As discussed in our client alerts on March 30, 2020, April 14, 2020 and May 22, 2020, the Federal Reserve Board (the “Fed”) announced on March 23, 2020 the establishment of the Term Asset-Backed Securities Loan Facility (“TALF 2020”). The terms and conditions of TALF 2020 are described in a term sheet released by the Fed1 as well as two updates to that term sheet.2 The most recent of these updates was issued on May 12, 2020 along with a list of Frequently Asked Questions (“FAQs”),3 which clarify the eligibility of investment funds to participate in TALF 2020. The FAQs were further revised by the Fed on May 20, 2020 and released along with a draft Master Loan and Security Agreement.4 Accordingly, in this memorandum we summarize certain of the terms of TALF 2020 as modified by the May 12 release and FAQs and describe certain tax and other considerations for investment funds seeking to borrow under TALF 2020.
TALF 2020: AN OVERVIEW
- Authorized by Section 13(3) of the Federal Reserve Act, TALF 2020 is intended to support the flow of credit to U.S. consumers and small businesses by facilitating the issuance of asset-backed securities (“ABS”) and improving ABS market conditions.
- TALF 2020 will serve as a funding backup for eligible ABS issued on or after March 23, 2020 (with certain exceptions described below).
- The Federal Reserve Bank of New York (“NY Fed”) will initially make up to $100 billion of loans available. The loans will each have a term of three years; will be nonrecourse to the borrower; and will be fully secured by eligible ABS.
- Using the Exchange Stabilization Fund, the United States Treasury Department (“U.S. Treasury”) will make an equity investment in the amount of $10 billion in the special purpose vehicle (“TALF SPV”) established for TALF 2020. The NY Fed will commit to lend to the TALF SPV on a recourse basis.
- Unless TALF 2020 is extended by the Fed, no new credit extensions will be made under the program after September 30, 2020.
- The Fed will publicly disclose information on a monthly basis regarding TALF 2020 during the operation of the facility, including information identifying each borrower and other participant in the facility, information identifying each Material Investor of a borrower, the amount borrowed by each borrower, the interest rate paid by each borrower, the types and amounts of ABS collateral pledged by each borrower, and overall costs, revenues, and other fees for the facility. A “Material Investor” is a person who owns, directly or indirectly, ten percent (10%) or more of any outstanding class of securities of an entity. Additional information regarding these public disclosures was included in our May 22, 2020 client alert.
INVESMENT FUND ELIGIBLITY UNDER TALF 2020
- Eligible borrowers include businesses that are (1) created or organized in the United States or under the laws of the United States, (2) have significant operations in and a majority of their employees based in the United States, and (3) maintain an account relationship with a primary dealer.
- Investment funds, whether currently existing or formed specifically to take advantage of opportunities in connection with TALF 2020, that are created or organized in the United States and managed by an investment manager that is created or organized in the United States and has significant operations in and a majority of its employees based in the United States are eligible borrowers for purposes of TALF 2020 (provided that a foreign government is not a Material Investor of the fund or the investment manager).
- Examples of an investment manager having significant operations in the United States are if it has greater than 50 percent of its (1) consolidated assets in, (2) annual consolidated net income generated in, (3) annual consolidated net operating revenues generated in, or (4) annual consolidated operating expenses (excluding interest expense and any other expenses associated with debt service) generated in, the United States as reflected in its most recent audited financial statements.
- An “investment fund” for purposes of TALF 2020 includes (1) any type of pooled investment vehicle that is organized as a business entity or institution, including a hedge fund, a private equity fund, and a mutual fund, and (2) any type of single-investor vehicle that is organized as a business entity or institution.
- Investment funds that only invest in TALF 2020 eligible ABS and only borrow from TALF 2020, as well as funds that invest in a mix of TALF 2020 eligible ABS and other assets are eligible borrowers under TALF 2020.
- Each borrower will make a continuous representation that such borrower is an eligible borrower, and as such, the borrower is expected to have a mechanism for continuously monitoring its direct and indirect investors as long as the TALF 2020 loan is outstanding. Each borrower will also be required to certify (i) that it is unable to secure adequate credit accommodations from other banking institutions and that it is not insolvent, and (ii) as to the conflicts of interest requirements in section 2019 of the Coronavirus Aid, Relief, and Economic Security Act. Additional information regarding these requirements was included in our May 22, 2020 client alert.
