Securitisation 2023 Comparisons

Securitisation as a Credit Risk Diffuser

In securitisations, the structural and contractual arrangements aim to isolate the credit risk of the securitised assets from the credit risk of the originator. The delinking of the credit risk of securitised assets is principally accomplished through the incorporation of one or more insolvency-remote entities referred to in Regulation (EU) 2017/2402 (the Securitisation Regulation) as securitisation special purpose entities (SSPEs), and the transfer of ownership of the financial assets from the originator to the SSPE. As a result, the originator insulates the assets in case of insolvency and ensures that the noteholders will receive principal and interest payments from the collateralised assets. As such, noteholders are typically exposed only to the credit risk of the underlying obligors.

Claw-back Risk

Typically, said delinking of credit risk is achieved through a sale of assets from the originator to the issuer (true sale), but it can also be achieved by way of an assignment or transfer, with the same legal effect. Upon completion of the transfer, the assets cease to belong to the originator’s insolvency estate. The Securitisation Regulation requires that the transfer to the SSPE should not be subject to severe (emphasis added) claw-back provisions in the event of the seller’s insolvency (Article 24 of the Securitisation Regulation). Severe claw-back provisions comprise:

• provisions that allow the liquidator of the seller to invalidate the sale of the underlying exposures on the basis that it was concluded within a certain period before the declaration of the seller’s insolvency; or
• provisions that enable the SSPE to prevent the invalidation under the above point only to the extent that the SSPE can prove that it was not aware of the insolvency of the seller at the time of sale.

However, notwithstanding this general prohibition of severe claw-back provisions under the Securitisation Regulation, claw-back risks deriving from national insolvency laws continue to exist in cases of fraudulent transfers – as is the case with transactions at an undervalue, unfair prejudice to creditors or transfers intended to improperly favour particular creditors over others.

Secured Loan

The transfer should not be recharacterised as a secured loan since that would place the transfer within the sphere of insolvency and its subsequent legal checks and constraints. This risk could materialise if:

• the seller is entitled to the return of the charged assets upon repayment of the purchased price;
• the purchaser must account to the seller for any profits made on disposal of the transferred assets; or
• the purchaser passes the risk of losses or damages incurred on the charged assets to the seller.

Legal Requirements

Pursuant to Article 2(2) of the Securitisation Regulation, an SSPE is an SPE that is established with the sole purpose of issuing securities collateralised by the transferred assets (receivables) and selling them to investors. In addition, pursuant to Article 4 of the Securitisation Regulation, an SSPE cannot be established in a third country that is listed as a high-risk jurisdiction. Within said legal boundaries, the legal form of the SSPE is left to the discretion of the originator; the SSPE might take the form of a limited partnership, a limited liability company, a trust or any other corporate form, depending on national specificities, such as the national legal and tax treatment of the SPE.

Typical Structure

SSPEs are typically structured as orphan limited liability companies. The SSPE’s activities are typically confined by negative covenants, which prohibit the entity from engaging in further activities, hiring employees, creating subsidiaries, incurring indebtedness, or granting securities beyond the scope of the securitisation transaction. SSPEs are typically off-balance sheet SPEs, which are thinly capitalised and have their assets segregated by transferring them to a trustee. This happens with the view of reducing the substantive consolidation risk, or the risk of piercing the corporate veil, as it is referred to in some EU jurisdictions where said doctrine applies, which permits the pooling of the assets and liabilities of distinct corporate entities. This doctrine may materialise in cases where the SSPE appears to have been structured in a fraudulent manner, as is the case where the SSPE is owned by or connected to the originator, and may allow domestic courts to disregard the legal separation of the corporate entities and treat them as one entity for liquidation purposes.

Credit rating agencies (CRAs) – ie, entities involved in the procedures to ensure the securitisation parties' compliance with the criteria set out in the Securitisation Regulation (see 4.5 Activities of Rating Agencies) – commonly request the appointment of at least one independent director in the SSPE’s board of directors, whose vote is required for the SSPE to initiate solvent or insolvent liquidation or winding-up proceedings, or to amend the articles of association. This requirement aims to protect investors’ interests from the risk of the originator taking control of the SSPE and gaining access to its assets. The constitutive documents shall also ensure that the delegated independent director is not an employee or otherwise affiliated with the originator.

A key consideration in securitisation transactions is ensuring that the transfer of the assets to the SPE will be affected as a true sale or assignment or transfer with the same legal effect, in a manner that is enforceable against the vendor and any third party. EU securitisations may typically be structured as “true sale” securitisations, where the exposures are removed from the originator’s balance sheet and effectively transferred to the SPE, or as assignments of assets, where the originator’s beneficial rights, titles and interests in and to the exposures evidenced by the underlying contracts are legally transferred to the SPE but the originator remains the holder of the legal title and the lender of record.

Conflict of Laws

The validity, perfection and enforceability of the transfer of financial assets are matters of the applicable national law determined in accordance with national conflict of law rules, which, in turn, may depend on the types of assets being transferred.

