Having only days previously made statements that such a deal was unlikely and warning their citizens to prepare for a no deal Brexit, the United Kingdom (UK) and the European Union (EU) announced on 24 December 2020 that they had reached an agreement in principle on trade and co-operation. More than 1200 pages long, the draft trade and co-operation agreement (TCA)[1] lays out the foundation for the future (i.e. post-Brexit) relationship on trade and business between the UK and EU, narrowly avoiding a no-deal Brexit mere days before the Brexit deadline. The TCA has since been universally approved by the ambassadors of the 27 EU countries allowing the deal to have immediate effect (although it still needs to be ratified by the EU parliament, which is scheduled for January 2021) and as at the date of this blog, has now been approved by the UK (through ratification in Parliament).

For those of you who have not been following the twists and turns of the UK’s departure from the EU (especially if you are wondering why we are still talking about Brexit when Brexit happened 11 months ago), the following summary of events may be helpful:

1. in May 2015, the Conservative Party, having spent the previous 5 years in a coalition government with the Liberal Democrat party, wins an outright majority in the House of Commons of the UK Parliament, on a manifesto including a pledge to hold a referendum on UK membership of the EU. On the morning after the election, the then Prime Minister, David Cameron, announced an intention to hold such referendum as soon as possible. Most people expected the referendum to result in a vote in favour of the UK remaining in the EU;
2. in June 2016, the referendum is held and the UK votes to leave the EU. David Cameron resigns as Prime Minister and Theresa May succeeds him;
3. the UK government serves notice on the EU that it intends to leave the EU, triggering a two year period in which to finalise an agreement to leave the EU;
4. the two year period has to be extended on numerous occasions. In large part, this is due to Theresa May calling an election in 2017 which leaves the Conservative Party as the largest party in the House of Commons, but without a majority (i.e. the Conservative Party became a minority government). No agreement that such government is able to negotiate with the EU is capable of securing the majority needed in the House of Commons to be ratified by the UK;
5. Theresa May resigns as Prime Minister and is replaced by Boris Johnson. He holds an election in 2019 which restores the Conservative Party majority in the House of Commons on a manifesto of “Getting Brexit done” and agrees a withdrawal agreement with the EU under which Brexit occurs on 31 January 2020, but with an 11 month “transition period” (also known as the “implementation period”) expiring on 31 December 2020. During the transition period, the UK remains subject to EU law and continues to trade with the EU as if it were still in the EU, while an agreement for the future trade relationship between the EU and the UK is to be negotiated. If no agreement had been reached between the EU and the UK by 31 December 2020, then the UK would have left the EU entirely and, in the absence of a trade agreement, would only have been able to trade with the EU on World Trade Organisation (or WTO) terms, which include significant tariff barriers and quota restrictions on such trade. In order for the UK to retain tariff and quota free trade access to the EU, an agreement on the future (i.e. post-Brexit) relationship between the EU and the UK needed to be agreed before the end of the transition period (i.e. by no later than 31 December 2020);
6. Brexit was thus a two stage process, whereby the UK’s departure was initially negotiated (i.e. the withdrawal agreement) and only thereafter was a post-Brexit trading agreement negotiated. The TCA represents that post-Brexit trading agreement.

The withdrawal agreement between the UK and the EU referred to in paragraph 5 above was entered into on 17 October 2019 (the Withdrawal Agreement). The Withdrawal Agreement was implemented as UK law by The European Union Withdrawal Act 2018, as amended by the European Union (Withdrawal Agreement) Act 2020 (the Withdrawal Act). Given that during the period of its membership of the EU, much UK law was derived from EU law, the Withdrawal Act provided for such law to remain part of UK law, provided that it was in force immediately prior to 1 January 2021 (which the Withdrawal Act has labelled the IP completion day).

Hence, after the IP completion day, existing EU laws will become part of UK domestic law (so-called retained EU law) which notably, on and from 1 January 2021, can only be amended, insofar as such laws apply in the UK, by UK legislation. EU laws that become applicable after IP completion day will not be part of the law of the UK. Following IP completion day, the UK becomes a third country for (amongst other things) the purposes of the EU financial services regulation. The TCA includes relatively few provisions for facilitating trade in services between the EU and the UK. Accordingly, there will not be “free trade” in services between the UK and the EU post IP completion day. One example of this is the financial services “passporting” regime, which allowed a financial services business that was approved to carry on financial services business in one EU member state to carry on the same business in other EU member states. Such passporting rights will, after IP completion day, no longer apply to UK financial services businesses that want to operate in the EU – such businesses will need to be separately approved and regulated to conduct such business by both UK and EU regulators.

