Luxembourg lawgoverned securitisation transactions

The Securitisation Regulation

The following article is an overview of the main mechanisms with respect to the application of Regulation (EU) 2017/2402 of the European Parliament and of the Council of 12 December 2017 laying down a general framework for securitisation and creating a specific framework for simple, transparent and standardised securitisation (the Securitisation Regulation) and the Luxembourg law of 22 March 2004 on securitisation, as amended (the Luxembourg Securitisation Law) in the context of securitisation transactions set up by a Luxembourg-incorporated securitisation special purpose vehicle.

Under the Securitisation Regulation, “securitisation” means a transaction or scheme whereby a credit risk is tranched as follows:

• payments depend on the performance of the underlying exposure;
• the distribution of losses during the ongoing life of the transaction is determined by the subordination of tranches; and
• the transaction does not constitute a specialised lending in order to finance or operate physical assets as defined in Article 147(8) of Regulation (EU) no. 575/2013.

In summary, one can therefore say that the two main criteria of the notion of securitisation under the Securitisation Regulation are the requirements of (i) credit risk and (ii) tranching.

The Luxembourg Securitisation law

However, under the Luxembourg Securitisation Law the definition of securitisation is broader as it does not require a securitisation undertaking to securitise credit risk by issuing tranched securities.

The Securitisation Regulation versus the Luxembourg Securitisation Law

In the light of these differences regarding the scope of the Securitisation Regulation and the Luxembourg Securitisation Law, a Luxembourg securitisation transaction can primarily be structured in three possible ways:

1. Securitisation which is subject only to the Luxembourg Securitisation Law

It is still possible to structure a Luxembourg securitisation transaction in such a manner that the structure will only have to be compliant with the Luxembourg Securitisation Law and will not be covered by the scope of the Securitisation Regulation. This can generally be achieved either by securitising a risk other than a credit risk or by not tranching the securities to be issued.

2. Securitisation under the Securitisation Regulation

Securitisation transactions which securitise credit risk and issue tranched securities, ie securities that contain different segments, eg senior and subordinated segments, will usually be subject to both the Luxembourg Securitisation Law and the Securitisation Regulation. In other words, this usually means that requirements and rules such as risk retention, transparency and due diligence need to be complied with by the securitisation undertaking in addition to the application of the general framework of the Luxembourg Securitisation Law. Consequently, the provisions set out in both the Luxembourg Securitisation Law and the Securitisation Regulation will have to be respected by a Luxembourg-incorporated securitisation special purpose vehicle in such a case.

3. STS (simple, transparent and standardised) securitisation

The Securitisation Regulation has also introduced a framework for simple, transparent and standardised securitisation transactions which fulfil the definition of STS securitisation as set out in the Securitisation Regulation. Such STS transactions are foremost a specific category of securitisation which needs to be assessed by applying the relevant provisions set out in the Securitisation Regulation (chapter 4 of the Securitisation Regulation). However, given that they would in most instances still fulfil the general definition of securitisation under the Luxembourg Securitisation Law, such transactions must also comply with all relevant requirements imposed by the law. For instance, the general requirement that any securitisation vehicle can offer its securities to the public on a continuous basis (ie more than three times a year on an all-compartment basis) only if it has been authorised by the Luxembourg financial supervisory authority (CSSF) also applies a priori to such STS transactions.

Specific cases of tranching

In the light of the above, one can therefore conclude that the crucial factor in determining whether or not the Securitisation Regulation will be applicable to a Luxembourg-incorporated securitisation vehicle in addition to the Luxembourg Securitisation Law is whether the transaction will entail the issuance of tranched securities. However, in specific cases the topic of tranching can give rise to discussions – the legal treatment of which is not entirely clear.

Pursuant to article 2(6) of the Securitisation Regulation, “tranche” means a contractually established segment of the credit risk associated with an exposure or a pool of exposures, where a position in the segment entails a risk of credit loss greater than or less than a position of the same amount in another segment, without taking account of credit protection provided by third parties directly to the holders of positions in the segment or in other segments.

Such tranches have different risk/return profiles and levels of seniority as well as different degrees of priority with respect to cash flows. Customarily, in case of losses the initial losses are absorbed by the equity or “junior” tranche, followed by the mezzanine tranche, which in turn is followed by the more senior tranches.

