualified purchasers (as defined in Section 2(51)(A)of the Investment Company Act). Therefore, most managed orarbitrage CLOs will fall under the purview of the Volcker Rule ascurrently drafted, despite the fact that CLOs are not regarded bymarket participants as either hedge funds or private equity funds.Balance sheet CLOs, which banks use for regulatory capitalefficiency by transferring loans (or the credit risk of the loans) fromits balance sheet to the CLO and then holding the equity in theCLO, can also be structured as Section 3(c)(7) vehicles, in whichevent the prohibitions on banking entity sponsorship and ownershipcontained in the Volcker Rule would apply. In addition, the VolckerRule may restrict the warehouse arrangements used to accumulateloans for a CLO if the placement agent is a banking entity and isregarded as the sponsor or adviser to the CLO, because thewarehouse facility could constitute a prohibited covered transactionunder Section 23A of the U.S. Federal Reserve Act. Theseproblems can be avoided if the regulations implementing theVolcker Rule do not treat CLOs as hedge funds or private equityfunds. Alternatively, CLOs can escape the Volcker Rule if they areoffered without relying on Section 3(c)(1) or Section 3(c)(7) andescape characterisation as a similar fund. Many balance sheetCLOs and some managed or arbitrage CLOs have been structuredto qualify for the SECs Rule 3a-7 exemption for issuers of ABS.However, Rule 3a-7 imposes many restrictions and is best suited forstatic or very lightly managed CLOs that do not invest in creditdefault swaps.Industry participants have argued that the Volcker Rule should notapply to CLOs, because the Volcker Rule includes a provision thatnothing in the rule limit or restrict the sale or securitization ofloans and a CLO is essentially a loan securitisation.As of the date of this writing, no further action has been taken onthe Volcker Rule by the federal regulators.

CFTC CPO Registration for CLOs

Any securitisation vehicle, including a CLO, which enters into aswap (including an interest rate or currency swap and some types ofcredit default swaps) is considered by the U.S. Commodity FuturesTrading Commission (CFTC) to be a commodity pool underSection 1a(10) of the U.S. Commodity Exchange Act and under theCFTCs Regulation 4.10(d). As a result, the collateral manager ofthe CLO is required to register with the CFTC as a CPO(commodity pool operator) or CTA (commodity tradingadviser) unless there is an applicable exemption. Most CLOsqualified for an exemption under the CFTCs Regulation 4.13(a)(4)because they required all U.S. investors to be qualifiedpurchasers. However, that exemption was revoked by the CFTCin 2012. Few, if any, post-credit crisis CLOs have entered into swaps.Nonetheless, most of these CLOs are authorised to enter into swapsand they may need to hedge as they invest more in fixed rate assetsor in assets denominated in a different currency than their liabilities.In any event, pre-credit crisis CLOs which entered into swaps aresubject to these new requirements.




The CFTC staff recognised that securitisations, including CLOs,would become subject to these registration requirements for the firsttime and issued an interpretation letter on 11 October 2012,excluding securitisation vehicles that met certain conditions fromthe definition of commodity pool. Most CLOs could not meetthese conditions because their investment activities are much moreactive than contemplated by this interpretation letter. In asubsequent interpretation and no-action letter issued by the CFTCstaff on 7 December 2012, the staff provided further exclusionsfrom commodity pool regulation for securitisation vehicles. InCFTC Letter No. 12-45, one example of a securitisation vehicle thatwould not be a commodity pool is a traditional CLO or CDO that(i) owns only financial assets consisting of corporate loans,corporate bonds, or investment-grade, fixed-income mortgage-backed securities, asset-backed securities or CDO tranches issuedby vehicles that are not commodity pools, (ii) is permitted to tradeup to 20 per cent of the aggregate principal balance of all financialassets owned by the issuer per year for three years, and (iii) usesinterest rate swaps to convert fixed rate financial assets to floatingand foreign exchange swaps to convert Euro-denominated assets toDollars, and none of these swaps may be terminated before therelated hedged asset has been liquidated. However, this letter statedthat if a CLO used swaps to create investment exposure, then thesecuritisation vehicle may be a commodity pool.CFTC Letter No. 12-45 also provided no-action relief forsecuritisation vehicles, including CLOs, formed prior to 12 October2012 if specified criteria were met. The CLO must not issuesecurities on, or after, 12 October 2012 and its securities must bebacked by payments on, or proceeds received in respect of, andtheir creditworthiness must primarily depend upon, cash orsynthetic assets owned by the CLO. Note that legacy securitisationvehicles, unlike new CLOs that rely on the exclusions described inthe prior paragraph, are permitted to hold synthetic assets. CFTC Letter No. 12-45 also granted temporary no-action relief forsecuritisation vehicles unable to rely upon CFTC Letter No. 12-14or CFTC Letter No. 12-45 until 31 March 2013.

