reproposal, the agencies reasoned that, after a five-year period, the
quality of the underwriting would be sufficiently evident that the
initial third-party purchaser or, if there was no initial third-party
purchaser, the sponsor, would suffer the consequences of poor
underwriting in the form of a reduced sales price for such interest.
The agencies also believe that the initial holder of the B-piece,
whether a third-party purchaser or the sponsor, would need to assume
that holding the B-piece for a five-year period would result in such
holder bearing the consequences of poor underwriting. Thus, by
permitting transfer after the five year-period, the agencies do not
believe that they are creating a structure which would result in the
initial holder being less demanding of the underwriting than if it was
required to retain the B-piece until expiration of the full sunset
period applicable to CMBS securitizations. In connection with this, the
agencies view the requirement (among other conditions) that a
subsequent purchaser, like the initial third-party purchaser, conduct
an independent review of the credit risk of each securitized asset to
be important, as this requirement will emphasize to the initial B-piece
holder that the performance of the securitized assets will be
scrutinized by any potential purchaser, thus exposing the initial
purchaser to the full risks of poor underwriting.
    The only change in the final rule from the reproposal is that it
allows the risk retention obligation to terminate once all of the loans
in a CMBS transaction are fully defeased. A loan is deemed to be
defeased if cash or cash equivalents have been pledged to the issuing
entity as collateral for the loan and are in such amounts and payable
at such times as necessary to timely generate cash sufficient to make
all remaining debt service payments due on such loan and the issuing
entity has an obligation to release its lien on the loan. Once the
collateral securing a loan is replaced with cash or cash equivalent
instruments in the full amount remaining due on the loan, thereby
defeasing the loan, any risk associated with poor underwriting is
eliminated and there is no need to require risk retention to continue
to be held.
    The standards for the agencies to provide exemptions to the risk
requirements and prohibition on hedging are outlined in section 15G.
The exemption allowing for a transfer of the B-piece by one qualified
third-party purchaser to another qualified third-party purchaser after
five years meets these requirements. The agencies decided that unless
there was a holding period that was sufficiently long enough to enable
underwriting defects to manifest themselves, the original third-party
purchaser might not be incentivized to insist on effective

underwriting of the securitized assets. The agencies believe that under
15 U.S.C. 78o-11(e)(2), a five-year retention duration helps ensure
high-quality underwriting standards for the securitizers and
originators of assets that are securitized or available for
securitization by forcing sponsors or initial third-party purchasers to
bear the risk of losses related to underwriting deficiencies.
Furthermore, the agencies believe that this exemption meets the
statute's requirement that the exemption encourage appropriate risk
management practices by the securitizers and originators of assets,
improve the access of consumers and businesses to credit on reasonable
terms, or otherwise is in the public interest and for the protection of
investors. The approach of requiring the third-party purchaser to hold
for at least five years accommodates continuing participation of B-
piece buyers in the market, in a way that requires meaningful risk
retention as an incentive to good risk management practices by
securitizers in selecting assets and addresses specific concerns about
maintaining consumers' and businesses' access to commercial mortgage
credit.\137\
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    \137\ While more than one commenter suggested that a sponsor who
retains the B-piece be allowed to transfer the B-piece within the
five year-period, the agencies do not agree that the sponsor should
be treated differently from a third-party purchaser in this regard.
The obligation to hold the B-piece for the five year-period is
designed to, and will help, ensure high quality underwriting
regardless of whether it is held by the sponsor or a third party.
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6. Government-Sponsored Enterprises
a. Overview of the Reproposal and Public Comment
    The reproposal provided in section 8 that the full guarantee (for
timely payment of principal and interest) by the Enterprises while they
operate under the conservatorship or receivership of FHFA with capital
support from the United States would have satisfied the risk retention
requirements of section 15G of the Exchange Act with respect to the
mortgage-backed securities issued by the Enterprises. Similarly, an
equivalent guarantee provided by a limited-life regulated entity that
succeeds to the charter of an Enterprise, and that is operating under
the authority and oversight of FHFA under section 1367(i) of the
Federal Housing Enterprises Financial Safety and Soundness Act of 1992,
would have satisfied the risk retention requirements, provided that the
entity is operating with capital support from the United States. The
reproposal also provided that the hedging and finance provisions would
not have applied to an Enterprise while operating under conservatorship
or receivership with capital support from the United States, or to a
limited-life regulated entity that succeeded to the charter of an
Enterprise and is operating under the authority and oversight of FHFA
with capital support from the United States. Under the reproposal, a
sponsor (that is, an Enterprise) utilizing this option would have been
required to provide to investors, in written form under the caption
``Credit Risk Retention'' and, upon request, to FHFA and the
Commission, a description of the manner in which it met the credit risk
retention requirements.
    As the agencies emphasized, if either an Enterprise or a successor
limited-life regulated entity began to operate other than as described,
the Enterprise or successor entity would no longer be able to avail
itself of the credit risk retention option provided by section 8 of the
reproposal and would have become subject to the related requirements
and prohibitions set forth elsewhere in the reproposal. The reproposal
did not alter the approach to the risk retention requirements for the
Enterprises in the original proposal.
    In explaining their reasons for this approach, the agencies
observed that because the Enterprises fully guarantee the timely
payment of principal and interest on the mortgage-backed securities
they issue, the Enterprises were exposed to the entire credit risk of
the mortgages that collateralize those securities.\138\ The agencies
also highlighted that the Enterprises had been operating under the
conservatorship of FHFA since September 6, 2008, and that as
conservator, FHFA had assumed all powers formerly held by each
Enterprise's officers, directors, and shareholders and was directing
its efforts as conservator toward minimizing losses, limiting risk
exposure, and ensuring that the Enterprises priced their services to
adequately address their costs and risk. Finally, the agencies
described how each Enterprise, concurrent with being placed in
conservatorship, entered into a Senior Preferred Stock Purchase
Agreement (PSPA) with the United States Department of the Treasury
(Treasury) and that the PSPAs provided capital support to the relevant
Enterprise if the Enterprise's liabilities exceeded its assets under
GAAP.\139\
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    \138\ See Original Proposal, 76 FR at 24111-24112; Revised
Proposal, 78 FR at 57959-57961.
    \139\ Under each PSPA as amended, Treasury purchased senior
preferred stock of each Enterprise. In exchange for this cash
contribution, the liquidation preference of the senior preferred
stock that Treasury purchased from the Enterprise under the
respective PSPA increases in an equivalent amount. The senior
preferred stock of each Enterprise purchased by Treasury is senior
to all other preferred stock, common stock or other capital stock
issued by the Enterprise.
    Treasury's commitment to each Enterprise is the greater of: (1)
$200 billion; or (2) $200 billion plus the cumulative amount of the
Enterprise's net worth deficit as of the end of any calendar quarter
in 2010, 2011 and 2012, less any positive net worth as of December
31, 2012. Under amendments to each PSPA signed in August 2012, the
fixed-rate quarterly dividend that each Enterprise had been required
to pay to Treasury was replaced, beginning on January 1, 2013, with
a variable dividend based on each Enterprise's net worth, helping to
ensure the continued adequacy of the financial commitment made under
the PSPA and eliminating the need for an Enterprise to borrow
additional amounts to pay quarterly dividends to Treasury. The PSPAs
also require the Enterprises to reduce their retained mortgage
portfolios over time.
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    The agencies received only a few comments on proposed section 8,
and those commenters generally supported allowing the Enterprises'
guarantee to be an acceptable form of risk retention in accordance with
the conditions proposed. As a consequence the agencies have decided to
adopt section 8 without any change.
    While the agencies understand the issues involved with the
Enterprises' participation in the mortgage market, the agencies
continue to believe that it is appropriate, from a public policy
perspective, to recognize the guarantee of the Enterprises as
fulfilling their risk retention requirement under section 15G of the
Exchange Act, while in conservatorship or receivership with the capital
support of the United States.\140\ The authority and oversight of the
FHFA over the operations of the Enterprises or any successor limited-
life regulated entity during a conservatorship or receivership, the
full guarantee provided by these entities on the timely payment of
principal and interest on the mortgage-backed securities that they
issue, and the capital support provided by Treasury under the PSPAs
\141\ provide a reasonable basis consistent with the goals and intent
of section 15G for recognizing the Enterprise guarantee as meeting the
Enterprises' risk retention requirement.
---------------------------------------------------------------------------

    \140\ See Revised Proposal, 78 FR at 57960.
    \141\ By its terms, a PSPA with an Enterprise may not be
assigned, transferred, inure to the benefit of, any limited-life,
regulated entity established with respect to the Enterprise without
the prior written consent of Treasury.
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    For similar reasons, the agencies believe that final rule's
restrictions and prohibitions on hedging and transfers of retained
interests should not apply to an Enterprise or any successor limited-
life regulated entity, as long as the Enterprise (or limited-life
successor

entity) is operating consistent with the conditions set out in the
rule. In the past, the Enterprises have sometimes acquired pool
insurance to cover a percentage of losses on the mortgage loans
comprising the pool.\142\ FHFA also has made risk-sharing through a
variety of alternative mechanisms a major goal of its Strategic Plan
for the Enterprise Conservatorships.\143\ Because each Enterprise,
while in conservatorship or receivership and operating with capital
support from the United States, will need to fully guarantee, and hold
the credit risk on, the mortgage-backed securities that it issues for
the provisions of section 8 of the rule to apply, the prohibition on
hedging the credit risk that a retaining sponsor is otherwise required
to retain would have limited the ability of the Enterprises to acquire
such pool insurance in the future or take other reasonable actions to
limit losses that would otherwise arise from the Enterprises' full
exposure to the credit risk of the securities that they issue.
---------------------------------------------------------------------------

    \142\ Typically, insurers would pay the first losses on a pool
of loans, up to 1 or 2 percent of the aggregate unpaid principal
balance of the pool.
    \143\ See, e.g., FHFA 2012 Report at 7-11; FHFA 2013 Report at
7-11.
---------------------------------------------------------------------------

    If any of the conditions in the rule cease to apply, an Enterprise
or any successor organization will no longer be able to rely on its
guarantee to meet the risk retention requirement under section 15G of
the Exchange Act and will need to retain risk in accordance with one of
the other applicable sections of this risk retention rule. Because
section 8 of the rule applies only so long as the relevant Enterprise
operates under the authority and control of FHFA and with capital
support from the United States, the agencies continue to believe that
the rule's approach with regard to the Enterprises' compliance with the
risk retention requirement of section 15G of the Exchange Act is
consistent with the maintenance of quality underwriting standards, in
the public interest, and consistent with the protection of
investors.\144\
---------------------------------------------------------------------------

    \144\ See Original Proposal, 76 FR at 24112; Revised Proposal 78
FR at 57961.
---------------------------------------------------------------------------

    The agencies recognize ongoing activity related to reform of the
Enterprises, and expect to revisit and, if appropriate, modify this and
other provisions after the future of the Enterprises and of the
statutory and regulatory framework for the Enterprises becomes clearer.
The agencies will continue to consider the impact of potential
arbitrage between various markets and market participants, and in
particular between the Enterprises and the private securitization
markets, and whether adjustments should be made to enhance investor
protection and financial stability.
7. Open Market Collateralized Loan Obligations
a. Background
    A CLO is an asset-backed security that is typically collateralized
by portions of tranches of senior, secured commercial loans or similar
obligations of borrowers who are of lower credit quality or that do not
have a third-party evaluation of the likelihood of timely payment of
interest and repayment of principal. As discussed in the reproposal,
commenters distinguished between two general types of CLOs: open market
CLOs and balance sheet CLOs. As described by commenters, a balance
sheet CLO securitizes loans already held by a single institution or its
affiliates in portfolio (including assets originated by the institution
or its affiliate) and an open market CLO securitizes assets purchased
on the secondary market, in accordance with investment guidelines.
    CLOs are organized and initiated by a CLO manager usually when the
CLO manager partners with a structuring bank that assists in financing
asset purchases that occur before the legal formation of the CLO.\145\
After the terms of a CLO transaction, including investment guidelines,
are agreed upon with key investors, the CLO manager will usually have
sole discretion under the governing documents to select portions of
tranches of syndicated commercial loans on the primary or secondary
market to be acquired by the CLO in compliance with the investment
guidelines. An SPV (issuing entity) is formed to issue the asset-backed
securities collateralized by commercial loans that the CLO manager has
selected and directed the CLO issuing entity to purchase. The CLO
manager retains the obligation to actively manage the asset portfolio,
in accordance with the investment guidelines, and earns management fees
and performance fees \146\ for management services provided.
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    \145\ Board of Governors of the Federal Reserve System, Report
to the Congress on Risk Retention 22 (Oct. 2010).
    \146\ In many cases, a portion of the manager's fees are
subordinated or contingent upon asset performance.
---------------------------------------------------------------------------