1. Transactions consisting of the issuance of securities and the entering into a loan agreement

In this context, the question arises whether, in a situation in which the securitisation undertaking issues securities and subscribes to a loan as part of the same securitisation transaction, the required tranching would already be fulfilled if an analysis of the position of the securities holder and the loan provider (both groups being exposed to the same portfolio of assets) would lead to the conclusion that they do indeed have different, subordinated positions as regards the distribution of losses of the transaction. In other words, can one already speak of tranching if the securities would not entail any specific subordination provisions, as such provisions only arise from the different risk positions under the securities and the loan (comparing the positions of the securities holders and the loan provider)?

The definition of “tranche” set out in article 2(6) of the Securitisation Regulation is rather wide and does not provide any clear-cut answers. As mentioned, the definition states that “tranche” means a contractually established segment of the credit risk associated with an exposure or pool of exposures, where a position in a segment entails a risk of credit loss greater than or less than a position of the same amount in another segment. It is, however, not clear precisely what would have to be understood by “segment”. In other words, the question arises whether “segment” could only be a specific contractual position created by the particular structure of the terms and conditions of the securities issued by the securitisation undertaking or whether one could also have different segments relating to the same exposure or pool of exposures if such segments have been brought about by the co-existence of two completely different tools (ie issuance of securities and the subscription to a loan).

Strictly speaking, however, the definitions of securitisation and tranche do not contain any such explicit distinction. The only prerequisite seems to be the reference in the definition of “tranche” to the fact that the different risk segments need to be contractually established by the securitisation undertaking. In this respect, it should however not be sufficient to have a different risk segment established by way of the participation of a third entity (ie an entity other than the issuer) providing particular risk insurance in case of losses under the securities.

2. Transactions consisting of the issuance of both debt and equity securities

Furthermore, the question arises whether, in a situation in which in addition to the issuance of debt securities the securitisation undertaking has also issued shares and the proceeds of such equity issuance have been used in the acquisition of the relevant securitisation, underlying tranching also arises. In such a situation one might argue that two different risk segments have been created which have brought about the existence of different categories of investors with regard to their risk exposures. In relation to this question, the Securitisation Regulation does not provide any specific indications as to how such a case must be assessed. However, given the fact that the share position ranking is legally and not contractually defined, if the equity issuance was done for general investment and cash flow generation purposes without there being a specific link to the shares participating in a particular underlying (similar to the position under the debt securities) such context should not be sufficient for the required tranching to arise. However, this might have to be viewed differently in a situation in which the securitisation undertaking has issued different types of shares with different rankings and where specific shares are explicitly linked to a particular underlying and whose dividend payments would only be generated from the proceeds originated by such underlying. Consequently, a case-by-case analysis ought to be carried out in such “equity-to-debt ratio” scenarios.

3. Single investor contexts

In single investor scenarios the question arises whether tranching can also occur if all the different risk segments are held by the same investor. There might be some uncertainty in this respect given that in case of losses under the securities the same investor will always be affected, so that from a practical perspective all losses irrespective of the tranche in question are always absorbed by the same investor. However, the fact that only one investor exists should not be decisive for the question of whether or not tranching has arisen. The definitions of both securitisation and tranche under the Securitisation Regulation do not require an assessment from an investor’s point of view. It should therefore ultimately not matter by whom the different risk segments are held. The main criterion is the requirement that different risk segments have been created contractually without focusing on the investor in question.

4. Losses occurring during the ongoing life of the transaction

Furthermore, the definition of securitisation pursuant to article 2(1)(b) of the Securitisation Regulation requires that “the subordination of tranches determines the distribution of losses during the ongoing life of the transaction or scheme”. In this respect, one might wonder whether, when only one single type of asset is securitised, tranching could occur. In such a situation one might argue that tranching could never materialise since, should the underlying assets stop performing, the whole structure would default and ultimately have to be terminated. It might therefore not be possible to speak of different risk segments persisting throughout the ongoing life of the transaction as the defaulting situation will affect all risk segments by ending all of them at the same time.

The Securitisation Regulation contains no specific references or rules (neither in the recitals nor in the main body of the regulation) from which it could undeniably be deduced that single asset securitisations are not to fall under the scope of the Securitisation Regulation.

From an investor protection perspective, we cannot conclude that the Securitisation Regulation is not applicable since such an approach would lead to the risk retention and transparency requirements set out in chapter 2 not being applicable. This would ultimately lead to a position in which the investors in a single asset securitisation transaction would be less protected than investors which have invested in securities linked to a pool of different assets, although the former, given the higher risk of the transaction being prematurely terminated, would be exposed to even more risk in this respect.

