On May 12, 2020, the Federal Reserve Board (Fed) released an updated term sheet (Term Sheet) in respect of the Term Asset-Backed Securities Loan Facilities (TALF 2020)1, which amends the TALF 2020 term sheets released on March 23, 2020 and April 9, 2020, respectively. On May 20, 2020, the Fed released Frequently Asked Questions updating those released by the Fed on May 12, 2020 (FAQs), a draft of the Master Loan and Security Agreement (MLSA), and certain other related documents, which collectively clarified and expanded on the initial scope and details of TALF 2020.2 While these recent Fed releases address a number of crucial questions raised by asset-backed securities (ABS) market participants in response to the initial Fed term sheets, they also give rise to concerns regarding the practicality and accessibility of TALF 2020 in respect of certain eligible ABS, most notably collateralized loan obligations (CLOs). We discuss some of the key updates and clarifications below.3
Clarification of Significant Operations and Majority of Employees. The Term Sheet provides that eligible TALF 2020 borrowers include businesses that (i) are created or organized in the U.S. or under the laws of the U.S., (ii) have significant operations in and a majority of their employees based in the U.S., and (iii) maintain an account relationship with a primary dealer. The “significant operations” requirement created a great deal of uncertainty in respect of the initial Fed term sheets, particularly in the context of private investment funds. The FAQs provide much needed clarity on the criteria that must be met to satisfy the “significant operations in and a majority of…employees” criteria set forth above.
First, the FAQs make it clear that in the private investment context, such language applies to the investment manager for the fund, as opposed to the fund itself. As a result, a private investment fund that is created or organized in the U.S. and managed by an investment manager that is also created or organized in the U.S. will be an eligible borrower for purposes of TALF 2020, provided that a foreign government does not directly or indirectly own 10 percent or more of an outstanding class of securities of such fund or the investment manager for such fund.
The FAQs also provide a non-exhaustive list of examples of what it means to have “significant operations in” the U.S. These include greater than 50% of consolidated assets, annual consolidated net income, annual consolidated net operating revenue, or annual consolidated operating expenses (excluding interest expense and any other debt service associated expenses) generated in the U.S., in each case, as reflected in the most recent audited financial statements.
To be eligible for TALF 2020, a borrower (or in the case of an investment fund, the investment manager of such fund), must satisfy the operations and employees requirement on a consolidated basis with its subsidiaries (i.e., without regard to any parent or sister companies).4
Monitoring and Disclosure of Material Investors. Consistent with the TALF used during the financial crisis of 2007-2009 (Original TALF), the FAQs also provide that any U.S. business with a Material Investor (defined below) that is a foreign government will not be an eligible borrower under TALF 2020. In addition, an investment fund that has an investment manager with any Material Investors that are foreign governments will likewise be ineligible for TALF 2020.
A “Material Investor” is a person who owns, directly or indirectly, 10% or more of any outstanding class of securities of an entity. This definition would seem to suggest a class-by-class ownership determination, in which case the ownership structure of a potential TALF borrower (or the related investment manager) with multiple classes or series would need to be evaluated in respect of each such class or series, even where a Material Investor in any such class or series may represent less than 10% of such borrower’s aggregate securities.
Pursuant to the MLSA, a TALF borrower is deemed to continually represent that it is an eligible borrower.5 TALF borrowers are expected to have mechanics in place to monitor direct and indirect investors for the life of the applicable TALF loan.
Following the commencement of TALF 2020, the Fed is expected to release information on a monthly basis that, among other things6, will identify the Material Investors of each TALF borrower. Although the FAQs only allude to Material Investors of a “borrower”, we would expect that Material Investors of an investment manager of an investment fund will also be subject to ongoing disclosure since for the related fund to be an eligible TALF borrower, the investment manager for such fund cannot have a Material Investor that is a foreign government.