Hedging

As CLOs expand beyond funding investments in U.S. Dollar-denominated floating rate loans with U.S. Dollar-denominatedfloating rate liabilities to CLOs which also invest in fixed ratebonds or in assets denominated in multiple currencies and fund withfixed and floating rate liabilities and multi-currency liabilities, theneed to enter into hedging arrangements will increase. In additionto the CFTC regulatory framework discussed above, these newCLOs will face other issues. Since the financial crisis, ratingagency requirements for hedge counterparties have become morestringent, and the credit ratings of many of the dealers whichtraditionally provided swaps to CLOs have been reduced. Thiscombination of heightened agency requirements with reduceddealer credit ratings makes hedging currency or interest rate riskschallenging for these new types of CLOs. For example, thisconcern is evident in emerging market and European CLOs.

Rating agencies have consistently required ratings triggers forhedge counterparties that enter into hedge agreements in CLOtransactions so that the issuer can de-link the counterparty risk ofthe hedge counterparty from the credit risk of the CLO. For a CLOwhich issues notes rated by Moodys, the counterparty must have aspecified minimum rating and, if the counterparty gets downgradedbelow a specified ratings trigger, then the hedge counterparty mustobtain a guarantee, replace itself or post collateral. If the hedgecounterparty is further downgraded below a lower specified ratingstrigger then the hedge counterparty must obtain a guarantee orreplace itself and post additional collateral in the interim. Moodysnew rating agency framework has additional requirements,including requiring execution of all ISDA documentation at close,including a credit support annex that incorporates specific collateralamounts and valuation percentages and requiring amendments tostandard ISDA provisions and clarifying certain events of defaultand termination events. Standard & Poors takes a similar approach the underpinning of its counterparty criteria is the replacementof a counterparty when its creditworthiness deteriorates. Theircriteria combine minimum eligible counterparty ratings, collateralamounts and remedy periods to support a maximum potential ratingon the securities. The basis for the criteria is that similar creditquality may be achieved through balancing the minimum eligiblecounterparty rating and the collateral amount, where lowerminimum eligible counterparty ratings result in higher collateralamounts. If the counterparty gets downgraded below a certain levelit must replace itself or obtain a guarantee from an appropriatelyrated guarantor.

* * *The CLO market in the United States made a triumphant return in2012 and CLO issuance is on a pace this year to surpass last yearsstrong numbers. This market is expanding to include other similarfinancial products the European CLO, the emerging market CLOand an expansion into asset classes such as high-yield bonds andcommercial mortgage related assets.

Endnotes

1. The most junior tranche in a CLO often consists ofsubordinated notes which do not bear an interest rate, butalso may be preferred shares, limited liability company orlimited partnership interests or certificates. For convenience,we refer to all of these CLO securities as equity.

2. Directive 2009/111/EC of 16 September 2009 amendingDirectives 2006/48/EC, 2006/49/EC and 2007/64/EC asregards banks affiliated to central institutions, certain ownfunds items, large exposures, supervisory arrangements, andcrisis management. Article 122a applies to new CLOtransactions issued on, or after, 1 January 2011, and existingCLO transactions where new underlying exposures areadded or substituted after 31 December 2014.

Acknowledgment

The authors would like to acknowledge the assistance, in thepreparation of this chapter, of Jay Williams, an associate in theStructured Products & Derivatives Group at Schulte Roth & ZabelLLP.



Craig Stein

Schulte Roth & Zabel LLP919 Third AvenueNew York, NY 10022USA

Tel: +1 212 756 2390Fax: +1 212 593 5955Email: [email protected]: www.srz.com

Craig Stein is a partner and co-head of the Structured Products &Derivatives Group at Schulte Roth & Zabel LLP. His practicefocuses on structured finance and asset-backed transactions,swaps and other derivative products, including credit- and fund-linked derivatives, prime brokerage and customer tradingagreements. He represents issuers, underwriters, collateralmanagers and portfolio purchasers in public and privatestructured financings, including collateralised loan obligations.Mr. Stein has been recognised by leading peer-reviewpublications as a leader in the industry and he speaks and writeswidely on advanced financial products. He earned hisundergraduate degree, cum laude, from Colgate University andhis J.D., cum laude, from the University of Pennsylvania LawSchool. He is a member of the ISDA Credit Derivatives MarketPractice Committee, the American Bar Association and the NewYork State Bar Association.