    CLOs are a type of CDO. Both are organized and initiated by an
asset manager that also actively manages the assets for a period of
time after closing in compliance with investment guidelines. Typically,
both CLOs and CDOs are characterized by relatively simple sequential
pay capital structures and significant participation by key investors
in the negotiation of investment guidelines.
    As discussed in the reproposal and below, the agencies believe that
the risk retention rules apply to CLOs because CLO managers clearly
fall within the statutory definition of ``securitizer'' set forth in
Exchange Act section 15G. Moreover, the agencies believe it is
consistent with the purpose of section 15G of the Exchange Act and
principles of statutory interpretation to apply the risk retention
rules to CLOs. There is no indication that Congress sought to exclude
any specific type of securitization structure from the requirements of
section 15G. Other than mandating specific types of exemptions based on
underwriting quality and for securitizations involving certain public
entities,\147\ Congress directed the agencies to apply risk retention
generally with respect to all asset-backed securities. Subject only to
specific limitations, authority to determine other exemptions was left
to the implementing agencies.
---------------------------------------------------------------------------

    \147\ 15 U.S.C. 78o-11(e).
---------------------------------------------------------------------------

    Moreover, contrary to commenters' suggestions, as discussed below,
developments in the CLO and leveraged loan market suggest that CLOs
present many of the same incentive alignment and systemic risk concerns
that the risk retention requirements of section 15G were intended to
address. CLO issuance has been increasing in recent years.\148\
Paralleling this increase has been rapid growth in the issuance of
leveraged loans,\149\ which are the primary assets purchased by most
CLOs. Heightened activity in the leveraged loan market has been driven
by search for yield and a corresponding increase in risk appetite by
investors.\150\ The agencies note that there is evidence that this
increased activity in the leveraged loan market has coincided with
widespread loosening of underwriting standards.\151\ In fact, a recent
review of a sample of leveraged loans by the Federal banking agencies
found that forty-two percent of leveraged loans examined were
criticized by examiners.\152\ The agencies

believe that increases in the origination and pooling of poorly
underwritten leveraged loans could expose the financial system to
risks.\153\ The Federal banking agencies have been monitoring this
market closely and have responded to concerns by issuing updated
leveraged lending supervisory guidance, which outlines principles
related to safe and sound leveraged lending activities, including
expectations that banks and thrifts exercise prudent underwriting
standards when originating leveraged loans, regardless of intent to
hold or distribute them.\154\ As discussed in more detail below, these
developments in the leveraged loan and CLO market represent similar
dynamics to issues in the originate-to-distribute model that were a
major factor in the recent financial crisis and that section 15G was
intended to address.
---------------------------------------------------------------------------

    \148\ Monetary Policy Report, Board of Governors of the Federal
Reserve System, at 23 (July 2014).
    \149\ Id. at 22; Semiannual Risk Perspective: Spring 2014,
Office of the Comptroller of the Currency, at 29 (June 2014).
    \150\ Monetary Policy Report, at 1-2, 22.
    \151\ Id.; Semiannual Risk Perspective: Spring 2014, at 5.
    \152\ Shared National Credits Program: 2013 Review, Board of
Governors of the Federal Reserve System, Federal Deposit Insurance
Corporation, Office of the Comptroller of the Currency, at 3
(September 2013) (``A focused review of leveraged loans found
material widespread weakness in underwriting practices, including
excessive leverage, inability to amortize debt over a reasonable
period, and lack of meaningful financial covenants.'').
    \153\ See, e.g., Semiannual Risk Perspective: Spring 2014, at 8.
    \154\ See ``Interagency Guidance on Leveraged Lending,'' Final
Supervisory Guidance, 78 FR 17766 (March 22, 2013), at http://www.gpo.gov/fdsys/pkg/FR-2013-03-22/pdf/2013-06567.pdf (Leveraged
Lending Guidance).
---------------------------------------------------------------------------

    For these reasons, and others discussed below, the agencies believe
it is appropriate to apply risk retention rules to open market CLOs as
well as balance sheet CLOs.
b. Overview of Original Proposal and Reproposal
    In the original proposal, the agencies observed that a CLO manager
generally acts as the sponsor by selecting the commercial loans to be
purchased by the CLO issuing entity and managing the securitized assets
once deposited in the CLO structure.\155\ Accordingly, the original
proposal would have required the CLO manager to satisfy the minimum
risk retention requirement for each CLO securitization transaction that
it managed by holding a sufficient amount of standard risk retention.
The original proposal did not include a form of risk retention designed
specifically for CLO securitizations.
---------------------------------------------------------------------------

    \155\ See Original Proposal, 76 FR at 24098 n. 42.
---------------------------------------------------------------------------

    As discussed in the reproposal, many commenters on the original
proposal raised concerns regarding the impact of the proposal on open
market CLOs. Some commenters asserted that most asset management firms
currently serving as open market CLO managers do not have the balance
sheet capacity to fund 5 percent horizontal or vertical slices of the
CLO. They asserted that imposing standard risk retention requirements
on these managers could cause independent CLO managers to exit the
market or be acquired by larger firms. According to these commenters,
the resulting erosion in market competition could increase the cost of
credit for large companies that are of lower credit quality or that do
not have a third-party evaluation of the likelihood of timely payment
of interest and repayment of principal and that are represented in CLO
portfolios above the level that otherwise would be consistent with the
credit quality of these companies.
    Certain commenters also asserted that open market CLO managers are
not ``securitizers'' under section 15G of the Exchange Act and,
therefore, the agencies do not have the statutory authority to subject
them to risk retention requirements. These commenters asserted that CLO
managers are not ``securitizers'' as defined in section 15G of the
Exchange Act because they do not own, sell, or transfer the loans that
comprised the CLO's collateral pool, but only direct which assets would
be purchased by the CLO issuing entity.
    In the reproposal, the agencies discussed these comments and
explained that the definition of ``securitizer'' under section 15G of
the Exchange Act applied to open market CLO managers.\156\ To help
address concerns raised by commenters to the initial proposal, the
agencies proposed an alternative method for risk retention compliance
for CLOs that the agencies believed would be consistent with the
purposes of risk retention. This alternate approach would be available
under the reproposal to an open market CLO, the assets of which consist
primarily of portions of senior, secured syndicated loans acquired by
the issuing entity directly from sellers in open market transactions
and servicing assets, and that holds less than 50 percent of its assets
by aggregate outstanding principal amount in loans syndicated by lead
arrangers that are affiliates of the CLO or CLO manager or originated
by originators that are affiliates of the CLO or CLO manager (lead
arranger option).
---------------------------------------------------------------------------

    \156\ See 2013 Reproposal, 78 FR at 57962.
---------------------------------------------------------------------------

    Under the reproposal, as an alternative to the standard options for
vertical or horizontal risk retention, the sponsor of an open market
CLO could avail itself of the lead arranger option only if, among other
requirements: (1) The CLO did not hold or acquire any assets other than
CLO-eligible loan tranches (discussed below) and servicing assets (as
defined in the reproposed rule); (2) the CLO did not invest in ABS
interests or credit derivatives (other than permitted hedges of
interest rate or currency risk); and (3) all purchases of assets by the
CLO issuing entity (directly or through a warehouse facility used to
accumulate the loans prior to the issuance of the CLO's liabilities)
were made in open market transactions on an arm's length basis. In
addition, to be eligible for the option, the governing documents of the
open market CLO would have to require, at all times, that the assets of
the open market CLO consist only of CLO-eligible loan tranches and
servicing assets.
    Under the reproposal's lead arranger option, a term loan of a
syndicated credit facility to a commercial borrower would have
qualified as a CLO-eligible loan tranche if the firm serving as lead
arranger for the term loan tranche were to retain at least 5 percent of
the face amount of the term loan tranche. The lead arranger would have
been required to retain this portion of the loan tranche until the
repayment, maturity, involuntary and unscheduled acceleration, payment
default, or bankruptcy default of the loan tranche. This requirement
would have applied regardless of whether the loan tranche was purchased
on the primary or secondary market, or was held at any particular time
by an open market CLO, and was designed to allow meaningful risk
retention to be held by a party that has significant control over the
underwriting of assets that are typically securitized in CLOs, without
causing significant disruption to the CLO market.
    In order to ensure that a lead arranger retaining risk had a
meaningful level of influence on loan underwriting terms, the
reproposal would have required that the lead arranger be identified in
the legal documents governing the origination, participation or
syndication of the syndicated loan or credit facility and that such
documents include covenants by the lead arranger that it will fulfill
the requirement to retain a minimum of 5 percent of the face amount of
the CLO-eligible loan tranche. The lead arranger also would be required
to take on an initial allocation of at least 20 percent of the face
amount of the broader syndicated loan or credit facility, with no other
member of the syndicate assuming a larger allocation or commitment.
Additionally, a retaining lead arranger would have been required to
comply with the same sales and hedging restrictions as sponsors of
other securitizations until the repayment, maturity, involuntary and
unscheduled acceleration, payment default, or bankruptcy default of the
loan tranche. Voting rights within the broader

syndicated loan or credit facility would also have to be defined in
such a way that holders of the ``CLO-eligible'' loan tranche had, at a
minimum, consent rights with respect to any material waivers and
amendments of the legal documents governing the underlying CLO-eligible
loan tranche. Additionally, the pro rata provisions, voting provisions,
and security associated with the CLO-eligible loan tranche could not be
materially less advantageous to the holders of that tranche than the
terms of other tranches of comparable seniority in the broader
syndicated credit facility.
    Under the reproposal's lead arranger option for open market CLOs,
the sponsor would have been required to disclose a complete list of
every asset held by an open market CLO (or before the CLO's closing, in
a warehouse facility in anticipation of transfer into the CLO at
closing). This list would have been required to include the following
information: (i) The full legal name and Standard Industrial
Classification category code of the obligor of the loan or asset; (ii)
the full name of the specific CLO-eligible loan tranche held by the
CLO; (iii) the face amount of the CLO-eligible loan tranche held by the
CLO; (iv) the price at which the CLO-eligible loan tranche was acquired
by the CLO; and (v) for each loan tranche, the full legal name of the
lead arranger subject to the sales and hedging restrictions. Second,
the sponsor would have been required to disclose the full legal name
and form of organization of the CLO manager. This information would
have been required to be disclosed a reasonable period of time prior to
the sale of the asset-backed securities in the securitization
transaction (and at least annually with respect to information
regarding the assets held by the CLO) and, upon request, to the
Commission and the sponsor's appropriate Federal banking agency, if
any. Further, the lead arranger and CLO manager would be required to
certify or represent as to the adequacy of the collateral and the
attributes of the borrowers of the senior, secured syndicated loans
acquired by the CLO and certain other matters.
c. Overview of Public Comments
    The agencies received many comments asserting that the proposed
options for open market CLOs would be unworkable under existing CLO
practices and would lead to a significant reduction in CLO offerings
and a corresponding reduction in credit to commercial borrowers. These
commenters asserted that the likelihood of a significant number of lead
arrangers retaining 5 percent risk retention (in any of the forms
permitted by the rule) would be remote and only the largest CLO
managers would be able to finance the proposed risk retention
requirement through the standard risk retention option. While larger
managers might have sufficient financing, several commented that the
risk retention requirements would make the management of CLOs less
profitable and might cause many managers to decrease their activity in
the market. One commenter highlighted a recently issued paper by the
Bank of England and the European Central Bank to suggest that risk
retention rules in Europe that apply to CLO managers have contributed
to a reduction in European CLO issuance.\157\ Several commenters
asserted that if the risk retention requirement causes a reduction in
participation by open market CLOs in the leveraged loan market, some of
the resulting reduced credit availability would be replaced by non-CLO
credit providers, but cost of capital and instability in the market
would increase.
---------------------------------------------------------------------------