New Borrower Certifications. Each TALF borrower will be required to certify that “it is unable to secure adequate credit accommodations from other banking institutions”. According to the Fed, lack of adequate credit does not mean that no credit is available, but rather that the prices or conditions of such credit are inconsistent with a “normal, well-functioning market”. As such, this certification can be based on “unusual economic conditions in the market”.
While this requirement may seem consistent with TALF 2020’s objective to respond to market dislocations in the ABS markets, it raises serious practicality concerns for market participants. Absent more objective criteria, it remains unclear precisely how a TALF borrower will establish and certify that credit prices and conditions are inconsistent with a normal, well-functioning market. What will be deemed an acceptable source of this information? If banking institutions need to be solicited for credit requests prior to accessing TALF 2020, how many banking institutions need to be solicited? What parameters are relevant to determine whether a market is well-functioning?
Without further revisions or clarifications, this certification in itself may discourage a number of potential participants from borrowing under TALF 2020.
No Affiliate Securitizations. Similar to Original TALF, the FAQs provide that, subject to certain limited exceptions for SBA Pool Certificates or Development Company Participation Certificates, a TALF borrower may not obtain a TALF loan for ABS backed by loans originated or securitized by the borrower or an affiliate of the borrower.
Issuer and Sponsor Certification. Consistent with Original TALF, the FAQs require that the issuer and the sponsor must ensure that the information included in the offering document of newly issued ABS (other than SBA Pool Certificates and Development Company Participation Certificates) includes a signed certification7 indicating, among other things, that (i) such ABS is “eligible collateral”, and (ii) the sponsor has executed and delivered an indemnity undertaking indemnifying the TALF special purpose vehicle (TALF SPV)and the Fed from any losses they may suffer if such certifications are untrue. If the sponsor is a special purpose vehicle, the sponsor’s direct or indirect ultimate parent must also execute the certification and indemnity undertaking. For ABS issued on or after March 23, 2020 and before May 22, 2020, such certification and undertaking must be provided under separate agreements.
In respect of a CLO, the FAQs explicitly provide that, for purposes of the certification and indemnity, the sponsor will be the collateral manager, even if it is not deemed a “sponsor” for risk retention purposes.
Notably, since legacy CMBS is not newly issued, it would seem that such certification and indemnity will not be required for TALF 2020 eligible CMBS.
LIBOR Fallback Language. The FAQs state that the Fed “generally will expect” both the underlying TALF 2020 eligible leveraged loans and floating-rate ABS with interest rates tied to LIBOR to include LIBOR fallback language, such as that recommended by the Alternative Reference Rates Committee (ARRC) or substantially similar language.
Most TALF 2020 eligible ABS can satisfy this requirement by incorporating the ARRC language. However, unique issues arise in the context of CLOs, where the related TALF 2020 borrowers will likely need some assurance that the underlying leveraged loans satisfy the LIBOR fallback criteria. This assurance would seemingly come from the eligibility certifications provided by the sponsor and the issuer discussed above. However, given the stated generality of the Fed’s expectation regarding adequate LIBOR fallback language, it remains unclear precisely what level of compliance a CLO’s underlying leveraged loans will need to meet in order to satisfy this standard.
Fed’s Voting Consent. Consistent with Original TALF8, the FAQs provide that a TALF borrower may not exercise or refrain from exercising any voting, consent or waiver rights or any right to direct, initiate, recommend or approve any action under any ABS that serves as collateral, without the consent of the Fed.
In the case of CLOs, which were not eligible ABS under Original TALF, this requirement raises certain practical concerns for investors acquiring the “controlling class” tranche of a CLO with TALF loan proceeds, which traditionally has consent rights in a number of crucial circumstances, including certain material transaction amendments and the removal of the collateral manager for cause. Absent a change in the requirement, its practicality, as it pertains to CLOs, may ultimately hinge upon the Fed’s ability to quickly respond to a consent request, particularly in circumstances where consent is deemed if not received within a prescribed time-frame.