Paul N. Watterson, Jr.

Schulte Roth & Zabel LLP919 Third AvenueNew York, NY 10022USA

Tel: +1 212 756 2563Fax: +1 212 593 5955Email: [email protected]: www.srz.com

Paul N. Watterson, Jr. is a partner and co-head of the StructuredProducts & Derivatives Group at Schulte Roth & Zabel LLP. Heconcentrates on structured product and derivative transactions,formation and representation of credit funds and capital marketsregulation, and is counsel to many participants in thesecuritisation, credit and derivatives markets. He representsunderwriters, issuers and managers in structured financings,including CLOs, and is involved in structured finance transactionsthat use credit derivatives, including regulatory capitaltransactions and repackagings. He advises funds and otheralternative investment vehicles on their transactions inderivatives, loans, asset-backed securities and CDOs. Mr.Watterson has also been active in the creation of derivativeproducts that reference hedge funds. He is a regular speaker atmajor industry events and is widely published and recognised bypeer-reviewed publications. He earned his A.B., cum laude, fromPrinceton University, and his J.D., magna cum laude, fromHarvard Law School.

Schulte Roth & Zabel LLP (www.srz.com) is a full-service law firm with offices in New York, Washington, D.C. and London. Werepresent placement agents, issuers, dealers, investors and investment managers in offerings of a variety of investment products,including private investment funds, asset-backed securities (ABS) and structured products. Our firm also structures derivativesproducts, including unleveraged and leveraged derivatives referencing bonds, loans, investment funds, commodities, equitysecurities, interest rates and currencies, and advises clients on forwards, repurchase agreements, securities lending agreements,prime brokerage agreements and master netting agreements. The firms tax, ERISA, investment management, regulatory andbankruptcy lawyers have experience with these products and lend their expertise to every transaction.

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US Taxation of Non-USInvestors in SecuritisationTransactions

A. Introduction

This chapter discusses, in plain business English, special US taxrules applicable to non-US investors in securitisation transactions.These rules include, among others, a 30 per cent US withholdingtax on non-US investors and the ability of non-US investors to holdsecurities in bearer form. For a more detailed discussion of thetopics covered in this chapter, complete with citations to therelevant primary authorities, readers should see chapter 12 of JamesM. Peaslee & David Z. Nirenberg, FEDERAL INCOMETAXATION OF SECURITIZATION TRANSACTIONS ANDRELATED TOPICS (4th Ed., Frank J. Fabozzi Associates 2011)from which this chapter is derived. More information about thebook and free updates are available at www.securitizationtax.com. This chapter also discusses the effect on mortgage-backed securitiesof the Foreign Investment in Real Property Tax Act of 1980(FIRPTA). The chapter finishes with a discussion of the ForeignAccount Tax Compliance Act (FATCA) rules enacted on 18 March2010, which generally will apply to payments made after 31December 2013. This legislation requires foreign entities tomonitor and report on accounts or ownership interests held directlyor indirectly by specified US persons. Its purpose is to prevent USpersons from avoiding tax by hiding income earned through foreignaccounts and entities. Noncompliance is penalised through aspecial additional withholding tax.Except where otherwise noted, it is assumed in this chapter that anon-US investor has no connection with the United States otherthan the holding of the asset-backed security under discussion, andspecifically that the investor does not hold the security inconnection with a US trade or business conducted by the investor.In very general terms, income of a non-US investor that iseffectively connected with a US trade or business is not subject tothe 30 per cent withholding tax, but is instead subject to a netincome tax at the rates applicable to domestic taxpayers. A non-USinvestor buying an asset-backed security need not fear that it will bedeemed to be engaged in a US trade or business because ofactivities of the issuer, except in those fairly rare cases in which theissuer is engaged in a US trade or business and the security istreated as a partnership interest.