With regard to the assignment of, or security over, receivables, Article 14 of Regulation (EC) 593/2008 (Rome I Regulation) provides that:

• the relationship between the assignor/security provider and the assignee/security provider is governed by the law applicable to the agreement between said parties; and
• the law governing the underlying claims determines the assignability of the claim, the relationship between the assignee and the debtor, the conditions under which the assignment can be invoked against the debtor and whether the debtor’s obligations have been discharged.

However, the Rome I Regulation does not provide for any rules in relation to the enforceability of an assignment of receivables as regards third parties; hence, such rules are jurisdiction-specific.

Regarding financial assets other than receivables, notwithstanding any relevant agreement of the parties, the creation, perfection and enforcement of a security interest over, or transfer of, assets is governed by the law where such asset is located.

Perfection requirements are governed by the national applicable law. However, with regard to cases where the transfer is performed by means of an assignment and perfected at a later stage than the closing of the transaction, the triggers to effect such perfection should include at least the following events:

• severe deterioration in the seller's credit quality standing;
• the insolvency of the seller; and
• unremedied breaches of contractual obligations by the seller, including the seller’s default.

True Sale Securitisations

As far as “true sale” securitisations are concerned, the transfer of the assets is typically ascertained based on certain criteria that demonstrate that the assets have indeed been isolated from the originator’s balance sheet. More specifically:

• the transfer of the receivables shall constitute an unequivocal sale, and shall be absolute, unconditional and in writing;
• the requirements affecting the legal transfer of the assets as enshrined in the Securitisation Regulation or the applicable national rules shall be satisfied – for instance, and according to Article 20(6) of the Securitisation Regulation, the underlying assets included in the securitisation shall not be encumbered or in any condition that could jeopardise the enforceability of the true sale or assignment or transfer with the same legal effect and, to this purpose, the seller shall provide relevant representation and warranties;
• the transfer should not be recharacterised as a secured loan – this risk could materialise if:
1. the seller is entitled to the return of the charged assets upon repayment of the purchased price;
2. the purchaser has to account to the seller for any profits made on disposal of the transferred assets;
3. the purchaser passes the risk of losses or damages incurred on the charged assets to the seller; or
4. the transferred assets are no longer part of the originator’s insolvency estate and could not be substantively consolidated into the originator’s estate; and
• the transfer could not be challenged on any grounds of fraudulent or preferential transfer to the detriment of the originator’s investors.

The fulfilment of these conditions is usually confirmed through a true sale legal opinion, which CRAs (see 4.5 Activities of Rating Agencies) typically request to ascertain the transaction risk and the insolvency and bankruptcy-remoteness of the SSPE from the originator.

A securitisation is the more typical way to construct a bankruptcy-remote transaction. When the assignment is performed under general contract laws, there may be exposure to general insolvency constraints, including claw-back rights.

Covered Bonds Transactions

Apart from securitisations, in some jurisdictions credit institutions have another tool in their arsenal to engage in bankruptcy-remote transactions and become isolated from the insolvency risk of the originator. Pursuant to Directive 2013/36/EU (Directive CRD IV), as transposed into national laws, covered bonds are commonly issued by credit institutions to achieve a cheaper source of financing for offering mortgage loans or to finance sovereign debt in some countries. Covered bonds feature the following characteristics:

• they are issued by credit institutions that are subject to public supervision and regulation;
• a specific legislative framework must govern the issuance;
• the cover asset pool must provide sufficient collateral to cover bondholder claims throughout the whole term of the covered bond;
• noteholders have priority over the credit institution's unsecured creditors in a cover pool of financial assets;
• the credit institution has a continuous obligation to keep enough assets in the cover pool to cover the claims of covered noteholders; and
• public or other independent bodies supervise the credit institution's obligations in relation to the cover pool.

Covered bond transactions may be structured as follows.

• Direct issuance: covered bonds are issued by the credit institution, and segregation of the cover pool is achieved by way of a statutory pledge over the cover pool assets or by way of a guarantee, provided by the SPE that acquires the cover pool.
• Indirect issuance: the assets are sold by the issuing credit institution to an SPE, which constitutes a subsidiary of the issuing credit institution.

Upon registration of the relevant pledge and the issuance of covered bonds, related transactions and payments to covered bondholders and other secured creditors are not impacted by the insolvency of the issuer.

Other Alternatives to Securitisation

Legal practitioners seeking alternatives to securitisation should look into national laws, which tend to provide for jurisdiction-specific alternatives.

An issue of utmost importance in securitisation transactions is preserving “tax neutrality”. This means ensuring, to the extent feasible, that the parties involved in the securitisation processes will not incur additional tax liabilities that could raise the tax cost of the transaction. Achieving tax neutrality is also an essential element for the favourable rating of the issued securities by the CRAs (see 4.5 Activities of Rating Agencies). To this end, CRAs typically require an indemnity from the originator to cover unforeseen tax charges that may arise for the issuing SSPE.

The domestic legislation of certain EU member states may impose certain tax liabilities on the transfer of assets and the execution of payments by the originator, the SSPE and the investors. With regard to cross-border securitisation transactions, tax treaties are also taken into consideration for the tax determination. In general, the tax considerations that are mostly encountered in securitisation transactions are the following.