    \157\ The Case for a Better Functioning Securitisation Market in
the European Union, Bank of England and the European Central Bank
(May 2014), available at https://www.ecb.europa.eu/pub/pdf/other/ecb-boe_case_better_functioning_securitisation_marketen.pdf.
---------------------------------------------------------------------------

    Some commenters expressed specific concerns about the proposed lead
arranger option. These commenters stated that having lead arrangers
hold a portion of the loan would increase the costs of arranging loans,
thus restricting the availability of credit to borrowers or increasing
the cost of credit to borrowers. In addition, commenters expressed
concern that few loans would satisfy the definition of ``CLO-eligible
loan tranche.'' Furthermore, they asserted that the additional voting
rights required by the reproposal would be administratively unworkable
and commercially unacceptable. Several commenters also raised concerns
that the proposed option would expose the arranger to potential
liability and litigation risks that arrangers should not be expected,
and would not be willing, to assume. Commenters raised particular
concern about the requirement that a lead arranger represent that the
loans and collateral meet specified criteria. They asserted that such a
representation would require the lead arranger to make subjective and
difficult determinations regarding the adequacy of collateral, and the
sufficiency of the security interest in the collateral and certain
other matters, and could expose the lead arranger to potential
liability.
    Another concern raised by several commenters was that the proposed
lead arranger option would prevent prudent risk management practices
and thus invite criticism from lead arrangers' bank regulators because
the hedging restriction would prohibit arrangers from actively managing
the risks and disposing of loan assets in response to market
conditions, and would limit lead arrangers' capacities to provide other
forms of credit to borrowers. Further, commenters stated that use of
the option would increase the capital and FDIC assessment charges for
lead arranger banks and cause corresponding increases in the pricing of
CLO-eligible tranches. In addition, some commenters raised concerns
that the proposed option's creation of both CLO-eligible loans and non-
eligible loans with otherwise comparable characteristics would distort
and restrict the initial syndication process and the secondary loan
market, as the secondary loan market would place a premium on CLO-
eligible loans and liquidity related to non-eligible loans would be
reduced. Relative to a ``normal'' market, both types of loans would be
less liquid because they would each reflect a smaller, divided market.
    As discussed in Part B.1 of this Supplementary Information, a
number of commenters expressed concern that the proposed restriction on
cash flow distributions to eligible horizontal residual interests would
make the eligible horizontal residual interest an unworkable option for
CLOs. They suggested that the cash flow distribution restriction would
significantly reduce returns to equity investors, making CLOs
unattractive investments and cause dramatically reduced CLO issuances.
Further, a few commenters supported a phase-in period while markets
adjust to the final rule or a grandfathering for certain legacy CLOs.
Two commenters also recommended that the risk retention rules follow
the European risk retention rules with respect to CLOs.\158\ One such
commenter expressed concerns that inconsistent regulations would cause
bifurcation of the CLO market and substantially reduce market
liquidity. Further, a few commenters asserted that the costs of
imposing risk retention on CLO managers exceeds the benefits and that
the agencies have not performed an adequate economic analysis in
connection with the CLO option.
---------------------------------------------------------------------------

    \158\ The agencies note that Articles 404-410 of the EU Capital
Requirements Regulation significantly amended Article 122a of the
European Union's Capital Markets Directive with respect to the use
of third parties to retain risk.

---------------------------------------------------------------------------

    Some commenters continued to assert that open market CLO managers
are not ``securitizers'' and are, therefore, not subject to section
15G. These commenters asserted that under the plain language of the
statute, CLO managers cannot ``sell'' or ``transfer'' the assets
securitized through the CLO because they do not own, possess, or
control the assets. Additionally, commenters asserted that the CLO
manager acts as an agent to the CLO issuing entity in directing the
purchase of assets, so it could not sell or transfer the assets to a
third party to meet the definition, because it would be equivalent to
selling or transferring the assets to itself. They asserted that the
use of ``indirectly'' in the definition of securitizer was intended to
prevent the party that originates a loan from avoiding risk retention
obligations by passing the loan through an associated intermediary that
organized and initiated the securitization.
    The commenters also asserted that the interpretation is not
supported by the legislative history or statutory purpose of the Dodd-
Frank Act. They suggested that Congress primarily intended to address
problems with the originate-to-distribute model and transparency issues
in securitization transactions, but open market CLOs differ from the
originate-to-distribute model and are more transparent than the
products Congress sought to regulate. The commenters stated that in the
originate-to-distribute model originators receive significant up-front
fees for originating loans, which they transfer into securitization
pools to promote the business of creating additional loans. They
asserted that CLOs differ from this model because the primary purpose
of CLOs is to provide investors with the ability to gain exposure to
commercial loans on a diversified basis, not to finance the creation of
financial assets. They also asserted that, unlike originators in the
originate-to-distribute model, who receive their compensation by
originating and transferring the assets to securitization pools, the
bulk of CLO managers' compensation is based on performance of the
securitized assets in the CLO. Regarding the transparency issues that
Congress sought to address, the commenters suggested that the primary
concern of Congress was to apply risk retention to highly opaque and
complex products like re-securitizations of asset-backed securities.
These commenters asserted that CLOs are more transparent than such
products because they contain fewer, larger, loans and the obligors of
such loans are typically known corporations on which investors can
perform extensive due diligence, and the loans are traded in a liquid
market that assesses risks and underwriting quality.
    In addition to the above comments, some commenters requested
alternative options for meeting risk retention or that the agencies
provide an exemption from risk retention for managers of open market
CLOs where certain criteria would be met because of the nature and
characteristics of open market CLOs. In this regard, commenters
asserted that open market CLOs operate independently of originators and
are not part of, and do not pose the same risks as, the originate-to-
distribute model. They also suggested that CLO managers' interests are
fully aligned with CLO investors' interests because CLO managers bear
significant risk through their deferred, contingent compensation
structure, which they asserted is based heavily on performance of the
securitized assets. Further, commenters stated that most CLO managers
are registered investment advisors with associated fiduciary duties to
their investors. One commenter also referred to other regulations and
guidance, asserting that they already provide meaningful protections
against imprudent or inferior underwriting, including the leveraged
lending guidance released by the Federal banking agencies in 2013.\159\
Several commenters also supported their arguments by indicating that
the assets selected by CLO managers are evaluated through multiple
layers of underwriting and market decisions and CLO loan portfolios are
actively managed for much of the life of a CLO. Commenters further
asserted that CLO managers select senior secured commercial loans with
investor protection features. Some commenters asserted that, unlike
many other securitizations, CLOs are securitizations of liquid assets
and they are structurally transparent. They also stated that CLOs have
historically performed well and that this strong performance is
evidence that further regulation is unnecessary and that customary
features of CLOs, including overcollateralization and interests
coverage tests, protect investors. The alternative options and
exemption requests are discussed in further detail below.
---------------------------------------------------------------------------

    \159\ See Leveraged Lending Guidance.
---------------------------------------------------------------------------

d. Response to Comments
i. Definition of ``Securitizer'' and Legislative History of Section 15G
    The agencies have considered the concerns raised by commenters with
respect to the reproposal, including with respect to open market CLOs.
As discussed above, commenters asserted that CLO managers could not be
``securitizers'' within the definition thereof in section 15G of the
Exchange Act, including the contention that they do not legally own,
possess, or control the assets.
    As explained in the reproposal, the agencies believe that CLO
managers are clearly included within the statutory definition of
``securitizer'' set forth in section 15G of the Exchange Act. Subpart
(a)(3)(B) of section 15G begins the definition of a ``securitizer'' by
describing a securitizer as a ``person who organizes and initiates an
asset-backed securities transaction.'' CLOs clearly meet the definition
of ``asset-backed security'' set forth in section 3 of the Exchange
Act, which defines ``asset-backed security'' as ``a fixed income or
other security collateralized by any type of self-liquidating financial
asset (including a loan, a lease, a mortgage, or a secured or unsecured
receivable) that allows the holder of the security to receive payments
that depend primarily on the cash flow from the asset.'' \160\ As
discussed above, a CLO is a fixed income or other security that is
typically collateralized by portions of tranches of senior, secured
commercial loans or similar obligations. The holder of a CLO is
dependent upon the cash flow from the assets collateralizing the CLO in
order to receive payments. Accordingly, a CLO is an asset-backed
securities transaction for purposes of the risk retention rules.\161\
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    \160\ See 15 U.S.C. 78c(a)(79).
    \161\ Furthermore, CDOs are specifically mentioned as examples
both in the definition of ``asset-backed security'' and elsewhere in
section 941 of the Dodd-Frank Act. See 15 U.S.C. 78c(a)(79)(A)(ii)
and 78o-11(c)(1)(F). As discussed above, CLOs are a type of CDO and
CLOs and CDOs have the same general structure.
---------------------------------------------------------------------------

    A CLO manager typically negotiates the primary deal terms of the
transaction and the primary rights of the issuing entity and uniformly
directs such entity to acquire the commercial loans that comprise its
collateral pool. Under the plain language of the statute, therefore, a
CLO manager organizes and initiates an asset-backed securities
transaction.\162\
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    \162\ The definition of ``sponsor'' is discussed in Part II of
this Supplementary Information.
---------------------------------------------------------------------------

    The definition continues that the organizer and initiator of a CLO
does so

``by selling or transferring assets, either directly or indirectly,
including through an affiliate, to the issuer.'' A CLO manager
indirectly transfers the assets to the CLO issuing entity because the
CLO manager has sole authority to select the commercial loans to be
purchased by the CLO issuing entity for inclusion in the CLO collateral
pool, directs the issuing entity to purchase such assets in accordance
with investment guidelines, and manages the securitized assets once
deposited in the CLO structure. Most importantly, an asset is not
transferred to the CLO issuing entity unless the CLO manager has
selected the asset for inclusion in the CLO collateral pool and
instructed the CLO issuing entity to acquire it.
    Although some commenters have narrowly interpreted the term
``transferring'' to specifically require legal ownership or possession
of the object being transferred, the agencies observe that the plain
meaning of ``transfer'' does not first require ownership or possession
and otherwise is not as narrow as these commenters assert.\163\
``Transfer'' is commonly defined as ``to cause to pass from one to
another,'' which is precisely what the CLO manager does.\164\ The CLO
manager causes assets to be passed from the seller to the issuing
entity because the CLO manager selects the assets for the collateral
pool and directs the issuing entity to purchase such assets. Therefore,
the CLO manager ``transfers'' the assets according to a commonly
accepted definition of the word. There is no indication in the statute
that Congress intended to interpret the word ``transfer'' as narrowly
as commenters have advocated. If Congress had desired such an
interpretation that would be narrower than how the term is commonly
defined, the agencies believe that additional limiting language would
have been included in the statute. CLO managers, therefore, fall
clearly within the statutory definition of ``securitizer'' as set forth
in Exchange Act section 15G.
---------------------------------------------------------------------------

    \163\ See, e.g., Babbitt v. Sweet Home Chapter of Communities
for a Great Or., 515 U.S. 687, 697-98 (1995) (rejecting the argument
that the word ``harm,'' defined ``to cause hurt or damage to:
injure,'' should be read so narrowly as to require a showing of
direct injury to something).
    \164\ Merriam-Webster's Collegiate Dictionary 1253 (10th ed.
1995); See also Random House Webster's College Dictionary 1366 (2nd
ed. 1997); The New Oxford American Dictionary 1797 (Elizabeth J.
Jewell & Frank Abate eds., 2001).
---------------------------------------------------------------------------