ELIGIBLE TALF 2020 COLLATERAL5
- To be eligible to be pledged under TALF 2020, collateral must:
- be U.S. denominated cash (not synthetic) ABS;
- have a credit rating in the highest long-term or, if no long-term rating is available, short-term investment grade rating category from at least two eligible nationally recognized statistical rating organizations (“NRSROs”);
- not have a credit rating below the highest investment-grade rating category from an eligible NRSRO;
- be issued on or after March 23, 2020, with the exception of:
- commercial mortgage-backed securities (“CMBS”), which must be issued prior to March 23, 2020;
- Small Business Administration (“SBA”) Pool Certificates, which must be issued on or after January 1, 2019; and
- Development Company Participation Certificates, which must be issued on or after January 1, 2019;
- not bear interest payments that step up or step down to predetermined levels on specific dates;
- be ABS in respect of which all or substantially all of the underlying credit exposures are newly issued, except for CMBS;
- be ABS in respect of which all or substantially all of the underlying credit exposures are
- for newly issued ABS (i.e., non-CMBS), except for collateralized loan obligations (“CLOs”), be originated by U.S.-organized entities (including U.S. branches or agencies of foreign banks);
- for CLOs, have a lead or a co-lead arranger that is a U.S.-organized entity (including a U.S. branch or agency of a foreign bank); and
- for all ABS (including CLOs and CMBS), be to U.S.-domiciled obligors or with respect to real property located in the United States or one of its territories; and
- be ABS in respect of which:
- none of the underlying credit exposures are themselves cash ABS or synthetic ABS; and
- the underlying credit exposures are one of the following: (1) auto loans and leases; (2) student loans; (3) credit card receivables (both consumer and corporate); (4) equipment loans and leases; (5) floorplan loans; (6) premium finance loans for property and casualty insurance; (7) certain small business loans that are guaranteed by the SBA; (8) leveraged loans (limited to static CLOs, the manager of which has its principal place of business in the United States,6 and excluding commercial real estate CLOs); and (9) commercial mortgages.
- Investors may borrow against ABS they already own. If eligible ABS are not issued on the same day the investor borrows from TALF 2020, the ABS must have been acquired in an arm’s-length secondary market transaction within 30 days prior to the relevant loan subscription date.
- A borrower must agree not to exercise, or refrain from exercising, any voting, consent or waiver rights, or any rights to direct, initiate, recommend or approve any action, under an ABS that is used as eligible collateral without the consent of the NY Fed.
COMMON FUND TERMS
- Investment funds that utilized the 2009 Term Asset-Backed Securities Loan Facility were typically structured as closed-end funds that utilized capital commitment and drawdown mechanics, with the management teams compensated with management fees and carried interest distributed through a cash flow waterfall.
- Investment funds that borrow from TALF 2020 will be highly leveraged and potentially subject to certain limitations on interest deductibility.
- A fund may be classified as an “investor” for U.S. federal income tax purposes. If so, the expenses of the fund (other than interest) will constitute “miscellaneous itemized deductions” to its investors who are individuals and such expenses will not be deductible by the individuals.
- Investment interest may be subject to substantial limitations on deductibility under the tax laws of many states.
- As a result of borrowing to invest in TALF 2020 eligible ABS, a fund will incur “acquisition indebtedness” that constitutes “unrelated business taxable income” (or “UBTI”) for U.S. tax-exempt investors.
- To address these issues, fund sponsors may want to form a foreign entity treated as a corporation for U.S. federal income tax purposes to serve as a feeder fund that would invest in the U.S. TALF 2020 borrower. The foreign corporation will be a “passive foreign investment company” (or “PFIC”) for U.S. federal income tax purposes. U.S. taxable investors may then make a “qualified electing fund” election (a “QEF”) with respect to the PFIC. Pursuant to the QEF, U.S. investors will include their pro rata share of the fund’s ordinary earnings as ordinary income each year.
- There are three noteworthy benefits to this structure.
- Interest expenses that may have been nondeductible under federal or state tax law would reduce a U.S. investor’s QEF inclusion.
- Similarly, investment expenses (such as management fees), which would otherwise be nondeductible for U.S. investors, will reduce a U.S. investor’s QEF income inclusion. These reductions to the QEF inclusion amount are economically equivalent to a tax deduction.
- Finally, the PFIC will also block any UBTI from being realized by any U.S. tax-exempt investors.
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 any of the partners and counsel listed below.