• Transfer taxes: in some EU jurisdictions, a tax amount is levied on the instrument of transfer, and certain tax provisions mandate the payment of the tax amount. Also, depending on the tax cost and the consequences of non-payment, a reserve fund may be set aside to cover the relevant tax costs.
• Taxes on profit: in some EU countries, the sale proceeds under the sale agreement are treated as pure profit and, thus, a tax on the full amount is imposed on the originator. On the other hand, SSPEs need to ensure that executed payments are deductible from their receipts so as to limit their profit rates and, consequently, the tax due.
• Supply taxes: in some EU jurisdictions, supply taxes may be levied on the originator for the sale of assets that resulted from the delivery of goods or services. In this case, the originator may be entitled to tax relief, meaning they can retrieve the paid tax partially or in full in the event of the debtor’s default. However, the originator will be unable to reclaim this tax upon the transfer of the defaulted assets, whereas any agreement between the originator and the SSPE in this regard would question the integrity of the transfer as a “true sale”.
• Withholding taxes: a securitisation transaction requires the execution of multiple payments between the parties involved, and each payment may be subject to withholding tax. Therefore, it is essential to ensure that the transfer of interest-bearing assets to the SSPE or the payments executed by the SSPE to bondholders by way of interest should not culminate in withholding taxes.

The avoidance of any additional tax liabilities that parties in securitisation transactions may incur is contingent on the initial structuring of the transaction, the selection of a favourable tax jurisdiction for the incorporation of the SSPE, and close co-operation with the local tax authorities for the obtainment of necessary tax clearances for the execution of the deal.

Potential taxes on SPEs would generally entail transfer taxes, taxes on profit and withholding taxes; see 2.1 Taxes and Tax Avoidance for further information. However, the taxes payable by the SPE are jurisdiction-specific.

The taxes on cross-border transfers are jurisdiction-specific. Such cross-border transfers may entail:

• VAT, although this is more common on related factoring services and less common on the actual sale of receivables;
• tax on any payment of interest due to the notes issued by the SPE; and
• withholding tax (see 2.1 Taxes and Tax Avoidance).

The actual taxes on cross-border transactions depend on the applicable law and the existence of any applicable double tax treaties.

Each securitisation transaction may give rise to its own jurisdiction-specific tax implications relating to the structure of the securitisation transaction, including the type of the originator and receivables, the seat of establishment of the issuer, the type of financing provided to the issuer, and the agreement for the provision of any relevant factoring services.

Legal opinions may be obtained on the following taxation matters:

• the absence of withholding taxes and stamp duties;
• the tax treatment of the notes and the SPE; and
• the potential VAT on the transfer and on the services provided to the SPE.

The requirements for a transfer of financial assets to be treated as a true sale for accounting purposes are determined in line with the International Financial Reporting Standards (IFRS), as adopted by the EU and applied by credit institutions across the continent. However, accounting issues relating to securitisation transactions should be addressed by accountants, as the respective analysis falls outside the legal scope.

Legal opinions do not generally cover accounting matters, but may include certain qualifications or assumptions that may feed into other legal opinions or risk assessments.

The Securitisation Regulation is the main piece of EU legislation regulating EU securitisations, and introduced a framework of simple, transparent and standardised (STS) securitisations in the EU. The Securitisation Regulation has revised the disclosure, due diligence and risk retention rules encapsulated in the Capital Requirements Regulation, the Alternative Investment Fund Managers Directive and the Solvency II Directive, and has inaugurated a set of harmonised rules applicable to all forms of EU securitisation, thus offering cross-sectoral application.

Establishment of a Reporting Entity

As regards securitisation disclosure obligations, Articles 5 and 7 of the Securitisation Regulation have imposed specific disclosure requirements on the originator, the sponsor and the SSPE. The parties shall designate one entity from among themselves to be the first point of contact for investors and competent authorities, and to carry out the disclosure requirements under the Securitisation Regulation. The European Commission has specified these obligations by laying down implementing technical standards comprising formats and niche templates to help standardise the reporting procedures for stakeholders.

The method of disclosure varies depending on whether the requisite information pertains to public or private transactions. In public securitisations, information transparency is achieved through filings with a securitisation repository, or by registering an entity online to act as a securitisation repository. In private securitisations, the required information should be provided directly to investors, upon request, and to the competent authorities by the reporting entity.

Prior to pricing, the reporting entity is responsible for disclosing information related to the following aspects to investors, upon request:

• information about underlying exposures;
• all underlying documentation that is essential for the understanding of the transaction;
• an STS notification by virtue of Article 3 of the Securitisation Regulation; and
• (in private transactions) a transaction summary or overview of the main features of the securitisation.

Supervision and Sanctions Regarding Disclosure Obligations

Pursuant to Articles 22 and 32 of the Securitisation Regulation, non-compliance with the transparency obligations stipulated by Article 7 of the Securitisation Regulation might be penalised with administrative sanctions and remedial measures, without prejudice to the right of member states to impose criminal sanctions pursuant to Article 34 of the Securitisation Regulation. Member states shall inflict sanctions in the event of negligence or intentional infringement of disclosure obligations, which should be effective, proportionate and dissuasive. In particular, the competent authorities designated by member states are entitled to impose:

• a temporary ban preventing the originator and sponsor from providing an STS notification on the compliance of the securitisation with the Securitisation Regulation; and
• a maximum administrative pecuniary sanction of EUR5 million or its corresponding value in the national currency of the member state, or, where the obligor is a legal entity, of up to 10% of the total annual net turnover according to the last available financial accounts approved by the management body.