This blog considers how the risk retention provisions of the EU Securitisation Regulation will apply in the UK after the IP completion day.

The EU Securitisation Regulation –Risk Retention

Article 6 (Risk retention) of Regulation (EU) 2017/2042 (the EU Securitisation Regulation) creates a direct risk retention requirement that applies to the originator, sponsor or original lender of a securitisation. The obligation is to retain on an ongoing basis a material net economic interest in a securitisation of not less than 5%. The EU Securitisation Regulation also imposes an ‘indirect’ risk retention obligation, via the obligation on EU based institutional investors to verify that such risk retention obligation is being complied with as part of their due diligence requirements under Article 5 of the EU Securitisation Regulation (Due-diligence requirements for institutional investors). The Article 6 risk retention obligation only applies where one of the originator, sponsor, original lender or the securitisation issuer (known in EU Securitisation Regulation terminology as a “securitisation special purpose entity” or “SSPE”) is based in the EU. However, the Article 5 due diligence requirement applies to EU based institutional investors whenever they invest in a securitisation as defined in the EU Securitisation Regulation, which can include securitisations issued from third country jurisdictions. Accordingly, the “indirect” risk retention requirement can apply to non-EU securitisations, if the target market for such securitisation includes institutional investors located in the EU.

The five accepted retention methods are: vertical slice, originator share, random selection, first loss (portfolio), or first loss (asset-by-asset). Unlike in the US, mixing different retention methods is not permitted. Also unlike the US, the calculation of the 5% material net economic interest may vary between the five accepted retention methods. The 5% in the vertical slice method is calculated by reference to the nominal (i.e. principal) amount of the notes issued under such securitisation whereas for each of the other risk retention methods, the 5% is calculated by reference to the nominal amount of the assets being securitised. The nominal amount calculation is made solely by reference to the contractual amount of the relevant obligation – there is no requirement to determine the accounting value of such obligations.

The Securitisation (Amendment) (EU Exit) Regulations 2019

Ministers in the UK government have been granted powers to effect statutory instruments to amend retained EU law to correct certain deficiencies to their application in the UK. Largely this consists of changing references from EU regulators (who will not have jurisdiction in the UK from the IP completion day) to their domestic UK equivalents.

This occurred in relation to the EU Securitisation Regulation via the Securitisation (Amendment) (EU Exit) Regulations 2019 (SI 2019/660) (the UK Securitisation Regulations SI), which replaced references to “the Union” with “the United Kingdom”, “ESMA” with “FCA” and “the EBA” with “PRA”. The PRA is a division of the Bank of England whereas the FCA is a separate entity incorporated under and with duties and powers given by statute.

The Withdrawal Act and the UK Securitisation Regulations SI (which will apply from 1 January 2021) while adopting almost all of the EU Securitisation Regulation, have made some changes which will mean as of 1 January 2021, the UK will have a slightly different regulatory regime for securitisations than the EU.

Risk Retention RTS and Guidelines

Paragraph 7 of article 6 (Risk retention) of the EU Securitisation Regulation obliges the European Banking Authority (EBA), in close cooperation with the European Securities and Markets Authority (ESMA) and a few other bodies, to draft regulatory technical standards (RTS) and implementing technical standards that specify in greater detail the risk retention requirements for originators, sponsors and original lenders (Risk Retention RTS).

A draft of the Risk Retention RTS has been produced. However, it has not as yet been adopted by the EU Commission, which is a prerequisite to it being formally published (which needs to occur before it can apply under EU law). Given that most such EU secondary legislation only becomes applicable 20 days after being published, it is (in practical terms) impossible for the Risk Retention RTS to become applicable on or prior to the IP completion day. Accordingly, that Risk Retention RTS will not become retained EU law under the Withdrawal Act and will not form part of the UK securitisation regime. This is unfortunate, as the draft Risk Retention RTS did include helpful clarifications on how risk retention amounts were to be calculated and the (limited) circumstances where a disposal of a risk retention position might occur without breaching Article 6 of the EU Securitisation Regulation. While not binding, given that it is only in draft form, the draft Risk Retention RTS is seen as providing market participants with useful guidance as to the EBA’s likely view on how Article 6 should be interpreted. There is no equivalent guidance from the PRA and as the draft Risk Retention RTS was not produced by the PRA, it is difficult to regard it as representing guidance as to the PRA’s views.

In addition, from IP completion day, the UK will be free to enact its own secondary legislation regarding the implementation of the risk retention requirements under the UK Securitisation Regulations SI and this could lead to the EU and the UK having different implementation requirements in respect of risk retention requirements.