    Even if there were ambiguity as to whether CLO managers are covered
by the definition of ``securitizer,'' the agencies believe that the
interpretation of ``securitizer'' to include CLO managers is
reasonable. In addition to being consistent with commonly used
definitions of ``transfer,'' as discussed above, the interpretation is
consistent with the context, purposes and legislative history of the
statute. Further, the alternative interpretation argued by commenters
would lead to results that would be contrary to the purposes of section
941 and Congressional intent.
    The text surrounding the word ``transfer'' supports the agencies'
interpretation of the word. To read ``transfer'' narrowly to require
ownership or possession would make the preceding word ``sell''
superfluous because the act of selling necessarily involves the legal
transfer of the asset.\165\ In addition, the agencies do not believe
that the phrase ``including through an affiliate'' bolsters the
commenters' claim that ``transfer'' was intended to be interpreted in
this limited manner because the use of the word ``include'' in a
statute can signal that what follows is meant to be illustrative rather
than exclusive.\166\ As stated earlier, the agencies believe that a CLO
manager generally acts as the sponsor by selecting the commercial loans
to be purchased by the CLO issuing entity and managing the securitized
assets once deposited in the CLO structure, which the agencies believe
is a transfer or indirect transfer of the assets.
---------------------------------------------------------------------------

    \165\ Cf. Hibbs v. Winn, 542 U.S. 88, 101 (2004) (stating that
it is one of the most basic interpretive canons, that `` `[a]
statute should be construed so that effect is given to all its
provisions, so that no part will be inoperative or superfluous, void
or insignificant. . . .' '') (quoting 2A N. Singer, Statutes and
Statutory Construction Sec.  46.06, pp.181-186 (rev. 6th ed. 2000)).
    \166\ See Samantar v. Yousuf, 560 U.S. 305, 316-17 (2010). While
Congress referred to transferring through affiliates as an example
of indirect transfer, it did not preclude other forms of indirect
transfer in the definition of ``securitizer,'' nor did it
specifically limit the definition to parties in the chain of title.
---------------------------------------------------------------------------

    The agencies also disagree with the commenters' assertion that the
CLO manager does not transfer or sell assets because, as an agent of
the CLO, it is on the same side of the transaction as the purchaser
(the special purpose issuing entity). Under the same reasoning, one
could claim that an originator of assets that creates a special purpose
vehicle to issue asset-backed securities and transfers assets to that
special purpose vehicle could never be a securitizer, because the
originator also essentially would be transferring the assets to itself.
If that were the case, then many types of securitizations would not
have an entity that would be subject to risk retention.
    Moreover, the agencies disagree with commenters' assertions that
Congress intended section 15G to apply primarily to securitizations
within the originate-to-distribute model. Congress did not specify that
the requirements of the statute apply only to certain types of
securitization models or structures. Indeed, section 15G specifies that
risk retention applies to all securitizers,\167\ unless they have a
specific exemption under the statute or the agencies provide a specific
exemption in accordance with criteria set forth in the statutory
text.\168\ Congress did not specifically exclude securitizations that
are not part of an originate-to-distribute model--or any other
particular market model or structure of securitization--from risk
retention. Although the legislative history indicates that Congress was
concerned about securitizations within the originate-to-distribute
model, nowhere in the text or legislative history did Congress indicate
that it intended for risk retention not to apply to transactions that
some may assert are not ``originate-to-distribute'' securitizations.
---------------------------------------------------------------------------

    \167\ See 15 U.S.C. 78o-11(b)(1) (``[T]he Federal banking
agencies and the Commission shall jointly prescribe regulations to
require any securitizer to retain an economic interest in a portion
of the credit risk for any asset that the securitizer, through the
issuance of an asset-backed security, transfers, sells, or conveys
to a third party.'').
    \168\ See 15 U.S.C. 78o-11(c)(1)(G)(i) and 15 U.S.C. 78o-11(e).
---------------------------------------------------------------------------

    Furthermore, the leveraged loan market shares characteristics with
the ``originate-to-distribute'' model that led to the deterioration in
underwriting standards that were a major factor in the recent financial
crisis. Originators of leveraged loans often retain little or no
interest in the assets they originate, and originate and underwrite
with the intention of distributing the entire loan. In this regard,
leveraged loans purchased by CLOs are often originated as a fee-
generating, rather than a lending business, and originators do not have
the same incentive to underwrite carefully as they would for loans they
intend to keep in portfolio. These characteristics of the leveraged
loan market pose potential systemic risks similar to those observed in
the residential mortgage market during the crisis, whether the loans
are placed with CLOs or other types of institutional investors.
    Additionally, there is no evidence to support the notion that
Congress expected ``securitizer'' to be read narrowly so that risk
retention requirements would apply only to sponsors of securitizations
which have a specific type of structure or only to sponsors that
fulfill a narrow and specific structural role in a

securitization transaction. Furthermore, the agencies believe that the
narrow reading of ``securitizer'' supported by commenters could lead to
results that would appear contrary to Congressional intent by opening
the statute to easy evasion. Under such an interpretation, it would be
feasible for many sponsors to evade risk retention by hiring a third-
party manager to ``select'' assets for purchase by the issuing entity
that have been pre-approved by the sponsor. This could result in a
situation in which no party to a securitization can be found to be a
``securitizer'' because the party that organizes the transaction and
has the most influence over the quality of the securitized assets could
avoid legally owning or possessing the assets.\169\ Interpreting the
term ``securitizer'' to produce such an easily evaded rule would be an
unreasonable result that cannot comport with the intent of Congress in
enacting section 15G of the Exchange Act.
---------------------------------------------------------------------------

    \169\ As discussed, Congress clearly expected this rule to apply
to sponsors of CDOs, but the commenters' claims, if credited, would
also exclude sponsors of CDOs from the requirements of risk
retention.
---------------------------------------------------------------------------

    With respect to the issuance of asset-backed securities, there is
always a sponsor responsible for the organization and initiation of the
issuance of asset-backed securities.\170\ The issuing entity for a CLO
transaction is a special purpose vehicle formed by some other party
solely for the express purpose of issuing asset-backed securities.
However, some person or other entity--namely, the sponsor--``organized
and initiated'' this special purpose vehicle with the intent that this
special purpose vehicle would issue asset-backed securities. The
agencies do not believe that the special purpose vehicle formed to
issue asset-backed securities in a CLO transaction does so independent
of the actions of a sponsor. The agencies also note that the commenters
did not identify another party to an open market CLO transaction other
than the CLO manager that should be considered the sponsor.
---------------------------------------------------------------------------

    \170\ Similar to the agencies interpretation of ``securitizer''
to include CLO managers, the definitions of ``issuer'' in both the
Securities Exchange Act of 1934 and Securities Act of 1933 include,
with respect to certain kinds of vehicles, ``the person or persons
performing the acts and assuming the duties of depositor or manager
pursuant to the provisions of the trust or other agreement or
instrument under which the securities are issued.''
---------------------------------------------------------------------------

    As indicated in the legislative history of the Dodd-Frank Act, the
broad purpose of the statute was to ``create incentives that will
prevent a recurrence of the excesses and abuses that preceded the
crisis, restore investor confidence in asset-backed finance, and permit
securitization markets to resume their important role as sources of
credit for households and businesses.'' \171\ In drafting section 941,
Congress recognized that it would be impractical for many investors to
adequately assess and monitor the risks of assets underlying complex
securitization products.\172\ As a result, Congress sought to encourage
monitoring and assessment of such assets by the parties better suited
to do so, namely those who organize and initiate the
securitizations.\173\ Like other securitization sponsors, a CLO manager
is the party best positioned to adequately monitor and assess the risk
of the securitized assets. For the reasons discussed above, the
agencies continue to find that a CLO manager is a ``securitizer'' under
section 15G of the Exchange Act.\174\
---------------------------------------------------------------------------

    \171\ S. Rep. No. 111-176, at 128.
    \172\ Id.
    \173\ Id. at 129 (``When securitizers retain . . . risk, they
have `skin in the game,' aligning their economic interests with
those of investors. . . . Securitizers who retain risk have a strong
incentive to monitor the quality of the assets they purchase from
originators, package into securities, and sell. . . . Originators .
. . will come under increasing market discipline because
securitizers who retain risk will be unwilling to purchase poor-
quality assets.'').
    \174\ Furthermore, the agencies believe that this applies to
other issuances of asset-backed securities in which the securitized
assets are selected by a manager and no other transaction party
meets the definition of ``sponsor.'' See Parts III.B.4 and III.B.8
of this Supplementary Information.
---------------------------------------------------------------------------

ii. Exemption Requests and Alternative Proposals
    Many commenters suggested that the risk retention rules should not
be applied to open market CLOs because, as described above, they
believe the structural and other characteristics of open market CLOs
make risk retention unnecessary. Among the primary characteristics
highlighted to justify an exemption, commenters asserted that CLO
managers' subordinated compensation structure aligns their interests
with those of investors, CLOs differ from the originate-to-distribute
model, and the underwriting of CLOs' assets is subject to multiple
levels of scrutiny. As an alternative to an exemption based solely on
such characteristics, several commenters supported exemptions for open
market CLOs meeting certain qualifications. One commenter proposed an
exemption from risk retention for open market CLOs that met the
following conditions: (i) The asset manager must be a registered
investment adviser under the Investment Advisers Act of 1940;\175\ (ii)
all U.S. investors must be qualified purchasers or knowledgeable
employees, consistent with reliance on the section 3(c)(7) exemption
from investment company status under the Investment Company Act; \176\
(iii) the pool of assets are permitted and expected to be traded by the
asset manager on behalf of the issuer in accordance with contractually
agreed restrictions; (iv) the asset management agreement establishes a
standard of care that requires the asset manager to employ a degree of
skill and care no less than it uses for its own investments and
consistent with industry standards for asset managers that are acting
on behalf of comparable clients; and (v) the investment adviser effects
agency cross trades on behalf of its advisory client only in accordance
with section 275.206(3)-2 of the Commission's rules under the
Investment Advisers Act.\177\
---------------------------------------------------------------------------

    \175\ 15 U.S.C. 80b-3(b).
    \176\ 15 U.S.C. 80a-3(c)(7).
    \177\ 17 CFR 275.206(3)-2.
---------------------------------------------------------------------------

    The agencies also received several comments in continued support of
an option that was suggested with respect to the original proposal that
the agencies did not include in the revised proposal. This suggestion
would allow an open market CLO manager to satisfy its risk retention
requirement by holding a combination of notes issued by the CLO,
modeled to reflect the risks assumed by CLO managers through their
subordinated compensation structure, and equity securities issued by
the CLO and purchased by the CLO manager.
    Several commenters supported an option that would expand the above
proposal by allowing managers of ``Qualified CLOs'' to satisfy the risk
retention requirement by purchasing 5 percent of the CLO's equity and
maintaining a subordinated compensation structure. Commenters proposed
that, in order to be deemed a Qualified CLO, the CLO's governing
transaction documents would have to include specific requirements in
the following areas: Asset quality; portfolio composition; structural
features; alignment of the interests of the CLO manager and investors
in the CLO's securities; regulatory oversight; and transparency and
disclosure. Commenters suggested requirements under each of these
categories that they asserted would ensure high quality underwriting
and investor protection. They also suggested that this proposal should
be adopted along with the third-party option and pro rata risk
retention reduction proposals described below, as they do not feel that
the option alone would sufficiently address the projected

effects that the rule will have on open market CLOs.
    Several commenters suggested that the agencies could adopt the
commenters' exemption proposals under the agencies' exemptive authority
provided by section 15G(e).\178\ Alternatively, commenters supporting
the Qualified CLO proposal suggested the proposal could be adopted as a
construction of the statutory requirement that a securitizer retain not
less than 5 percent of the ``credit risk'' of any asset. In this
regard, the commenters asserted that by acquiring 5 percent of the
equity interest in the CLO, and by bearing the subordinated risk of
non-payment embedded in the compensation structure demanded by
investors, the CLO manager would be retaining far more than 5 percent
of the credit risk associated with the CLO's assets. As support for
this suggestion, the commenters cited research concluding that the
majority of likely losses for a typical CLO are borne by the bottom 20
percent of the CLO capital structure.
---------------------------------------------------------------------------