Moreover, the Securitisation Regulation confers supervisory responsibilities over the securitisation activities upon the European Securities and Markets Authority (ESMA). ESMA carries out the determination and design of the reporting requirements, forms the content of the STS notification, maintains a list of all STS securitisations, and oversees securitisation repositories and co-operation between the competent authorities.

As discussed in 4.1 Specific Disclosure Laws or Regulations, the Securitisation Regulation provides for a harmonised set of rules. Nevertheless, rules falling outside the scope of the Securitisation Regulation are still applicable in public securitisations. In particular, Regulation (EU) 2017/1129 (Prospectus Regulation) is applicable in the case of public offerings in regulated markets.

The Prospectus Regulation comprises mandatory principles and rules regulating the content, format, approval and publication of securities that are offered to the public. Through its implementation, the EU has attempted to grapple with divergent approaches on information disclosure, which could fragment the internal capital market and protect investors by removing information asymmetries between them and the issuers. The Prospectus Regulation has direct applicability to EU member states and ensures that public offerings are executed in a uniform manner throughout the EU.

Risk Retention Requirement Under Article 6 of the Securitisation Regulation

The risk retention requirement set out in Article 6 of the Securitisation Regulation applies to all types of securitisations and works to align the interests of the parties involved in the securitisation processes and the institutional investors. The article requires, as a minimum, the originator, sponsor or the original lender to retain, on an ongoing basis, a material net economic interest in the securitisation of not less than 5%. That interest shall be measured at the origination and shall be determined by the notional value for off-balance sheet items.

The following applies for the purposes of risk retention.

• The originator must either itself or through related entities be directly or indirectly involved in the original agreement that created the obligations or potential obligations to be securitised. Also, it should be an “entity of real substance”, meaning that it should conform with the “sole purpose test”, which provides that an entity is precluded from the role of the originator if it has been established or operates for the sole purpose of securitising exposures.
• The sponsor could be either a credit institution or an investment firm (both terms as defined in MiFiD) that establishes and manages an asset-backed security or asset-backed commercial paper programme or other securitised scheme purchased from third parties. The day-to-day management can be delegated to an entity authorised under the UCITS Directive, AIFMD or MiFID II.
• An original lender is an entity that, itself or through related entities, directly or indirectly, concluded the original agreement that created the obligations being securitised.

The risk retention requirement can be achieved through a variety of methods by which the net economic interest can be calculated, as follows:

• vertical slice, whereby at least 5% of the nominal value of each class of notes is retained;
• originator’s pari passu share, whereby an interest in revolving assets equal to at least 5% of the nominal value of the assets is retained;
• randomly selected exposures kept on balance sheet, provided that the selection is made from a pool entailing 100% of the assets;
• first loss exposure, whereby the first lost position in at least 5% of the underlying assets is retained; and
• first loss tranche, whereby the most subordinated payment obligation in the securitisation structure is retained. In most EU securitisations, the risk retention level is achieved through this calculation method, and the retainer is often the originator.

Amendments to the Existing Risk Retention Provisions

Article 6 of the Securitisation Regulation has updated the risk retention provisions embedded in Articles 405–410 of the Capital Requirements Regulation (CRR). Compared to the existing framework, the new rules have introduced some nuances relating to the following:

• cross-sectoral application;
• direct application (“direct approach”) to the originator – the investor is no longer required to perform due diligence to ensure that the originator holds a 5% interest stake in the transaction;
• the “sole purpose test” by which an entity is precluded from the role of the originator if it has been established or operates for the sole purpose of securitising exposures;
• the prohibition on the adverse selection of assets by the originators to prevent information asymmetry between the originators and the investors; and
• the European Systemic Risk Board (ESRB) will monitor the securitisation market in order to prevent systemic risks.

Lastly, it should be noted that Regulation (EU) 2021/558 – by virtue of which the regulatory barriers to securitisations of non-performing exposures (NPEs) have been lifted – has extended the risk retention obligation from the originator, the sponsor or the lender to the servicer specifically for NPE securitisation transactions. According to Article 6(1) of the Securitisation Regulation, to qualify as a risk retention holder, the servicer will need to be able to demonstrate that it has expertise in servicing exposures of a similar nature to those securitised and that it has well-documented and adequate policies, procedures and risk management controls in place relating to the servicing of exposures.

Furthermore, and contrary to traditional STS securitisations where the net economic interest to be retained is calculated on a nominal value, the risk retention requirement in NPE securitisations is to be determined on the basis of the discounted value, according to the following principles:

• the retention of a material net economic interest shall not be less than 5% of the sum of the net value of the securitised exposures that qualify as non-performing exposures and, if applicable, the nominal value of any performing securitised exposures;
• the net value of the NPE shall be computed by deducting the non-refundable purchase price discount agreed at the level of the individual securitised exposure at the time of origination or, where applicable, the outstanding value at the time of origination; and
• for the purposes of determining the net value of the NPE, the non-refundable purchase price discount may include the difference between:
1. the nominal amount of the tranches of the NPE securitisation underwritten by the originator for subsequent sale; and
2. the price at which these tranches are first sold to unrelated third parties.