B. TEFRA Registration Requirements

1. Overview

A debt instrument in bearer form may be transferred by assignmentand delivery. Further, the only prerequisite to receiving payments

on such a debt instrument is presentment of the instrument to theissuer (or its paying agent). Thus, the issuer would have no need orability to track changes in ownership of the instrument.Accordingly, there would be no easy paper trail for the IRS tofollow in identifying owners. With a view to increasing taxpayer compliance, TEFRA amendedthe Code to prohibit, with limited exceptions, the issuance orholding of debt obligations in the United States in bearer form.Specifically, the TEFRA rules require all registration-requiredobligations (as defined below) to be in registered form. (TheTEFRA registration requirements are tax related and distinct fromany need to register securities with the Securities and ExchangeCommission or state agencies under US securities laws.)An obligation is in registered form for these purposes if (1) it isregistered as to both principal and interest with the issuer or itsagent and can be transferred only by the surrender of the oldobligation to the registrar for its reissuance, or the issuance of a newobligation, to the transferee, (2) principal and interest may betransferred only through a book entry system maintained by theissuer or its agent, or (3) it is registered as to both principal andinterest with the issuer or its agent and can be transferred onlythrough either of the methods described in (1) or (2). Bonds areconsidered to be in registered form if they are required to be heldthrough a book entry system maintained by a clearing organisationeven if holders can obtain physical certificates in bearer form inextraordinary circumstances that are unlikely to occur (specifically,the clearing organisation going out of business without appointmentof a successor). Under the Hiring Incentives to RestoreEmployment Act of 2010 (HIRE Act), an obligation issued after 18March 2012 will also be in registered form if it is held through adematerialised book entry system or any other book entry systemspecified by the Treasury. Any obligation that is not in registeredform is considered to be in bearer form. An obligation is consideredto be in bearer form if it is currently in bearer form, or if there is aright to convert it into bearer form at any time during the remainingperiod that it is outstanding.The issuance of a registration-required obligation in bearer formcan result in severe sanctions to the issuer. The issuer of aregistration-required obligation in bearer form is liable for an excisetax equal to the product of one per cent of the principal amount ofthe obligation and the number of years (or portions thereof) from itsissue date to its maturity date (section 4701) (see Endnote 1). Also,the issuer is not permitted to deduct interest paid on the obligationin computing taxable income or, with limited exceptions, earningsand profits. Finally, obligations issued in bearer form that do notcomply with the Eurobond exception (described below) are noteligible for the portfolio interest exemption from the 30 per cent

David Z. Nirenberg

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Ashurst LLP US Taxation of Non-US Investors in Securitisation Transactions

withholding tax on interest (described below). The sanctionsdescribed in the two preceding sentences generally affect only USissuers or issuers that are owned (in whole or in part) by USpersons, but the excise tax is potentially applicable to all issuers. Any US taxpayer that holds a registration-required obligation inbearer form in violation of the TEFRA rules is also subject tocertain tax penalties. In general, the holder of a registration-required obligation in bearer form is denied deductions for any lossfrom the obligation, and any gain from the obligation that otherwisewould be capital gain is converted into ordinary income. Theholder sanctions apply to an obligation only if the issuer was notsubject to the excise tax (described above), and thus are generally aconcern only for debt obligations that were issued under theEurobond exception described below. A registration-required obligation is defined generally as anyobligation other than one that: is issued by an individual; is not of atype offered to the public; or has a maturity at issue of not more thanone year. Thus, the TEFRA registration requirements do not applydirectly to home mortgages and other consumer receivables that areobligations of individuals. In fact, such obligations are almostnever issued or held in registered form. Conventional commercialloans and mortgages are generally not of a type offered to the publicand traditionally have been issued in bearer form. However,because interest on bearer securities not issued under the Eurobondexception generally cannot be paid to a foreign holder free of USwithholding tax (see below), many commercial loans andcommercial mortgages are now issued in registered form.For purposes of applying the issuer sanctions only, an obligation is notregistration-required if it is issued under the Eurobond exception,which allows bearer paper to be offered outside of the United States tonon-US investors. As discussed below, for obligations issued after 18March 2012, the Eurobond exception will continue to apply only forpurposes of applying the issuer excise tax.In general, an obligation qualifies for the Eurobond exception if (1)the obligation is targeted to non-US investors upon its originalissuance, (2) the obligation provides for interest to be payable onlyoutside the United States, and (3) for any period during which theobligation is held other than in temporary global form, theobligation and each coupon contain a TEFRA legend. For anobligation to be targeted to non-US investors there must be, in thelanguage of the statute, arrangements reasonably designed toensure that the obligation will be sold (or resold in connectionwith the original issue) only to a person who is not a United Statesperson. To satisfy this arrangements test, generally it is necessaryto meet detailed restrictions on offers, sales, and deliveries ofobligations during an initial seasoning period and to obtaincertifications as to the non-US status of investors. The HIRE Act limited the scope of the Eurobond exception forobligations issued after 18 March 2012, so that it will continue toapply only as an exception to the issuer excise tax. Thus,registration-required obligations issued after that date in bearerform will be subject to the other issuer sanctions (including denialof interest deductions) and will not be eligible for the portfoliointerest exemption. What this means in practical terms is that theEurobond exemption will no longer be available with respect toobligations issued after 18 March 2012, for issuers that aredomestic taxpayers or owned by domestic taxpayers becauseinterest on bearer paper would not be deductible.