    \178\ One commenter suggested that the Qualified CLO proposal
could also be exempted based on the agencies' authority under
section 15G(c)(1)(G)(i).
---------------------------------------------------------------------------

    The agencies do not believe that it would be appropriate to exempt
open market CLOs from the risk retention requirement under section
15G(e). The statute permits the agencies to adopt or issue exemptions,
if the exemption would: (A) help ensure high quality underwriting
standards for the securitizers and originators of assets that are
securitized or available for securitization; and (B) encourage
appropriate risk management practices by the securitizers and
originators of assets, improve the access of consumers and businesses
to credit on reasonable terms, or otherwise be in the public interest
and for the protection of investors.\179\ While the agencies recognize
that certain structural features of CLOs contribute to aligning the
interests of CLO managers with investors, the agencies do not believe
these structural features would support a finding that the exemption
would help ensure high quality underwriting standards and there are
reasons why such an exemption may run counter to the public interest
and protection of investors.\180\
---------------------------------------------------------------------------

    \179\ 15 U.S.C. 78o-11(e)(2).
    \180\ For similar reasons, the agencies do not believe an
exemption would be appropriate under section 15G(c)(1)(G)(i).
---------------------------------------------------------------------------

    As discussed above, many of the structural features that commenters
cited as mitigating risk factors for CLOs were shared by other types of
CDOs, such as CDOs of asset-backed securities, that performed poorly
during the financial crisis. Although the structural features can offer
protection to investors in senior tranches, such protections are
exhausted when a portfolio's default rate significantly exceeds
anticipated losses, as was the case for CDOs of asset-backed securities
during the financial crisis. In such a situation, the manager may be
incented to engage in even more risky behavior to maintain cash flow
and ensure the payment of its subordinated compensation. Although CLOs
performed better than other CDOs during the financial crisis, the
better performance of leveraged loans after the financial crisis in CLO
portfolios could be partially attributed to lowered interest rates and
other government interventions. Some commenters claimed that CLOs are
composed of higher quality assets that undergo significant underwriting
scrutiny and that include investor protection features, but the
significant recent credit deterioration in the leveraged loan market,
as described above, demonstrates increasing risks in the types of
assets held by CLOs. The agencies also note that while the final rule
does not include an exemption for open market CLOs, the removal of the
proposed restriction on cash flow distributions to the eligible
horizontal residual interest, as described in Part B.1 of this
Supplementary Information, will provide greater flexibility for CLO
managers to satisfy the standard risk retention option, which may
reduce the cost of the standard risk retention option.
    The agencies recognize that management fees incorporate credit risk
sensitivity and may contribute to some degree to aligning the interests
of the CLO manager and investors with respect to the quality of the
securitized loans. On the other hand, as discussed above, this
subordinated compensation structure could also lead to a misalignment
of interests between the CLO manager and investors in certain
circumstances. Moreover, as discussed in the reproposal, these fees do
not appear to provide an adequate substitute for risk retention because
they typically have small expected value, especially given that CLOs
securitize leveraged loans, which carry higher risk than many other
securitized assets. Even combining the expected value of the manager's
compensation with a 5 percent interest in the equity of the CLO would
be inadequate because, as described by a commenter, such an equity
interest would also likely amount to under one percent of the fair
value of the ABS interests issued to third parties (which is less than
the 5 percent required for an eligible horizontal residual interest).
Further, management fees are not funded in cash at closing and
therefore may not be available to absorb losses as expected. Generally,
the agencies have declined to recognize such unfunded forms of risk
retention and the agencies are not persuaded that an exception should
be made for open market CLOs.
    Some commenters supported an alternative approach that would reduce
the risk retention requirement for open market CLOs, on a pro rata
basis, to the extent that the commercial loans backing the issued CLO
securities met certain underwriting criteria. In order to qualify for
reduced risk retention, the commercial loans would have to be senior
secured first lien loans that either (i) have a ratio of first lien
debt to total capitalization of less than or equal to 50 percent; or
(ii) have a total leverage ratio of less than or equal to 4.5
times.\181\ Further, this approach would reduce the risk retention
requirement to the extent that the CLO holds a subset of loans
requiring certain specialized treatment. This approach would require
determination of whether a loan qualifies for reduced risk retention
treatment to be made at the time of origination. Further, this approach
provided that loans originated before the applicable effective date of
the rule should not require risk retention when securitized after such
date.
---------------------------------------------------------------------------

    \181\ In this context, leverage ratio refers to the borrower's
total debt divided by earnings before interest, taxes, depreciation
and amortization (EBITDA).
---------------------------------------------------------------------------

    The agencies are not persuaded that the risk retention requirement
should be reduced to the extent commercial loans backing the issued CLO
securities meet the criteria proposed by the commenters. As discussed
in Part V.A of this Supplementary Information, the final rule already
provides exemptions from the risk retention requirement for qualifying
commercial loans that meet specific underwriting standards. The
agencies developed these standards to be reflective of very high
quality loans. The commenters' approach relies on significantly weaker
standards, and the agencies do not believe that these criteria, which
would permit securitization with no risk retention for loans to
borrowers who are of lower credit quality or that do not have a third-
party evaluation of the likelihood of timely payment of interest and
repayment of principal, would satisfy the statutory requirements for an
exception to help ensure high quality underwriting standards.

    The agencies also disagree with the proposition that, in the
context of CLOs, loans originated before the applicable effective date
of the rule should not be subject to risk retention. Section 15G of the
Exchange Act applies to any issuance of asset-backed securities after
the applicable effective date of the rule, regardless of the date the
assets in the securitization were originated. The agencies note,
however, that securitizations of loans meeting the seasoned loan
exemption in section 19(b)(7) of the rule would not be subject to risk
retention requirements.
    The agencies also received a number of comments in support of
approaches to allow a third party, rather than the CLO manager, to
retain some or all of the required credit risk in certain
circumstances. To be eligible under these approaches, the third party
would be required to have a role in setting the selection criteria for
the assets held by a CLO and the power to veto any change to asset
selection criteria. Specifically, the commenters' proposal would
require: (i) Prior to the CLO's acquisition of the initial CLO assets,
the third party to review and assent to key transaction portfolio
terms, including the asset eligibility criteria, concentration limits,
collateral quality tests, and reinvestment criteria of the CLO's asset
pool; and (ii) any material change to the above parameters to receive
prior written consent by the third party retaining the CLO credit risk.
Further, to enable the third party retaining credit risk to evaluate,
before the CLO closes, whether the CLO manager is able to meet the
asset selection criteria, the commenters proposed that at least 50
percent of the initial asset pool would have to be acquired (or be
under a commitment to be acquired) by the closing date. One of the
approaches would also require that the CLO manager be a registered
investment adviser and would permit multiple parties to jointly satisfy
the CLO's risk retention requirement.
    Another commenter proposed a different third-party retention
option, under which a sponsor's risk retention requirement would be
satisfied if one or more third parties agreed to hold the required
minimum risk retention. The commenter's suggested option would only
apply to CLOs that are securitizations of corporate debt and servicing
assets; inclusion of other ABS interests would be prohibited. The third
party or a party appointed by the third party would be required to
perform an independent review of the credit risk of each securitized
asset. Further, the proposal would require the CLO manager to provide
information to investors about the investment experience of each third-
party purchaser.
    While the agencies considered the third-party retention proposals
carefully, they have concluded that the proposals would not provide an
appropriate method of risk retention. The proposed third-party
retention options would result in retention of the credit risk by a
third party that would have less control over the CLO portfolio than
the CLO manager. These alternatives would result in weaker means of
influencing the underwriting quality in CLO portfolios and are
therefore inadequate substitutes for risk retention.
    While, as discussed in Part III.B.5 of this Supplementary
Information, the final rule allows third-party purchasers to retain
credit risk in CMBS transactions, CLO and CMBS transactions vary in
several significant ways that make such an option more challenging in
the CLO context. For example, differences between CMBS and CLO
transactions would make it more challenging for third-party investors
to perform thorough independent reviews of loans in CLO portfolios,
including the dynamic nature of CLO portfolios and the larger number of
loans in typical CLO portfolios. In CMBS transactions, the loan pool is
chosen and is static before issuance, which permits loan-level due
diligence by the third-party investor. In CLOs, the loan pool is
typically not complete before issuance, and the pool is dynamic,
limiting the ability of a third-party investor to conduct loan-level
due diligence before issuance. Under proposals submitted by commenters,
the third-party purchaser would be limited to evaluating investment
criteria for the CLO and would not conduct loan-level due diligence. In
this regard, the third-party purchaser would not be conducting loan-
level re-underwriting, and consequently is not a reasonable substitute
for the original effort of the sponsor in underwriting the loan pool.
Furthermore, the third-party retention proposals would provide the
third-party purchaser with minimal power or influence over the
composition or quality of the CLO's collateral pool after closing. In
contrast to CMBS transactions that generally give the third-party
purchaser the right to reject loans from the pool, no similar authority
would be granted to CLO third-party purchasers under commenters'
proposals.
    Given the weakening of underwriting and increase in risk in the
leveraged loan market, the agencies do not believe that existing market
practice is sufficiently robust to substitute for risk retention.
Furthermore, the agencies do not believe the alternative approaches
suggested by commenters would significantly add protection to
investors, as investors in CLOs would presumably already have the
opportunity to review and assent to key portfolio transaction
terms.\182\ For these reasons, the agencies have decided against
adopting the third-party risk retention option. While the agencies
considered whether further parameters around a third-party risk
retention option for CLO sponsors would be appropriate, the agencies
were not able to identify parameters that would function well for CLOs
or that would further the regulatory purposes of the risk retention
rules.
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    \182\ The risk retention approaches for CLOs suggested by
commenters also reflect standard market practices for certain other
types of CDOs (e.g., CDOs of asset-backed securities) that performed
poorly during the financial crisis in which key investors negotiated
asset selection criteria and reinvestment criteria and changes to
those criteria required investor consent.
---------------------------------------------------------------------------

    The agencies have also carefully considered commenters' views about
the impact the proposed rules would have on CLO issuance and the
commercial loan markets in general. As discussed in the reproposal, the
agencies acknowledge that requiring open market CLO managers to satisfy
the risk retention requirement could result in fewer CLO issuances and
less competition in this market. However, the agencies note that other
entities, such as hedge funds and loan mutual funds, also purchase
commercial loans and believe that the market will adjust to the rule
and that lending to creditworthy commercial borrowers, on appropriate
terms, will continue at a healthy rate. The agencies also note that
commenters' concerns about the impact of European risk retention
requirements on European CLO issuance may be misplaced, as economic
conditions have constrained the available supply of potential
collateral for European CLOs.
    Furthermore, the agencies believe projected impacts on the CLO
market are justified by the benefits that will be produced by
subjecting open market CLOs to the risk retention rules. As discussed,
the agencies have significant concerns about recent activity in the
leveraged loan market. The search for yield in the low interest rate
environment has led investors to take on more risk in this market by
investing in lower quality commercial loans that contain fewer lender
protections.\183\ The agencies believe that valuations on lower-rated
corporate bonds and

leveraged loans are stretched and excesses in these markets could lead
to higher levels of future defaults and losses.\184\ The origination
and securitization of such poorly underwritten loans could generate
systemic financial risks.\185\
---------------------------------------------------------------------------

    \183\ See, e.g., Monetary Policy Report, at 1-2, 22; Semiannual
Risk Perspective: Spring 2014, at 5.
    \184\ See, e.g., Monetary Policy Report, at 1-2.
    \185\ See, e.g., Leveraged Lending Guidance at 17771 (``[A]
poorly underwritten leveraged loan that is pooled with other loans
or is participated with other institutions may generate risk for the
financial system.''); Shared National Credits Program: 2013 Review
at 8 (``Poorly underwritten or low quality leveraged loans,
including those that are pooled with other loans or participated
with other institutions, may generate risks for the financial
system.'').
---------------------------------------------------------------------------