Penalty for Non-Compliance with Risk Requirement Obligation

Please see 4.1 Specific Disclosure Laws or Regulations regarding the imposition of penalties for non-compliance with the risk retention requirement.

Disclosure Obligations

Article 7 of the Securitisation Regulation imposes a number of periodic reporting obligations upon the originator, sponsor and issuer, which shall be principally executed on a quarterly basis. In particular, the reporting entity shall make the following information available to holders of securitisation positions and investors:

• loan-level data on the securitisation positions; and
• an investor report comprising information on:
1. the credit quality and performance of underlying exposures;
2. trigger events affecting the priority of payments or the replacement of the parties involved;
3. cash flows generated by the underlying exposures and the liabilities of the securitisation; and
4. risk retention.

Furthermore, the article stipulates reporting obligations on inside information that should be made available to the public as soon as possible in accordance with Article 17 of Regulation (EU) 596/2014 (Market Abuse Regulation). These obligations take effect when significant events transpire, such as:

• any material breach of the obligations contemplated by the transaction documents;
• any structural change that can materially impact the performance of the securitisation;
• any change in the risk characteristics of the securitisation or the underlying exposures that could materially impact the performance of the securitisation;
• in the case of STS securitisations, where the securitisation ceases to meet the STS requirements or where competent authorities have taken remedial or administrative actions; and
• any material amendment to the transaction documents.

Disclosure Mechanisms

The mechanisms for disclosure depend on the type of the transaction:

• for public securitisations that require the publication of a prospectus, disclosure is achieved through a regulated securitisation repository or, should that not be available, through a website that meets certain standards; and
• for private transactions, disclosure may be achieved through a repository but can also be achieved privately.

Please see 4.1 Specific Disclosure Laws or Regulations regarding the penalties imposed for non-compliance with the periodic disclosure requirements.

Under Article 28 of the Securitisation Regulation, the originator, sponsor or SSPE may use the services of a third party to assess and confirm the compliance of the securitisation with the STS criteria. These services are typically provided by CRAs that have been registered or certified in accordance with Regulation (EC) 1060/2009 on CRAs (CRA Regulation) and been authorised by the member states’ competent authorities to engage in compliance assessments. The CRA Regulation focuses on three aspects that aspire to secure the integrity of the final assessment and a high level of investor protection:

• for the purpose of registration, CRAs shall comply with specific obligations related to the conduct of their business, ultimately aimed at ensuring the independence and validity of the rating process;
• CRAs shall conduct their business in a manner that prevents potential conflicts of interest (ie, they shall not provide their services where they provide individual services to one of the parties involved in the securitisation), in order for high-quality ratings and high levels of transparency to be achieved; and
• CRAs shall be registered and supervised by ESMA, which is equipped with investigatory and remedial powers.

Moreover, the issuer, sponsors and originators in a securitisation transaction must appoint at least two CRAs to provide independent ratings, and should consider appointing one CRA with a market share lower than 10% total market share, subject to the condition that such a small CRA is capable of rating the relevant issuance or entity.

Pursuant to Article 32 of the Securitisation Regulation, in the event of a CRA failing to notify material changes or any other changes that could reasonably affect the assessment of the competent authority, the latter is entitled to temporarily revoke the respective CRA’s authorisation.

Financial institutions hold capital on the basis of their risk-weighted assets (RWAs). Financial entities engaged in securitisation transactions typically have to abide by certain capital requirement rules that provide for a certain amount that should be held in the entities’ reserves in respect of the securitisation exposures. This amount is calculated as the market value of the securitisation position multiplied by a defined stress factor, which is determined on the basis of the duration, the credit rating and the type of the securitisation position.

Capital Requirements Applicable to Banks

Pursuant to the CRR, the risk-weighted exposure amount for securitisations might be limited through the recognition of a significant risk transfer (SRT) to third parties. The SRT principle is applicable to both traditional and synthetic securitisations, and is subject to the fulfilment of either of the following conditions:

• the risk-weighted exposure amounts of the mezzanine securitisation positions held by the originator institution in the securitisation do not exceed 50% of the risk-weighted exposure amounts of all mezzanine securitisation positions existing in this securitisation; or
• in the absence of mezzanine securitisation positions, the originator institution does not hold more than 20% of the exposure value of the first loss tranche in the securitisation and can demonstrate that the exposure value of the first loss tranche exceeds a reasoned estimate of the expected loss on the underlying exposures by a substantial margin.

Conversely, the competent authorities may grant the originator institution the permission to reduce the amount exposure where such institution demonstrates that a commensurate transfer of credit risk to third parties has been achieved and adequate internal risk management policies and methodologies to assess the transfer of credit risk are in place. The permission is contingent on similar conditions for both traditional and synthetic securitisations, with the additional requirement of the exposures having to be placed beyond the reach of the institution and its creditors in synthetic securitisations. The authorities shall inform the European Banking Association (EBA) of their decision.