Non-Call Period. The FAQs provide that eligible ABS must not be subject to an optional redemption (other than a customary clean up redemption)9 that can be exercised (i) prior to three years after the disbursement date of any TALF loan secured by such ABS, or (ii) at any time when the Fed or the TALF SPV owns such ABS (TALF Non-Call Period).
Under the proposed formulation, if the original TALF borrower were to repay a TALF loan and sell the related ABS to another investor that receives a new TALF loan, the TALF Non-Call Period would reset. In addition, were the Fed or TALF SPV to take ownership of the applicable ABS (e.g., as a result of foreclosure or collateral surrender), the TALF Non-Call Period could extend for the life of such ABS. This could be further exacerbated if the Fed were to further extend the TALF 2020 program term beyond September 30, 2020.
This limitation is especially problematic for subordinated noteholders of CLOs, where the right to optionally redeem the senior notes after a prescribed non-call period is fundamental to their investment. We note, however that the FAQs would not seem to preclude redemption by refinancing of the non-TALF financed tranches of a CLO.
It is unclear why the optionality afforded by Original TALF, in respect of which optional redemptions were subject to a conditional Fed consent right, is not presently contemplated by TALF 2020.
Required Ratings. TALF 2020 eligible ABS tranches must have a credit rating in the highest long-term or, if no long-term rating is available, the highest short-term investment-grade rating category, in each case, from at least two of S&P, Moody’s or Fitch. While the Fed may consider including other nationally recognized rating agencies in the future, this requirement in the meantime could be especially problematic for legacy CMBS, which are often rated by rating agencies other than those specifically prescribed by the Fed.
Previously-held ABS. The FAQs provide that a TALF borrower can receive a TALF loan for any eligible ABS that is acquired in an arms-length secondary market transaction within 30 days prior to the relevant loan subscription date, so long as such transaction is for a cash purchase price that does not reflect any economic arrangement such as financing or hedging arrangements, and has a settlement date that is on or before such subscription date.
Haircuts as a Measure of Average Life. The FAQs provide that for all ABS, other than Small Business Administration loans, the Fed will lend to the applicable TALF borrower an amount equal to the market value of the pledged collateral, minus a haircut based on the average life of the applicable ABS and set forth in the term sheet.10 The minimum haircut for CLOs is 20%.
The average life will be calculated based on certain prepayment assumptions and market conventions. The prepayment assumption for CLOs is a 10% conditional prepayment rate (i.e., 10% of the principal of the underlying pool is assumed to be prematurely paid). ABS issued on or after May 22, 2020 will be required to publish its average life in the related offering document.
Collateral Review. The FAQs provide that even if an ABS meets the TALF 2020 collateral eligibility requirements, the Fed may reject such ABS for any reason. In making this determination, the Fed may take into account the credit quality, transparency and simplicity of the structure. In addition, the Fed will not fund a TALF loan if, in its judgment, a TALF borrower or its affiliates have direct or indirect economic interest in the underlying assets of such ABS that would impact the incentive of such TALF borrower to independently assess the risk of investment in such ABS. The Fed encourages potential TALF borrowers to contact the Fed in advance of any loan request to address any concerns.
CLO-Specific Fed Guidance
Characteristics of a Static CLO. In order to qualify as a TALF 2020 eligible “static CLO”, such CLO (i) cannot reinvest any proceeds from the underlying leveraged loans, unless such reinvestment period begins after the TALF Non-Call Period, (ii) can only sell underlying leveraged loans that have defaulted in payments of principal and interest or that are sold to the sponsor at par plus accrued interest, and (iii) must have a collateral manager whose principal place of business is the U.S. As an accommodation to the traditional U.S. broadly-syndicated CLO structure, the requirement that the collateral manager have its principal place of business in the U.S. replaces the requirement that the CLO issuer be a U.S. entity.
Although the ability of a TALF 2020 eligible CLO to sell defaulted assets is a welcome development, the Fed’s criteria for what constitutes a defaulted asset is substantially narrower than those contained in a typical CLO. Notably, TALF 2020 eligible CLOs are not able to sell “Credit Risk” assets (other than to the sponsor at par).