Other topics of discussion under the Securitisation Regulation

1. Direct lending activities

a. Direct lending under the Luxembourg Securitisation Law

Pursuant to the Luxembourg Securitisation Law, securitisation usually involves the acquisition of one or several claims from an originator. However, it is accepted that under specific circumstances a securitisation undertaking may itself expressly grant loans instead of their being acquired on the secondary market. The CSSF states in its Frequently Asked Questions on Securitisation (October 2013) that direct lending can be regarded as securitisation provided that the securitisation undertaking does not allocate funds from the public to a credit activity on its own account, and that the documentation relating to the issue either clearly defines the assets on which the service and the repayment of the loans granted by the securitisation will depend, or clearly describes the borrower(s) and/ or the criteria according to which the borrowers will be selected, so that investors are adequately informed of the risks. Consequently, in specific circumstances and subject to the conditions mentioned above, direct lending is an accepted securitisation activity within the meaning of the Luxembourg Securitisation Law.

b. Direct lending under the Securitisation Regulation

The Securitisation Regulation does not however expressly confirm whether direct lending transactions qualify as securitisation within the meaning of article 2(1) of the Securitisation Regulation.

However, taking a closer look at the mechanism of the Securitisation Regulation and its definitions, one could conclude that direct lending might not be covered by it as several aspects of the regulation might convey the idea that the securitised risks must have been created by an entity other than the securitisation undertaking itself.

For instance, the definition of “securitisation special purpose entity” clearly states that such an “SSPE” means a corporation, trust or entity other than an originator or sponsor and that the activities of the securitisation undertaking are structured so as to isolate the obligations of such an undertaking from those of the originator. In this respect, the originator is defined as being an entity that was involved in the original agreement and which created the obligations or potential obligations of the debtor or potential debtor giving rise to the exposures being securitised or which purchases a third party’s exposures on its own account and then securitises them.

Furthermore, the Securitisation Regulation explicitly refers to two different types of securitisation transactions, ie “traditional securitisation” and “synthetic securitisation”.

Traditional securitisation is to be understood as a securitisation involving the transfer of the economic interest in the exposures being securitised through the transfer of ownership of those exposures from the originator to a securitisation undertaking or through sub-participation by a securitisation undertaking, where the securities issued do not represent payment obligations of the originator. Synthetic securitisation means a securitisation where the transfer of risk is achieved by the use of credit derivatives or guarantees, and the exposures being securitised remain exposures of the originator.

In particular, the concept of traditional securitisation shows that the purpose of the securitisation undertaking is primarily to acquire already existing exposures, which will be transferred from the originator to the securitisation undertaking, instead of the securitisation undertaking itself creating such exposures by direct lending.¹ This idea seems to be corroborated by most of the official European Commission and European Parliament publications with respect to the Securitisation Regulation, as in none of these publications can any explicit reference be found to the notion that direct lending activities engaged in by a securitisation undertaking are to be viewed as securitisation within the meaning of the Securitisation Regulation.

In fact, most of the publications refer to the various parties in a securitisation transaction such as the original lender, the originator, the sponsor, the securitisation undertaking, the underwriter, etc. These entities are all viewed as separate, each having its own distinctive function in the securitisation. Furthermore, the briefing note dated January 2018 from the European Parliament on common rules and new framework for securitisation clearly states that securitisations under the Securitisation Regulation are viewed as either “traditional” or “synthetic”.²

However, in both definitions the risks to be securitised are transferred to the securitisation undertaking and therefore could not be created by it by direct lending activities. The aforementioned briefing note further states that in the context of traditional securitisations the assets are effectively transferred to the securitisation undertaking and removed from the originator’s balance sheet. This means that the assets must have been existing assets which were acquired by the securitisation undertaking from the originator. In a direct lending scenario, such subsequent transfer of an existing exposure could not occur since it would have been the securitisation undertaking itself which created the underlying obligations. Therefore, unlike the position taken in Luxembourg as regards the Luxembourg Securitisation Law, direct lending activities do not seem to qualify as securitisation under the Securitisation Regulation. However, on the other hand, such an assessment would lead to the result that in a direct lending scenario in particular the risk retention and transparency obligations, which are foremost a mechanism to protect the investors, would not be applicable. From a mere investor protection perspective it does not seem to make sense to distinguish between scenarios in which existing assets were acquired by the securitisation undertaking and those in which the securitisation proceeded to create them itself. It is therefore advisable to assess any context containing a direct lending component on a case-by-case basis, to follow closely any publication of circulars or statements of the CSSF on securitisation and, in situations where the non-compliance risk might be very high, to address the CSSF for clearance on an individual basis.