Capital Requirements Applicable to Insurance Companies

Insurers and reinsurers are subject to specific capital requirements pursuant to the Solvency II Regulation (EU) 2015/35 (Solvency II) when investing in securitisations. For this purpose, Solvency II has divided securitisation positions into three categories by which different capital requirements apply:

• a securitisation position is considered type 1 under a set of stringent criteria and mostly includes positions with a rating of or better than BBB and senior tranches;
• a resecuritisation position is established where at least one of the underlying requirements is a securitisation position and the associated risk is divided into tranches again; and
• a securitisation position is considered type 2 if it does not fall under the previous categories.

In accordance with Article 21 of the Securitisation Regulation, the use of derivative contracts shall be limited to the purpose of hedging the SSPE’s fluctuating exposures, meaning the interest rate or currency risk. These derivatives shall be underwritten and documented. The SSPE shall not enter into derivative contracts with a swap provider for any other reason, and shall ensure that the pool of underlying exposures does not include derivatives.

The primary piece of legislation applicable to EU over-the-counter (OTC) derivatives is the European Market Infrastructure Regulation (EU) 648/2012, as amended and in force (EMIR). Under EMIR, the parties entering a derivative contract are classified as financial counterparties (FCs) and non-financial counterparties (NFCs). The first category comprises institutional investors such as credit institutions, investment firms, insurers and pension funds, while the second category comprises entities that do not fall under the FC category. Pursuant to the classification, the derivative type and the trade date, the counterparties are subject to specific obligations, as follows.

• Clearing obligation – all standardised OTC derivatives must be centrally cleared through central counterparties (CCPs), which are commercial firms that interpose between the two counterparties to the transaction. CCPs are authorised either by the competent authorities of member states (the “bottom-up” approach) or by ESMA in consultation with the ESRB (the “top-down” approach). For the purpose of determining when counterparties become subject to the clearing obligation, FCs and NFCs need to calculate whether their positions count toward the clearing thresholds designed by ESMA. The clearing threshold depends on the class of OTC contracts; for interest rate and foreign exchange derivative contracts, the threshold is currently set at EUR3 billion.
• Reporting obligation – all OTC derivative contracts shall be reported to a trade repository, meaning a central data centre, by the working day following their trade day.
• Monitoring obligation – counterparties are required to monitor and mitigate the operational and counterparty credit risk. In an effort to mitigate the credit risk, EMIR has introduced:

1. stringent rules on prudential, organisational and conduct of business standards for CCPs;
2. mandatory CCP-clearing for standardised OTC contracts; and
3. risk mitigation standards, such as exchange of collateral, for contracts that have not been cleared.

Please see 4.1 Specific Disclosure Laws or Regulations regarding the potential penalties that could be imposed for non-compliance with the derivative limitations entailed in the Securitisation Regulation provisions.

The protection of investors’ interests in securitisations is achieved in numerous ways, including the following:

• the disclosure requirements imposed under the Securitisation Regulation allow investors to undertake due diligence and monitor the securitisation procedures;
• the disclosure requirements imposed under the Prospectus Regulation impose certain rules on listed securities in order to allow investors to make informed decisions on their investments;
• monthly investor reports shall include information relating to insider dealing and market manipulation; and
• MiFID II and Regulation (EC) 1060/2009 on credit rating agencies impose certain rules regarding product governance and conflicts of interest aimed at securing investors' interests.

At the EU level, the main legislative framework that applies to securitising banks is the Securitisation Regulation, the CRR and national law.

Please see 2.1 Taxes and Tax Avoidance.

No such practice currently applies to EU securitisations. However, certain limitations on financial activities could be placed on cross-border securitisation transactions where a participating party is a US investor. In this case, the Volcker Rule under the US Investment Company Act of 1940 applies and prohibits the investing bank from conducting certain activities with its own accounts for the purpose of consumer protection – ie, short-term proprietary trading of securities, derivatives or commodity futures.

As a consequence of being structured as off-balance sheet SPVs, SSPEs face the risk of a shortfall of cash below what is obligated to pay to their investors. Against this backdrop, certain forms of credit enhancement have been utilised in the securitisation market. The most prominent method is credit risk tranching, by which the junior noteholders suffer the first losses on the portfolio due to default of the underlying borrowers. Typically, the holder of a junior security, also called a C note, is the originator (or an affiliate) performing under its obligations for risk retention. Other forms of credit enhancement comprise over-collateralisation, where the consideration paid for the transferred assets is in excess of the face value of the securities, credit letters, surety bonds or internal reserve funds.

In contrast to the USA, where government-sponsored entities are engaging in securitisation transactions, no such practice has been developed in the European market.

Investors in securitisations typically include hedge funds, pension funds, credit institutions and insurance and reinsurance undertakings.

Securitisation transactions are typically completed as a “true sale” of assets through a sale agreement concluded between the originator and the SSPE. The sale agreement encompasses the typical covenants concerning the transfer of the assets and the determination of an amount as consideration for the acquisition, as well as some high-level covenants pertaining to conditions precedent to the transfer, title perfection, the declaration of a trust over the proceeds arising under the assets, the repurchase of non-compliant receivables or ineligible assets, and undertakings, representations and warranties in favour of the acquiring SSPE.