    Increased appetite from investors for higher yielding and higher
risk assets in the leveraged loan market creates an environment
susceptible to some of the abuses and excesses that occurred in the
residential and commercial mortgage markets that contributed to the
financial crisis. In particular, the agencies are concerned that this
environment could create incentives to originate an increased volume of
loans, without regard for quality or underwriting standards, for the
purpose of distribution through securitization. The agencies therefore
have concluded that requiring open market CLO managers or lead
arrangers to retain economic exposure in the securitized assets will
help ensure the quality of assets purchased by CLOs, promote discipline
in the underwriting standards for such loans, and reduce the risk that
such loans pose to financial stability.
    For the reasons discussed above, the final rule requires open
market CLO managers to satisfy the minimum risk retention requirement
for each CLO securitization transaction that it manages by holding a
sufficient amount of standard risk retention or meet the requirements
of the alternative lead arranger option. After considering all
comments, the agencies are adopting, largely as proposed, the lead
arranger option for open market CLOs, under which an open market CLO
could satisfy the risk retention requirement if the firm serving as
lead arranger for each loan purchased by the CLO retains at the
origination of the syndicated loan at least 5 percent of the face
amount of the term loan tranche purchased by the CLO. The lead arranger
is required to retain this portion of the loan tranche until the
repayment, maturity, involuntary and unscheduled acceleration, payment
default, or bankruptcy default of the loan. This requirement applies
regardless of whether the loan tranche was purchased on the primary or
secondary market, or was held at any particular time by an open market
CLO issuing entity.
    Under the final rule's lead arranger option, the sponsor is
required to disclose a complete list of every asset held by an open
market CLO (or before the CLO's closing, in a warehouse facility in
anticipation of transfer into the CLO at closing). This list requires
the following information (i) the full legal name, Standard Industrial
Classification category code and legal entity identifier (LEI) issued
by a utility endorsed or otherwise governed by the Global LEI
Regulatory Oversight Committee or the Global LEI Foundation (if an LEI
has been obtained by the obligor) of the obligor of the loan or asset;
(ii) the full name of the specific CLO-eligible loan tranche held by
the CLO; (iii) the face amount of the CLO-eligible loan tranche held by
the CLO; (iv) the price at which the CLO-eligible loan tranche was
acquired by the CLO; and (v) for each loan tranche, the full legal name
of the lead arranger subject to the sales and hedging restrictions.
Also, the final rule requires the sponsor to disclose the full legal
name and form of organization of the CLO manager. The sponsor is
required to provide these disclosures a reasonable period of time prior
to the sale of the asset-backed securities in the securitization
transaction (and at least annually with respect to information
regarding the assets held by the CLO) and, upon request, to the
Commission and the sponsor's appropriate Federal banking agency, if
any. Further, the CLO manager is required to certify or represent as to
the adequacy of the collateral and certain attributes of the borrowers
of the senior, secured syndicated loans acquired by the CLO and certain
other matters.
    The agencies have added to the disclosure requirement the
disclosure of an obligor's LEI issued by a utility endorsed or
otherwise governed by the Global LEI Regulatory Oversight Committee or
the Global LEI Foundation, if an LEI has been obtained by the obligor.
The agencies believe that the LEI requirement allows investors in open-
market CLOs to better track the performance of assets originated by
specific originators. The effort to standardize a universal LEI has
progressed significantly over the last few years.\186\ As LEI use
becomes more mandated and widespread pursuant to other rules, the
agencies anticipate that LEI disclosure by obligors under the lead
arranger option will become the standard.
---------------------------------------------------------------------------

    \186\ The Commission has prescribed the disclosure of LEI in
other rulemakings. See, e. g., Nationally Recognized Statistical
Rating Organizations; Final Rule, 79 FR 55078 (Sept. 15, 2014) and
Reporting by Investment Advisers to Private Funds and Certain
Commodity Pool Operators and Commodity Trading Advisors on Form PF;
Final Rule, 76 FR 71128 (Nov. 16, 2011).
---------------------------------------------------------------------------

    In response to commenter concerns, the agencies have removed from
the lead arranger option for open market CLOs the requirement that lead
arrangers and CLO managers certify as to the adequacy of the collateral
and the attributes of the borrowers of the senior, secured syndicated
loans that they purchase and certain other matters and make certain
covenants. Instead, a lead arranger will be required to certify that it
has evaluated the effectiveness of its internal supervisory controls
with respect to the process for ensuring that loans included in a CLO-
eligible tranche meet all of the requirements set forth in section 9 of
the rule applicable to CLO-eligible loan tranches and has concluded
that its internal supervisory controls are effective. CLO managers will
be required to certify that they have policies and procedures to
evaluate the likelihood of repayment and that they have followed such
policies and procedures when determining the adequacy of the collateral
and attributes of the borrowers of the loans that they purchase. These
certifications are similar to those required of depositors with respect
to QRMs and other qualifying asset classes. The agencies believe these
modifications will reduce concerns about risks and challenges that
commenters asserted would be faced in connection with the requirement
that there be representations that the loans meet the rule's criteria.
The agencies also note that the reference to ``ensuring'' that loans
are CLO-eligible loans should be interpreted in a manner similar to
such reference in this Supplementary Information with respect to QRMs
and other qualifying asset classes.
    As the agencies noted in the reproposal, the lead arranger option
for open market CLOs is intended to allocate risk retention to the
parties that originate the underlying loans and that likely exert the
greatest influence on how the loans are underwritten, which is an
integral component of ensuring the quality of assets that are
securitized. Subject to considering certain factors, section 15G
permits the agencies to allow an originator (rather than a sponsor) to
retain the required amount of credit risk and to reduce the amount of
credit risk required of the sponsor by the amount retained by the
originator.\187\ In developing the

proposed lead arranger option, the agencies considered the factors set
forth in section 15G(d)(2) and concluded that it is consistent with the
purposes of the statute to allow lead arrangers of open market CLOs to
satisfy the risk retention requirement.\188\
---------------------------------------------------------------------------

    \187\ 15 U.S.C. 78o-11(c)(G)(iv), (d) (permitting the Commission
and Federal banking agencies to allow the allocation of risk
retention from a sponsor to an originator).
    \188\ 15 U.S.C. 78o-11(d)(2). These factors are whether the
assets sold to the securitizer have terms, conditions, and
characteristics that reflect low credit risk; whether the form or
volume of transactions in securitization markets creates incentives
for imprudent origination of the type of loan or asset to be sold to
the securitizer; and the potential impact of risk retention
obligations on the access of consumers and business to credit on
reasonable terms, which may not include the transfer of credit risk
to a third party.
---------------------------------------------------------------------------

    The agencies considered the commenters' views that the option will
not be widely adopted by lead arranger banks, but the agencies believe
the option provides additional flexibility for lead arranger banks and
non-banks and therefore may reduce disruption to the market. The
agencies also believe that this option for open market CLOs will
meaningfully align the incentives of the party most involved with the
credit quality of these loans--the lead arranger--with the interests of
investors. Commenters raised concerns that banks would likely not want
to retain risk without being allowed to hedge or transfer that risk due
to concern about criticism from regulators. However, the agencies note
that these concerns were not raised for balance sheet CLOs where banks
would be required similarly to retain a portion of the loans' risk
without selling or transferring that retained risk. In addition, to the
extent the comments referred to supervisory standards, the Federal
banking agencies note that supervisors take into account many
considerations when reviewing loan portfolios, including applicable
regulations and guidance regarding underwriting and risk management.
Alternatively, incentives would be placed on the CLO manager to monitor
the credit quality of loans it securitizes, if it retains risk under
the standard risk retention option.
    For the reasons discussed above, open market CLO managers clearly
fall within the statutory definition of ``securitizer'' in Section 15G
and therefore are subject to the risk retention requirement. The
agencies also believe that subjecting open market CLOs and their
managers to the risk retention requirement is within their authority
and consistent with the purposes of section 15G. The agencies believe
the final rule places risk retention responsibility on the parties most
capable of ensuring and monitoring the credit quality of the assets
collateralizing open market CLOs--the CLO manager or the lead arranger.
Further, the agencies believe these two options provide sufficient
flexibility to avoid significant disruptions to the CLO and credit
markets.
8. Municipal Bond ``Repackaging'' Securitizations
a. Overview of the Reproposal and Public Comments
    Several commenters on the original proposal requested that the
agencies exempt municipal bond repackaging securitizations from risk
retention requirements, the most common form of which are often
referred to as ``tender option bonds.'' \189\ In order to reflect and
incorporate the risk retention mechanisms currently implemented by the
market, the reproposal included two additional risk retention options
for certain municipal bond repackagings. The proposed rule closely
tracked certain requirements for these repackagings, outlined in IRS
Revenue Procedure 2003-84, that are relevant to risk retention.\190\
Specifically, in the revised proposal, the agencies proposed additional
risk retention options for municipal bond repackagings issued by a
``qualified tender option bond entity,'' which would be defined as an
issuing entity of tender option bonds in which:
---------------------------------------------------------------------------

    \189\ As described by one commenter, a typical tender option
bond transaction consists of the deposit of a single issue of highly
rated, long-term municipal bonds in a trust and the issuance by the
trust of two classes of securities: floating rate, puttable
securities (the ``floaters''), and an inverse floating rate security
(the ``residual''). The holders of floaters have the right,
generally on a daily or weekly basis, to put the floaters for
purchase at par, which put right is supported by a liquidity
facility delivered by a highly rated provider and causes the
floaters to be a short-term security. The floaters are in large part
purchased and held by money market mutual funds. The residual is
held by a longer term investor (bank, insurance company, mutual
fund, hedge fund, etc.). The residual investor takes all of the
market and structural risk related to the tender option bond
structure, with the floaters investors only taking limited, well-
defined insolvency and default risks associated with the underlying
municipal bonds, which risks are equivalent to those associated with
investing in such municipal bonds directly.
    \190\ Revenue Procedure 2003-84, 2003-48 I.R.B. 1159.
---------------------------------------------------------------------------

     Only two classes of securities are issued: a tender option
bond and a residual interest;
     The tender option bond qualifies for purchase by money
market funds under Rule 2a-7 under the Investment Company Act of 1940;
\191\
---------------------------------------------------------------------------

    \191\ This requirement is in section 10 of the final rule
(definition of ``tender option bond'').
---------------------------------------------------------------------------

     The holder of a tender option bond has the right to tender
such bonds to the issuing entity for purchase at any time upon no more
than 30 days' notice; \192\
---------------------------------------------------------------------------

    \192\ This requirement is in section 10 of the final rule
(definition of ``tender option bond'').
---------------------------------------------------------------------------

     The collateral consists solely of municipal securities as
defined in section 3(a)(29) of the Securities Exchange Act of 1934 and
servicing assets, and all the municipal securities have the same
municipal issuer and the same underlying obligor or source of payment;
     Each of the tender option bond, the residual interest and
the underlying municipal security are issued in compliance with the
Internal Revenue Code of 1986, as amended (the ``IRS Code''), such that
the interest payments made on those securities are excludable from the
gross income of the owners;
     The issuing entity has a legally binding commitment from a
regulated liquidity provider to provide 100 percent guarantee or
liquidity coverage with respect to all of the issuing entity's
outstanding tender option bonds; \193\ and
---------------------------------------------------------------------------

    \193\ The final rule defines a regulated liquidity provider as a
depository institution (as defined in section 3 of the Federal
Deposit Insurance Act (12 U.S.C. 1813)); a bank holding company (as
defined in 12 U.S.C. 1841) or a subsidiary thereof; a savings and
loan holding company (as defined in 12 U.S.C. 1467a) provided all or
substantially all of the holding company's activities are
permissible for a financial holding company under 12 U.S.C. 1843(k)
or a subsidiary thereof; or a foreign bank (or a subsidiary thereof)
whose home country supervisor (as defined in section 211.21 of the
Board's Regulation K (12 CFR 211.21)) has adopted capital standards
consistent with the Capital Accord of the Basel Committee on Banking
Supervision, as amended, provided the foreign bank is subject to
such standards.
---------------------------------------------------------------------------

     The issuing entity qualifies for monthly closing elections
pursuant to IRS Revenue Procedure 2003-84, as amended or supplemented
from time to time.
    Under the reproposal, the sponsor of a qualified tender option bond
entity could satisfy its risk retention requirements by retaining an
interest that, upon issuance, would meet the requirements of an
eligible horizontal residual interest but that, upon the occurrence of
a ``tender option termination event'' as defined in section 4.01(5) of
IRS Revenue Procedure 2003-84, as amended or supplemented from time to
time, would meet requirements of an eligible vertical interest.\194\
---------------------------------------------------------------------------

    \194\ Section 4.01(5) of IRS Revenue Procedure 2003-84 defines a
tender option termination event as: (1) a bankruptcy filing by or
against a tax-exempt bond issuer; (2) a downgrade in the credit-
rating of a tax-exempt bond and a downgrade in the credit rating of
any guarantor of the tax-exempt bond, if applicable, below
investment grade; (3) a payment default on a tax-exempt bond; (4) a
final judicial determination or a final IRS administrative
determination of taxability of a tax-exempt bond for Federal default
on the underlying municipal securities and credit enhancement, where
applicable; (5) a credit rating downgrade below investment grade;
(6) the bankruptcy of the issuer and, when applicable, the credit
enhancer; or (7) the determination that the municipal securities are
taxable.