2. Borrowing activities by a securitisation undertaking

a. Implications under the Luxembourg Securitisation Law

Usually, the securitisation undertaking is financed by the issuance of securities whose value or yield depends on the risks assumed by the securitisation undertaking pursuant to article 1(1) of the Luxembourg Securitisation Law. In specific instances it is however accepted that the securitisation undertaking uses borrowing or intra-group financing on a temporary basis in order to pre-finance the acquisition of the risks to be securitised while it proceeds to the issuance of securities to investors at a later stage (warehousing).

Furthermore, it is accepted that borrowing can be done on a lasting but limited basis. In this respect, it is however important to note that such borrowing can only be done on an ancillary basis while the main and determining purpose of the transaction must always be securitisation, ie the economic transformation of risks into securities. In other words, borrowing can only be viewed as acceptable if the transaction as a whole also includes the issuance of securities for a proportionately substantial amount (see question 9 of the CSSF Frequently Asked Questions on Securitisation, October 2013).

b. Implications under the Securitisation Regulation

As far as the Securitisation Regulation is concerned, it seems unclear whether a securitisation undertaking falling under the scope of the Securitisation Regulation would also be permitted to engage in borrowing activities. The official EU Commission and EU Parliament publications are silent on this point. However, the definition of “traditional securitisation” set out in article 2(9) of the Securitisation Regulation refers to the fact that the securities issued do not represent payment obligations of the originator. From this reference one might have to conclude that a securitisation transaction under the Securitisation Regulation must also primarily entail the issuance of securities by the securitisation undertaking. Furthermore, the explanatory memorandum regarding the official proposal for the Securitisation Regulation of the European Parliament and of the Council (2015/0226 (COD)) dated 30 September 2015 states on page 2 that securitisation refers to transactions that enable a lender or other originator of assets to refinance a set of loans or assets by converting them into securities.³ This aspect is also reflected in recital 19 of the Securitisation Regulation, which refers to the acquisition of risks to be securitised and which in this context states that such risks are transformed into tradable securities. However, despite these indications it still seems unclear whether, at least to a certain extent and as an ancillary activity to the issuance of securities, the securitisation undertaking could engage in borrowing by entering into loan agreements rather than by issuing securities only. Should one come to the conclusion that mixed issuing and borrowing structures would not be covered by the Securitisation Regulation, it might unduly provide a possibility to circumvent the obligations of the Securitisation Regulation, which again from an investor protection perspective might not be convincing. It is therefore advisable that market participants follow closely any developments in terms of publications or statements made by the CSSF or ESMA in this respect.

Summary

• The application of the Securitisation Regulation rests on two main components: the securitisation of credit risk and the occurrence of tranching.
• Securitisation transactions set up by a Luxembourg-incorporated securitisation undertaking which do not securitise credit risk and where no tranched securities are issued usually fall under the scope of the Luxembourg Securitisation Law only.
• Tranching should also arise out of a combination of the issuance of securities and the granting of a loan, as tranching should occur whenever different risk segments are contractually established.
• The ordinary share capital of the securitisation undertaking may not be sufficient for tranching given that the ranking of shareholders of the securitisation undertaking is legally established and does not arise by way of contractual relationship.
• Single investor scenarios should not automatically lead to the conclusion that tranching has not occurred as single investor status should be irrelevant if two different risk segments are held by the same investor.
• The securitisation of one single asset should usually also qualify as tranching and can therefore constitute a securitisation under the Securitisation Regulation irrespective of the fact that in case of a default of such asset the transaction will automatically come to an end.
• Whether direct lending and borrowing activities carried out by a securitisation undertaking and which are acceptable under the Luxembourg Securitisation Law would also fall under the scope of the Securitisation Regulation is unclear. Arguments from an investor protection perspective might however lead to the conclusion that such transactions, provided credit risk is securitised and the securities in question are indeed tranched, would need to comply with the Securitisation Regulation.

^{1. European Parliament, Understanding Securitisation, Backgroundbenefits-risks, October 2015- PE569.017}

^{2. Briefing EU Legislation in Progress, January 2018, PE 608.777}

^{3. European Commission COM (2015) 472 final}