2. Asset-Backed Securities

The TEFRA rules apply in a straightforward way to pay-throughbonds, pass-through debt certificates, and REMIC regular interests.

They are registration-required obligations and must be issued inregistered form unless the Eurobond exception applies. AlthoughREMIC residual interests are probably not obligations forTEFRA purposes, under the REMIC rules, they cannot be issued inbearer form without jeopardising the issuers status as a REMIC. The treatment of pass-through certificates under the TEFRA rules ismore complex. Except where otherwise noted, it is assumed in thisdiscussion that the issuing trust is classified for tax purposes as atrust. For substantive tax purposes, pass-through certificates are notrecognised to be debt of the issuing trust; instead, they merelyevidence ownership of the trust assets. It would make little sense,however, to exclude pass-through certificates from the reach of theTEFRA rules. They are generally liquid securities similar to tradeddebt instruments. Further, applying a look-through approach wouldproduce odd consequences. The pass-through certificates wouldnot be subject to the registration requirement if the underlying trustassets were obligations of individuals or loans not of a type offeredto the public. If the trust assets included any registration-requiredobligations, it would not be possible to issue certificates in bearerform under the Eurobond exception. These unsettling results are avoided under regulations thateffectively treat pass-through certificates (as defined in theregulations) as obligations of the issuing trust for TEFRA purposes.Thus, the nature of the underlying obligations is irrelevant inapplying the TEFRA rules to such certificates. The certificatesmust be in registered form unless the Eurobond exception appliesbased on an offering of the certificates (as distinguished from theobligations held by the trust) outside of the United States.The regulations define a pass-through certificate as a pass-through or participation certificate evidencing an interest in a poolof mortgage loans (emphasis added) to which the grantor trustrules apply, or a similar evidence of interest in a similar pooledfund or pooled trust treated as a grantor trust. Apart from anexample of a trust holding 1,000 residential mortgages, theregulations offer no guidance on the meaning of the term pool.

C. Withholding Tax

1. Overview

In general, a non-US investor that receives fixed or determinableannual or periodical income (FDAP income) from US sources issubject to a 30 per cent tax on the gross amount of such income,unless either a statutory exemption applies or the tax is reduced oreliminated under an income tax treaty between the United Statesand the investors country of residence. The tax is required to becollected and paid over to the Internal Revenue Service (theService) by any withholding agent in the chain of payment, but isdue whether or not it is collected by withholding.The two types of income that are likely to be earned by an investorin asset-backed securities are interest and gain from the sale orexchange of the securities. Although interest is FDAP income, gainfrom the sale or exchange of securities, including gain attributableto market discount and option premium, is not. Gain representingaccrued original issue discount is treated as interest and thus isFDAP income. Thus, the withholding tax discussion hereinconcentrates on interest income. Certain other types of FDAPincome that may be earned from asset-backed securities arediscussed below.In general, interest income is subject to the withholding tax if it isderived from US sources, unless either the exemption for portfoliointerest (described below) applies, or the tax is reduced or

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Ashurst LLP US Taxation of Non-US Investors in Securitisation Transactions

eliminated under a treaty. In some cases, tax may be required to bewithheld from payments of interest even if those payments are notincludible in full in the income of the payee. The investor, however,would be entitled to a refund of any excess tax withheld. Specialrules apply to original issue discount, and to dividends paid by amutual fund out of interest income.The source of interest income depends on the status of the borrower.Interest is generally US source if the borrower is a resident of theUnited States or is organised in the United States. Thus, interest onall of the following typically would be sourced in the United States:a pass-through certificate issued by a grantor trust holdingobligations of US residents, and pay-through bonds; and pass-through debt certificates that are considered debt of a US resident.Pay-through bonds issued by an entity classifi

Securitisation 2013 Guide

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