---------------------------------------------------------------------------

    Under the reproposal, the sponsor of a qualified tender option bond
entity could also satisfy its risk retention requirements by holding
municipal securities from the same issuance of municipal securities
deposited in the qualified tender option bond entity, the face value of
which retained municipal securities would be equal to 5 percent of the
face value of the municipal securities deposited in the qualified
tender option bond entity.
    The proposed prohibitions on transfer and hedging set forth in
section 12 of the reproposal applied to the holder of a residual
interest in, as well as any municipal securities retained by the
sponsor of, a qualified tender option bond entity, if those interests
were held in satisfaction of the sponsor's risk retention requirements
under section 10 of the reproposal.
    The reproposal also would have allowed the sponsor of a qualified
tender option bond entity to satisfy its risk retention requirements
under subpart B of the proposed rule using any other risk retention
option in the reproposal, provided the sponsor meets the requirements
of that option.
    The agencies received many comments regarding the proposed tender
option bond options. Most of the comments requested an exemption from
risk retention for tender option bonds and, in the absence of an
exemption, recommended either technical clarifications or adjustments
to the proposed options for tender option bonds to cover a broader
range of transaction structures.
    Several commenters recommended that the final rule exclude issuance
of tender option bonds from the risk retention requirements for a
variety of reasons, including:
     The originate-to-distribute model that poses moral hazard
risks in certain securitization transactions is not present in a tender
option bond program;
     The tender option bond structure does not create
information gaps for investors because tender option bond programs do
not involve pooling large numbers of unrelated assets;
     The underlying bonds in a tender option bond structure
generally are from one original issuance with the same issuer and
borrower/obligor;
     The fund that selects the municipal bond to be deposited
into a tender option bond structure retains virtually all of the risk
related to such municipal bonds, and the tender option bond structure
provides liquidity that is not found with typical asset-backed security
products; and
     The industry generally does not define tender option bonds
as structured finance products or asset-backed securities.
    Commenters urging exclusion of tender option bonds from the risk
retention requirements also stated that the current tender option bond
market provides municipal issuers with access to a diverse investor
base and a more liquid market, and subjecting tender option bonds to
the risk retention requirements would significantly increase the costs
of tender option bond programs and adversely affect the state and local
governments that indirectly receive funding through these programs.
They also commented that applying the risk retention rules to these
structures would decrease the availability of tax-exempt investments in
the market for money market funds, which are continuing to face limited
investment options due to constraints imposed by Rule 2a-7 under the
Investment Company Act.
    A few commenters proposed that a sponsor of tender option bonds
could satisfy its risk retention requirements if the residual interest
holder provides, either directly or indirectly through an affiliate (i)
100 percent liquidity coverage on the floaters, (ii) a binding
reimbursement obligation to the provider of the 100 percent liquidity
coverage, or (iii) 100 percent credit enhancement on the underlying
municipal securities. A few commenters took the position that any
residual interest in any tender option bond structure should qualify as
a risk retention option under the rule if the residual interest is held
by an unaffiliated entity that agrees to subordinate its right to
payment to the floater holders and the liquidity provider until the
occurrence of a tender option termination event.
    One commenter recommended broadening the exemption relating to
asset-backed securities issued or guaranteed by a state or municipal
entity to include securities collateralized by such exempt securities.
Several commenters proposed that only municipal bond repackaging
transactions with initial closing dates after the applicable effective
date of the rule be subject to the risk retention requirements.
    Other commenters advocated for a broader tender option bond risk
retention option that would include most or all currently existing
tender option bond programs, including those that issue tender option
bonds with a notice period for tender of up to 397 days, tender option
bond programs that hold assets other than tax-exempt municipal
securities and servicing assets,\195\ tender option bond programs that
hold securities issued by more than one issuer,\196\ and tender option
bond programs in which the required retained interest is held by
multiple beneficial owners, so long as all such owners are managed by a
common regulated entity.\197\
---------------------------------------------------------------------------

    \195\ One commenter explained that other qualifying assets
should include taxable municipal securities, preferred stock of
registered closed-end investment companies that primarily invest in
municipal securities, tender option bonds or tender option bond
residual interests that are already issued and outstanding, and
custodial receipts representing beneficial interests in any of the
foregoing. A second commenter's alternative proposal includes tender
option bond programs that hold taxable municipal securities and
``securities evidencing a beneficial ownership interest in municipal
securities.'' A third commenter's alternative proposal included
tender option bond programs for which the ``underlying collateral
consists solely of tax-exempt assets or beneficial interests in such
assets.''
    \196\ One commenter explained, in limited instances, assets held
by tender option bond trusts consist of municipal securities from
different issues from the same issuer or of more than one issuer.
    \197\ One commenter explained that this allocation is common
practice in large fund complexes, and broadening this definition
would not change the alignment of interests of the trust holders.
Another commenter requested that the agencies allow multiple
investment companies to satisfy the sponsor risk retention
requirements.
---------------------------------------------------------------------------

    Several commenters suggested technical clarifications, adjustments
and corrections, including: The definition of qualified tender option
bond entity should clarify the requirements with respect to the
liquidity guarantee; \198\ the requirement that tender option bonds be
eligible securities under Rule 2a-7 under the Investment Company Act
should be removed because it is unnecessary in the risk retention
context; the definition of tender option bond should be revised so that
the purchase price is par or face value plus accrued interest; the
definition of qualified tender option bond entity should require that
the tender right be supported by a liquidity facility or guarantee,
except upon the occurrence of specified tender option termination
events, and that such liquidity facility or guarantee be enforceable
against the entity obligated to support or guarantee the purchase of
the bonds upon tender; and the agencies should provide more specific
guidance on how the disclosure

requirements would apply to tender option bonds.\199\
---------------------------------------------------------------------------

    \198\ One commenter explained that the liquidity facility in a
tender option bond program is typically structured as a credit
enhancement of the underlying assets and not of the floaters
themselves.
    \199\ One commenter asked that the agencies clarify that the
disclosure requirements applicable to the sponsor of a qualified
municipal repackaging entity be limited to: (i) the name and form of
organization of the qualified municipal repackaging entity, (ii) a
description of the form and material terms of the retained interest,
(iii) whether the qualified municipal residual interest is held by
the sponsor or a qualified residual holder, and (iv) a description
of the face value or fair value of the qualified municipal residual
interest or the municipal securities that are separately retained.
---------------------------------------------------------------------------

    A few commenters expressed concern that the option to retain the
residual interest only if it otherwise qualified as an eligible
horizontal residual interest before, and an eligible vertical interest
after, the occurrence of a tender option termination event was
inconsistent with the partnership tax analysis used to pass through the
tax-exempt interest on the bonds because the residual interest in a
tender option bond structure is not legally subordinated at any time.
However, another commenter stated that a residual interest is
substantially equivalent to an eligible horizontal residual interest
prior to the occurrence of a tender option termination event and an
eligible vertical interest after a tender option termination event
because (i) prior to the occurrence of a tender option termination
event, the residual holder bears all the market risk, and (ii) after a
tender option termination event, any credit losses are shared pro rata
between the floaters and the residuals.
    As part of a broader alternative definition for a qualified tender
option bond entity, it was suggested that the retained risk in a
qualified municipal repackaging entity should be either a residual or
legally subordinate ABS interest equal to at least 5 percent of the
face value (or fair market value, if no face value is available) of the
assets of the entity at closing.
    A group of commenters suggested that, if the agencies do not
provide a full exemption for tender option bonds, the rule should state
that retaining a residual interest in a qualified tender option bond
entity equal to 5 percent of the fair value (determined as of the date
of deposit) of the deposited assets should satisfy the risk retention
requirements, without regard to the requirements applicable to eligible
horizontal residual interest or eligible vertical interest
requirements.
    Other commenters recommended that the agencies permit the sponsor
or the residual holder to purchase and retain a residual interest with
an upfront cash investment value equal to 5 percent of the initial
market value of the municipal securities in the tender option bond
program. In addition, commenters asked that the rule allow a sponsor to
aggregate the amount of a tender option bond residual interest it
holds, with the municipal securities it directly holds, as of the date
of deposit, in determining its risk retention requirement.
    It was also suggested that the value of the collateral posted by a
residual holder for a liquidity facility should be recognized, and that
the residual holder's interest should be calculated as the sum of (a)
the face amount of the residual certificate and (b) the market value of
the collateral posted by the residual to secure the liquidity facility.
    In terms of valuing the residual interest, one commenter suggested
that the 5 percent market value retention amount be calculated at the
time of the purchase of the municipal bond or the issuance of
securities, to better conform to common industry practice and the
realities of the tender option bond program, if the agencies decide not
to exempt tender option bonds. This commenter explained that it would
be impractical and costly to constantly monitor any fluctuation in the
market value of the municipal bonds, and that no adjustments should
have to be made if, during the life of the tender option bond trust,
the market value of those bonds fluctuates above or below the market
value that is initially calculated.
    Several commenters requested that the agencies permit a party other
than the sponsor of the issuing entity with respect to tender option
bonds to be the risk retainer. Commenters stated that such a party may
include a third-party investor that selects the underlying asset for
the transaction and obtains the primary financing benefit of the
structure, the funds or other investors that purchase residuals in the
tender option bond trust to satisfy the sponsor's risk retention
obligations as third-party purchasers, and a third-party investor with
respect to tender option bond programs that are made available by
sponsors and used by such third-party investors.
    A few commenters requested that the final rule confirm that the
``sponsor'' is the bank that creates the tender option bond program.
Commenters explained that the residual holders do not perform any of
the traditional functions of a sponsor. One commenter claimed that
deeming the funds that purchase residuals to be the ``sponsors'' for
purposes of risk retention would have implications under other rules
that use the term ``sponsor,'' including Rule 2a-7 under the Investment
Company Act and proposed Securities Act Rule 127B.
    In connection with the prohibition on hedging in the reproposal,
which prohibits hedges that are ``materially related to the credit
risk'' of the tender option bond residual interests and securitized
assets, a group of commenters requested that the agencies clarify the
meaning of that restriction to ensure that sponsors can manage the
risks associated with up to 95 percent of the assets held by a tender
option bond program. It was also requested that the agencies exclude
from the hedging prohibition: (i) risk reducing and other transactions
with regard to the underlying municipal security that are entered into
by the sponsor prior to the establishment of the municipal bond
repackaging structure, and (ii) transactions between the sponsor or its
affiliates and an unrelated third party where the purpose of such
transaction is to provide financing to such unrelated third party for
such municipal securities on connection with a municipal bond
repackaging structure.
b. Final Rule
    After considering carefully the comments received on the reproposal
as well as the purpose and language of section 15G of the Exchange Act,
the agencies have adopted in the final rule the proposed tender option
bond options with some modifications. In response to specific commenter
concerns, the final rule incorporates certain technical clarifications
and adjustments.
    The final rule does not provide an exemption from risk retention
requirements for sponsors of issuing entities with respect to tender
option bonds. The agencies continue to believe that tender options
bonds are asset-backed securities under the definition in section 15G
because they are securities collateralized by self-liquidating
financial assets and the holders of the securities receive payments
that depend primarily on cash flow from the securitized assets.\200\
Therefore, the sponsors of the issuing entities with respect to tender
option bonds are subject to section 15G and the credit risk retention
rules.
---------------------------------------------------------------------------