As stated in 5.1 Bankruptcy-Remote Transfers, the sale agreement contains certain warranties provided from the originator to the acquiring entity in the form of corporate and asset warranties. Through corporate warranties, the originator guarantees that it has the full legal right, power and authority to enter and perform all of its obligations under the agreement acting in its capacity as the legitimate owner of the exposures. On the other hand, through asset warranties the originator pledges that the underlying exposures meet the eligibility criteria and are not encumbered or otherwise in a condition that can be foreseen to adversely affect the enforceability of the true sale or assignment or transfer with the same legal effect.

Breach of the corporate warranty would typically be considered as breach for misrepresentation, which, if not remedied, could culminate in the originator’s default and/or early amortisation of the notes, and possibly a claim for damages. Breach of an asset warranty, on the other hand, is typically remedied through the repurchase of the transferred assets by the originator or the payment of compensation by the latter.

The contracting parties in a securitisation can reach an agreement that the transfer of the underlying exposures performed by means of “true sale” or assignment or transfer with the same legal effect can be perfected at a stage later than the closing of the transaction. According to Article 20 of the Securitisation Regulation, the triggers to effect such perfection could be at least the following events:

• severe deterioration in the seller's credit quality standing;
• the insolvency of the seller; and
• unremedied breaches of contractual obligations by the seller, including the seller’s default.

Once the perfection event transpires, the issuer (or a nominee on its behalf) typically proceeds with giving notice to the underlying obligors of the event of the transfer, directs the obligors to pay the outstanding amounts directly to the issuer, and takes any necessary action to recover the amount outstanding in respect of the assets, or to protect or enforce its rights against the obligors (for further information, see 1.3 Transfer of Financial Assets).

In securitisation transactions, certain covenants are provided by both the issuer and the originator. The issuer, the SSPE (as discussed in 1.2 Special-Purpose Entities (SPEs)), is typically constricted by negative covenants that ensure it is operating as an off-balance sheet SPE. The scope of these covenants restricts SSPEs from having independent management or employees, performing administrative functions concerning the receipt and distribution of cash, and generally engaging in financial activities that deviate from the scope of securitisation. On the other hand, the originator is bound by affirmative covenants relating to its corporate status, the ownership of the assets, and its obligation to perform under the transaction documents. In general, breach of any such covenant could lead to early amortisation or default under the notes.

A securitisation service provider can be appointed by the issuing SSPE to collect principal and interest payments from obligors and to transfer such amounts to the account(s) indicated by the issuer, initiate enforcement proceedings against the non-co-operative obligors and administer the asset portfolio after transaction closing, on a day-to-day basis. The servicing agreement could also provide for responsibilities of default management, collateral liquidation and/or the preparation of monthly reports in relation to the assets. According to Article 21 of the Securitisation Regulation, the transaction documentation shall clearly stipulate:

• the contractual obligations, duties and responsibilities of the servicer; and
• the processes and responsibilities necessary to ensure that a default by or an insolvency of the servicer does not result in a termination of servicing, such as a contractual provision that enables the replacement of the servicer in such cases.

Furthermore, it is contractually agreed that the servicer may subcontract or delegate the performance of all or any of its powers and obligations under the servicing agreement, provided that certain conditions are met.

The servicer is typically compensated for its services with a fixed servicing fee paid by the issuer out of the collections of payments from the obligors and in accordance with the priority of payments, which is contractually agreed. Breach of the obligations of the servicer under the servicing agreement might lead to the appointment of a replacement servicer or early amortisation or default under the notes.

Events of defaults under the securitisation documentation could be principally divided into events that trigger early amortisation but not the right to enforce against the collateral and those that lead to both. Furthermore, certain events of default or termination could give rise to the SSPE’s right to replace the services, or another relevant party to the securitisation.

Typical events of default under the notes comprise:

• failure of the issuer to pay principal on any notes and interest on senior note classes when due;
• the insolvency or bankruptcy of the issuer or the servicer;
• a breach of material covenants or misrepresentations; and
• the failure of the servicer or any other relevant party to perform under the obligations stipulated in their respective agreements.

At the outset of a default under the notes, senior noteholders will typically instruct the note trustee to declare all outstanding amounts under the notes immediately due and payable, and to enforce security over the securitised assets.

In securitisations, typical indemnification duties include indemnification for damages if the seller or servicer fails to meet their commitments. In particular, the issuer (and the security trustee) may be entitled to indemnifications against the originator for losses incurred in connection with the sale of assets, and against the servicer for losses incurred as a result of the servicer's negligence in performing its services. The precise indemnities contained in each transaction are determined by the conclusion of the parties' agreements.

The issuers in EU securitisations are typically bankruptcy-remote SSPEs, as described in 1.2 Special-Purpose Entities (SPEs).

According to Article 2 of the Securitisation Regulation, a sponsor is defined as a credit institution, whether incorporated in the EU or not, or a MiFID-regulated investment firm that is separate from the originator and establishes and manages an ABCP programme or other securitised scheme from third-party entities. The sponsor can delegate the day-to-day active portfolio management involved in that securitisation to an entity authorised under the UCITS Directive, AIFMD or MiFID II to perform such activity.