Similarly, Guidelines also do not automatically become retained EU-law. For these purposes, the effect of this is limited, as there are no extant Guidelines in relation to risk retention. However, the Bank of England (Bank) and Prudential Regulation Authority (PRA) Statement of Policy of December 2020[2] sets out the Bank’s and PRA’s approach to EU Guidelines and Recommendations in light of the UK’s withdrawal from the European Union (EU). The Bank and PRA expect PRA-regulated firms, investment firms in scope of the UK resolution regime and all Bank-regulated financial market infrastructure firms operating, or intending to operate, in the UK to make every effort to comply with existing EU Guidelines and Recommendations that are applicable as at the end of the IP completion day.

Other relevant considerations

Risk retention on a consolidated basis is permitted under the EU Securitisation Regulation and is also applicable in the UK post-Brexit. However, problems may arise where the risk retention holder is in the UK and the originator in the EU or vice versa.

In addition, there are discussions in various EU or EU related forums about potential future amendments to the EU Securitisation Regulation. For instance, the EBA published a report on 23 October 2019[3] on NPL securitisations, where it recommended changes to the EU risk retention rules both as to the manner in which the 5% net economic interest should be calculated and as to who could be the risk retainer in the context of NPL securitisations. No such amendment has occurred yet, but if it were to, such amendment would not now apply in the UK (unless the UK government deliberately choose to pass similar legislation). Similarly, the High Level Forum on Capital Markets Union published a paper on 10 June 2020[4], which made a number of recommendations regarding reducing the regulatory capital cost of securitisations for EU institutional investors. While none of these specifically addressed risk retention (and the paper suggested that the High Level Forum was broadly in favour of risk retention and the suppression of originate to distribute business models), it was indicative of a growing acceptance amongst European policy makers that elements of the EU Securitisation Regulation are overly restrictive and amount to impediments on fostering dynamic European capital markets. Against this backdrop, it would seem reasonable to anticipate that the EU may look to amend aspects of the EU Securitisation Regulation in the near future, which may have an impact of risk retention requirements. Any such amendments will not automatically apply in the UK and this could lead to significant divergence between the EU and UK regimes.

While not part of the scope of this blog, it is worth noting that there may be significant divergence between the EU and UK due diligence regimes under Article 5 following IP completion day. No doubt many readers of this blog will be familiar with the uncertainty around the interpretation of Article 5(1)(e) and whether such provision required non-EU securitisations to comply with the EU Securitisation Regulation reporting requirements (under Article 7) if sold to EU institutional investors. While there is growing market consensus that Article 5(1)(e) does not impose a de facto Article 7 reporting requirement on non-EU securitisations, there has been no official guidance to this effect. However, the UK government, in the UK Securitisation Regulations SI, has amended Article 5(1)(e) as it applies in the UK so that UK based institutional investors in non-UK securitisations will be required to ensure that such securitisations comply with Article 7 as if such securitisation had been carried out in the UK. This will potentially make it harder to market non-UK securitisations to UK institutional investors than to EU institutional investors (if Article 7 style reporting cannot be carried out in the jurisdiction where the securitisation is being issued).

Conclusion

As of 1 January 2021, the UK and the EU will have separate (albeit largely identical) regulatory regimes for securitisation. However, there is scope for future divergence in the application of those regimes, as well as the possibility for either or both of the EU or the UK to implement new rules in the future that are significantly different from each other’s. Market participants will need to bear this in mind when structuring securitisations and deciding whether to market them to EU institutional investors, UK institutional investors or both. If a transaction is offered to both EU and UK institutional investors, it will, post IP completion day, need to satisfy the requirements of both the EU and UK regimes – compliance with one cannot necessarily be assumed to amount to compliance with the other.

[1] https://ec.europa.eu/info/sites/info/files/brexit_files/info_site/tca-20-12-28.pdf

[2] https://www.bankofengland.co.uk/-/media/boe/files/paper/2019/interpretation-of-eu-guidelines-and-recommendations-boe-and-pra-approach-sop-december-2020.pdf?la=en&hash=44B9CDFD3F6C9D22674F4FE64FEB25F61695F58B

[3] Opinion of the European Banking Authority to the European Commission on the Regulatory Treatment of Non-Performing Exposure Securitisations – EBA-Op-2019-13

[4] A new vision for Europe’s capital markets – Final Report of the High Level Forum on Capital Markets Union. This report can be found at https://europa.eu/!gU33Hm