    \200\ 15 U.S.C. 78o-11(a).
---------------------------------------------------------------------------

    Consistent with the treatment of sponsors of other asset-backed
securities, the holder of risk retention in connection with the
issuance of tender option bonds may divide the ABS interests or tax-
exempt municipal securities required to be retained under the final
rule among its majority-owned affiliates, but may not do so among
unrelated entities that are managed by the sponsor or managed by an
affiliate of the sponsor. Accordingly, the sponsor of a tender option
bond issuance under the rule may not sell the ABS interests

required to be retained under the rule to a fund it manages unless such
fund is a majority-owned affiliate of the sponsor. Otherwise, the
credit risk associated with holding the ABS interest will be
transferred to the investors in the fund that purchased those ABS
interests, which would undermine the purpose and intent of the statute.
    The agencies believe that, with respect to some issuances of asset-
backed securities, it is possible that more than one party could meet
the definition of sponsor in the rule.\201\ With respect to those
issuances, it is the responsibility of the transaction parties to
designate which party is the sponsor and that party is then subject to
the requirements of the risk retention rules.\202\ The agencies note
that various commenters requested that the agencies designate the bank
that arranges and organizes the issuance of tender option bonds or the
party that owns the residual interest as the sponsor. Regarding such
requests, the agencies note that the party required to comply with the
risk retention rules with respect to a tender option bond issuance is
the party or parties that meet the definition of ``sponsor'' in the
rule \203\ and, depending on the specific facts and circumstances of
the issuance and how the parties structure the transaction, either the
arranging bank or the residual holder could be designated as the
sponsor in accordance with the final rule.\204\
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    \201\ The designation of a party as a sponsor of an issuance of
asset-backed securities for purposes of the final rule is not
related to whether or not such party is the sponsor for purposes of
other rules and regulations, including for example Rule 2a-7 under
the Investment Company Act (including the discussion of sponsor in
the Money Market Fund Reform, 79 FR at 47876) or section 13G of the
Bank Holding Company Act (Volcker Rule). Whether or not a party is
the sponsor under a particular rule or regulation is determined by
reference to that rule or regulation and the related legal
authority.
    \202\ While this concern was specifically raised by commenters
in the context of tender option bonds, the agencies note that it is
possible that any issuance of asset-backed securities could have
more than one party that meets the definition of sponsor, and the
analysis in this section would apply regardless of the
securitization structure or securitized assets.
    \203\ As noted in the discussion of the definition of
``securitizer'' with respect to CLOs in Part III.B.7 of this
Supplementary Information, the agencies do not believe that a
sponsor is required to have had legal ownership or possession of the
assets that collateralize an issuance of asset-backed securities.
    \204\ Nothing in the final rule prohibits the use by a sponsor
of agents in order to meet the sponsor's obligations under the final
rule, including the use of third-party service providers, such as an
underwriter or remarketing agent to distribute required disclosures
to investors in a timely manner. However, the sponsor remains liable
for compliance with its obligations under the final rule.
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    The purpose of the tender option bond risk retention options was to
address existing market practice for traditional tender option bond
issuances that are specifically structured such that the interest
payments made on those securities are excludable from the gross income
of the owners in the same way that the interest on the underlying
municipal securities is excludable. Certain commenters suggested that
the requirement that a residual interest in a tender option bond
structure meet the requirements of an eligible horizontal residual
interest before, and an eligible vertical interest after, the
occurrence of a tender option termination event was inconsistent with
the partnership tax analysis required to be used to ensure the pass-
through treatment of the tax-exempt interest on the tender option bonds
and tender option bond residuals. The agencies acknowledge that some
asset-backed securities are not legally structured as debt and, in
order to address this, the reproposal included and the final rule
adopts a definition of ``collateral'' which explicitly applies
``irrespective of the legal structure of issuance'' and includes
``fractional undivided property interests in the assets or other
property of the issuing entity, or any other property interest in such
assets or other property.'' The agencies believe that a residual
interest in a qualified tender option bond entity would meet the
requirements of an eligible horizontal residual interest before, and an
eligible vertical interest after, the occurrence of a tender option
termination event if: (i) prior to the occurrence of a tender option
termination event, the residual holder bears all the market risk
associated with the underlying tax-exempt municipal security; and (ii)
after the occurrence of a tender option termination event, any credit
losses are shared pro rata between the tender option bonds and the
residual interest.
    The agencies do not agree with comments suggesting that tender
option bond structures with an initial closing date prior to the date
on which rule becomes effective should be exempt from the rule or
``grandfathered.'' Consistent with the statute, the agencies believe
that the sponsor of issuances of asset-backed securities after the
applicable effective date should be subject to risk retention
requirements regardless of when the structure that issues those
securities was formed. A tender option bond structure may issue
additional asset-backed securities on multiple dates and may often
substitute collateral. These features, and the broad exemptive relief
requested by commenters, would allow for potentially limitless
issuances of asset-backed securities which would not be subject to any
risk retention requirements. Requiring tender option bond structures to
meet the credit risk retention requirements regardless of their closing
date is consistent with treatment of other securitization structures
that exist prior to and continue to issue ABS interests after the
applicable effective date of the rule, such as ABCP conduits and
revolving pool securitizations.
    The agencies have determined not to revise the definition of
qualified tender option bond entity to expand the types of assets such
structures can hold.\205\ The tender option bond option in section 10
of the final rule is narrowly drawn to address risk retention practices
in existing market structures and limit potential for abuse that could
result from a broad exemption based entirely on structural features.
Accordingly, under the final rule, sponsors of issuances of asset-
backed securities that are subject to risk retention and that are
collateralized by assets other than tax-exempt municipal securities
\206\ with the same municipal issuer and the same underlying obligor or
source of payment will need to comply with the requirements of one of
the other credit risk retention options. As a result, the final rule
does not permit a qualified tender option bond entity to hold a
residual interest in another tender option bond program or preferred
stock in a closed-end investment company that invests in municipal
securities.
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    \205\ As proposed, the final rule requires that the collateral
for a qualified tender option bond entity to consist only of
servicing assets and tax exempt municipal securities.
    \206\ The agencies believe that a beneficial interest in a tax-
exempt municipal security may be held by a qualified tender option
bond entity, but only if such beneficial interest is a pass-through
and pro rata interest in the underlying tax-exempt municipal
security. Therefore, a qualified tender option bond entity will be
permitted to hold an asset-backed security collateralized by a tax-
exempt municipal security only if such asset-backed security is a
pass-through and pro rata interest in the underlying tax-exempt
municipal security and the cash flows supporting such asset-backed
security are not tranched. A qualified tender option bond entity
will not be permitted to hold credit default swaps referencing
municipal obligations or tranched asset-backed securities, such as
tender option bonds.
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    The agencies have adopted the definition of tender option bond with
one change and a clarification. After considering comments, the
agencies are permitting tender option bonds with a notice period of up
to 397 days to qualify for the specialized option. The agencies note
that this time frame corresponds to the maximum remaining

maturity of securities allowed to be purchased by money market funds
under Rule 2a-7 under the Investment Company Act. Consistent with the
reproposal, the final rule requires that the tender option bond have
features which entitle the holder to tender the bond for a purchase
price equal to the approximate amortized cost of the security, plus
accrued interest, if any. The agencies believe that, in the context of
a tender option bond, ``amortized cost plus accrued interest''
typically equals face value or par value plus accrued interest.
    In response to commenters' suggestions for valuation methodologies
to determine the fair value of a residual interest in a tender option
bond issuance, to the extent that a particular valuation methodology is
appropriate in the fair value measurement framework under GAAP to
determine the fair value of a residual interest in a tender option bond
issuance, then such valuation methodology would be permitted under the
final rule to determine the fair value of a retained residual interest
in a tender option bond issuance. After careful consideration of
commenters' suggestions for alternative valuation methodologies, the
agencies do not believe there is a compelling reason to treat tender
option bond residual interests differently from any other eligible
horizontal residual interest, and the final rule requires that the
sponsor of a tender option bond calculate the fair value of the
residual interest.
    Consistent with the reproposal, the final rule requires the amount
of tax-exempt municipal securities held by the sponsor or a majority-
owned affiliate of the sponsor outside of the qualified tender option
bond entity to be determined by reference to the face value of the
municipal securities deposited in the qualified tender option bond
entity. For instance, if the face value of the tax-exempt municipal
securities deposited into a qualified tender option bond entity is $100
million, the sponsor or a majority-owned affiliate of the sponsor will
be required to hold tax-exempt municipal securities, identical to those
deposited in the tender option bond entity with respect to legal
maturity and coupon, with a face value of $5 million in order to
satisfy its requirements under the final rule. The agencies continue to
believe that this approach is an accurate and easily verifiable means
of calculating 5 percent risk retention because the retained municipal
securities are identical to and fungible with the deposited municipal
securities. This approach should help to minimize operational costs,
administrative burdens and additional costs.
    Regarding commenters' requests that the agencies give a sponsor of
a tender option bond credit for cash held as collateral for the
liquidity agreement, the final rule does not allow such cash collateral
credit to be credited toward satisfaction of the risk retention
requirements unless the cash is held in an account that meets the
requirements for an eligible horizontal cash reserve account. This
result is consistent with the approach regarding cash reserves
connected to issuances of asset-backed securities under other options
in the final rule.
    Regarding commenters' requests for certain adjustments to, and
clarification of, the hedging prohibitions with respect to the tender
option bond risk retention options and with respect to tender option
bond issuances generally, the agencies believe there is no reason to
treat sponsors of tender option bond structures any differently from
sponsors of other asset-backed securities issuances. Therefore, subject
to provisions of the rule regarding permitted hedges and the agencies'
interpretation of the hedging restrictions discussed elsewhere in this
preamble, the agencies believe that a hedging transaction entered into
prior to the establishment of the tender option bond trust should be
subject to the hedging prohibition. Permitting such hedges would allow
the sponsor of a tender option bond issuance to hedge its credit risk
exposure to the tender option bond issuance simply by hedging its
expected exposure to the underlying assets prior to the initial
issuance of the tender option bonds, effectively eliminating the
hedging prohibition. Similarly, regarding commenters' requests for an
exclusion for hedging transactions entered into between the sponsor of
a tender option bond issuance or its affiliates and an unrelated party
where the purpose of such transaction is to provide financing to such
third party for the municipal securities to be deposited into a tender
option bond structure, the agencies believe that the holder of retained
credit risk should not be permitted to hedge its exposure to the
retained credit risk. This approach is consistent with the treatment of
all other credit risk retention options in the final rule. The agencies
further believe that consideration of the purpose and intent of
transactions that effectively hedge or reduce the risks associated with
credit risk retention would undermine the hedging prohibition and the
purpose and intent of section 15G.
    Regarding commenters' requests to clarify the phrase ``materially
related to the credit risk'' in the hedging prohibition, the agencies
expect the sponsor of a tender option bond issuance to make that
determination based on the relevant facts and circumstances. To the
extent that the sponsor of a tender option bond issuance holds ABS
interests or tax exempt municipal securities in excess of the minimum
requirement under the final rule, then such sponsor would be permitted
to hedge such excess interests, but must hold ABS interests or tax
exempt municipal securities unhedged in an amount that satisfies the
minimum risk retention requirements applicable to such retained risk.
    The final rule does not include the requirement that the tender
option bonds issued by a qualified tender option entity be eligible
assets under Rule 2a-7 under the Investment Company Act. The agencies
were persuaded by commenters that analyzing compliance with such a
requirement would involve an assessment of information that might not
be available to sponsors and was unnecessary given the other conditions
to the sponsors' ability to rely on the risk retention options specific
to tender option bonds.
    The agencies are adopting the proposed disclosure requirements for
qualified tender option bonds with some clarification and a minor
addition. Based on comments, the agencies have added specific
disclosure requirements for sponsors that retain municipal securities