An underwriter in a securitisation transaction is an investment bank that acts as an intermediary between the issuer and the investors by arranging the securitisation and marketing the securities in a public offering. The underwriter, which could also be the originator, structures the deal and might also underwrite the transaction.

Please see 5.5 Principal Servicing Provisions.

The issued securities are usually bought by institutional investors, such as credit institutions, investment firms, insurers and pension funds.

According to Articles 21 and 23 of the Securitisation Regulation, the transaction documentation should clearly state the contractual obligations, duties and responsibilities of trustees. Trustees are also referred to as “security trustees” or “collateral agents”, and are mainly responsible for holding and administering the security granted over the securitised assets on behalf of the investors. Other duties may also be delegated to the trustee, such as enforcing the collateral in the event of default or receiving reports to verify the payment under the securities.

By way of definition, synthetic securitisations involve the transfer of risk of securitised exposures from the originator to the investors through a credit protection agreement. This agreement takes the form of a credit derivative – typically a credit default swap – or financial guarantee, whereby the originator agrees to pay the investor a credit protection premium and the investor agrees to pay the originator a credit protection payment if one of the contractually stated credit events occurs. The ownership of the securitised exposures remains with the originator.

From a structural standpoint, on the one hand, the fact that the ownership remains with the originator constitutes the main advantage of synthetic securitisations compared to traditional, since the originator continues to benefit from the proceeds arising from the securitised portfolio while also benefitting from the RWA benefits of securitisation. On the other hand, the main risk of synthetic securitisations is that they do not essentially constitute insolvency-remote transactions since such securitisations continue to carry the insolvency risk of the originator.

Synthetic securitisations are permitted in the EU. Contrary to STS securitisations, and owing to their inherent differences, synthetic securitisations are contingent upon additional requirements aiming, inter alia, to secure the positions of both the originator and the investor under the credit protection agreement.

In terms of scope, synthetic securitisations can only be labelled as STS when they are carried out by EU banks. Furthermore, the STS framework does not apply to arbitrage synthetic securitisations, where the objective is to profit from credit risk price fluctuations rather than to obtain credit risk protection linked to the originator's actual exposures.

Article 26b of Regulation (EU) 2021/557 (Amendment Regulation) provides that the underlying exposures need to have part of the core lending business activity of the originator and shall be held on its balance sheet or, in the case of a group structure, on its consolidated balance sheet at the transaction's closing date. Furthermore, the originator shall not hedge its exposure beyond the protection obtained through the credit protection agreement. Because the originator must hold the securitised exposures on the balance sheet, arbitrage securitisations are excluded from the reach of the STS label.

Synthetic securitisations are similarly subject to the 5% risk retention rule.

The following applies regarding the credit protection agreement:

• the agreement should meet the extensive credit risk mitigation requirements as stipulated by Article 244 of the CRR;
• the credit events that could trigger payments under the agreement should comprise at least those listed in Article 216 of the CRR, as these are well known and identifiable in the market and should ensure conformity with the prudential framework;
• Article 26c of the Amendment Regulation provides that the originator shall keep an updated reference register to identify the underlying exposures at all times in order to avoid conflicts with the investors and ensure the legal certainty of the agreement. The register must list the reference obligors, the reference obligations from which the exposures derive, and the nominal amount outstanding;
• Article 26d of the Amendment Regulation stipulates that the originator shall be required to disclose data on static and historical default and loss performance for at least five years; and
• Article 26e of the Amendment Regulation provides that:
1. a final adjustment mechanism should be established to secure that the interim payments will cover the actual losses incurred by the originator and that these losses will not be overstated to the detriment of the investors. The mechanism also specifies the maximum extension period applicable to the adjustment process, which shall not be longer than two years. Moreover, the mechanism should be able to define a termination date for the obligation of investors to make payments;
2. the originator is obliged to appoint an independent third-party verification agent before the closing of the agreement to review the accuracy of the credit events that could trigger default under the protection agreement;
3. the credit protection premium will be determined according to the outstanding size and the credit risk of the protected tranche. Non-contingent premiums and/or arrangements such as upfront premium payments, overly complex premium structures and rebate mechanisms do not conform with the synthetic securitisation framework; and
4. the originator may commit synthetic excess spread, as a form of credit enhancement available to investors – ie, a contractually determined amount to absorb losses that might transpire before the maturity date of the transaction. The total amount is calculated as a percentage of the entire outstanding portfolio balance at the beginning of the relevant payment period. The originator will receive the synthetic excess spread that is not used to cover credit losses that occur during each payment period.

In accordance with the disclosure technical standards published by ESMA (see 4.1 Specific Disclosure Laws or Regulations), securitisations could be carried out in relation to a wide range of asset classes, such as commercial, real estate, corporate, auto, consumer, credit card and leasing, which are annexed therein. The transferred assets should be credit claims or receivables that have a homogenous asset type, jurisdiction, applicable law and currency.

The structure of securitisations remains the same regardless of the securitised underlying exposures. On a more detailed level, however, unique commercial and legal issues may result in structural disparities.