Curiously, the Fed also permits asset sales to the CLO sponsor at par. As noted in “Issuer and Sponsor Certification” above, “sponsor” is defined to mean the collateral manager of a CLO for purposes of the required eligibility certification and related indemnification. However, the FAQs do not explicitly define sponsor for purposes of par sales. Nonetheless, we would anticipate the definition of sponsor will likely be the same in this context.
Clarification on Origination Dates. For a CLO to be TALF 2020 eligible, all or substantially all of the underlying leveraged loans must have been originated or refinanced on or after January 1, 2019. The FAQs clarified that in this context, “all or substantially all” means at least 95% (by principal balance) of the underlying leveraged loans.
As currently contemplated, this would enable certain legacy CLO warehouses to be taken out by a TALF 2020 eligible CLO.
Lead Arranger/U.S. Obligor. All or substantially all (determined in accordance with the criteria immediately above) of the credit exposures underlying a TALF 2020 eligible CLO must (i) have a lead or co-lead arranger that is a U.S. organized entity (including a U.S. branch or agency of a foreign bank), and (ii) be made to U.S. domiciled obligors.
Portfolio Criteria. To be eligible for TALF 2020, the underlying leveraged loans of a CLO must also:
- Be current on principal and interest.
- Be senior secured.
- An exception to this general rule would appear to be second lien loans, so long as they are in compliance with the Fed mandated concentration limitation referenced below.
- Satisfy the following concentration limitations:
- second lien loans cannot exceed 10% of the portfolio;
- debtor-in-possession loans cannot exceed 7.5% of the portfolio; and
- cov-lite loans cannot exceed 65% of the portfolio for broadly syndicated CLOs and 10% of the portfolio for middle market CLOs.
- The FAQs explicitly provide that if a loan is cross-defaulted or cross accelerated or pari-passu with another loan of the underlying obligor that requires compliance with a maintenance covenant or incurrence covenant, such loan will not be deemed a cov-lite loan.
- A “broadly syndicated” CLO is defined in the FAQs as a CLO that does not include leveraged loans with potential indebtedness of less than $150 million, and permits no more than 10% of leveraged loans of obligors with total potential indebtedness less than $250 million
- A “middle market” CLO is defined in the FAQs as a CLO in respect of which all or substantially all (i.e., 95% by principal balance) of the underlying leveraged loans have potential indebtedness of less than $250 million, and permits no leveraged loans of obligors with EBITDA (as calculated in the underlying instrument) of less than $10 million.
In addition, the CLO must also include at least one overcollateralization test that, unless satisfied, redirects cash flow from the subordinated tranches of such CLO to the TALF-eligible senior tranche.
First TALF Subscription Date
The release of the FAQs was accompanied by an announcement that the initial TALF 2020 subscription date will be June 17, 2020, and the first loan closing date will be June 25, 2020. The FAQs anticipate two subscription dates per month.
Although the guidance provided by the FAQs and the Term Sheet has addressed a number of lingering questions and concerns, there remain certain aspects of TALF 2020 that would benefit from additional clarity, expansion, and/or amendment. We are hopeful that the Fed will continue to heed constructive market feedback to the ends of both achieving the Fed’s stated objectives and providing an operationally feasible funding source for ABS market participants.
The Fed reserved the right to update the FAQs from time to time, and that eligible ABS may be expanded later to other asset classes. It would seem from these statements that the Fed continues to be open to considering requests by industry participants and trade associations for more expansive terms and conditions than those set forth in the Term Sheet and FAQs.
The foregoing is not an exhaustive summary, nor to does it purport to present all considerations relevant to TALF 2020. Seward & Kissel will continue to monitor TALF 2020 and keep clients apprised of any material developments. If you would like additional information about this or any other matter, or wish to discuss TALF 2020 further, please feel free to contact Greg B. Cioffi (email@example.com), Jeff Berman (firstname.lastname@example.org), or Abhijit Kurup (email@example.com).