WHAT IS IN AN ACRONYM?

Simply stated, a "collateralized loan obligation", or "CLO", is a debt security collateralized by commercial loans. Perhaps more commonly, however, the term "CLO" is used to refer to the entire structured finance transaction in which multiple classes of debt or equity securities are issued by a special purpose vehicle (an "SPV") whose assets consist principally of commercial loans.

In its pure form, a CLO can be distinguished from its transactional cousins with similar-sounding names: a "CBO" or "collateralized bond obligation", in which the underlying assets consist of corporate bonds, and a "CMO", or "collateralized mortgage obligation", in which the underlying assets consist of mortgage loans.

While these types of transactions are distinct in concept, in practice particular deals frequently contain a mix of bonds and secured and unsecured commercial loans. Accordingly, some market participants have adopted the use of the more generic term "collateralized debt obligation", or "CDO", either to encompass the entire universe of CLOs, CBOs and CMOs, or to describe specific transactions with "hybrid" collateral, such as high-yield bonds and secured loans. While the use of this more expansive term may be desirable and ultimately prevail, the market generally continues to attach the terms "CLO", "CBO" and "CMO" to transactions involving hybrid collateral, with the choice of term depending on the predominant type of collateral.

INTRODUCTION

The past two years have seen the dramatic emergence of an important new asset securitization structure—the bank-sponsored collateralized loan obligation, or "bank CLO." Beginning with the $5 billion R.O.S.E. Funding No. 1 Ltd. transaction sponsored by National Westminister Bank PLC in November 1996, a number of banks have used CLOs to dispose of sizable portions of their commercial loan portfolios. ² According to one rating agency, sixteen bank CLO transactions, accounting for $34.1 billion of rated securities, were closed in 1997. ³ Most market observers expect the market to expand significantly in 1998 and beyond.

Bank CLOs enable banks to sell portions of large portfolios of commercial loans (or in some cases, the credit risk associated with such loans) directly into the international capital markets, and offer banks a means of achieving a broad range of financial objectives, including the reduction of regulatory capital requirements, off-balance sheet accounting treatment, access to an efficient funding source for lending or other activities, and increased liquidity. To date, most bank CLOs have been very large transactions—typically ranging from $1 billion to $6 billion—undertaken by very large international banks, including banks based in the United Kingdom, Japan, France, Belgium, Canada and the Netherlands. In late 1997, NationsBank entered the market with a $4.2 billion CLO, and thereby became the first (and, as of this writing, the only) U.S. bank to complete a significant CLO in recent years.

The very large size of bank CLOs to date reflects in part the rather significant up-front transaction costs involved in completing a CLO. As more and more of these transactions are done, the up-front expenses should decline as transaction participants and the market become more familiar and comfortable with the CLO "technology." While the need to minimize credit and other risks through diversification of the loan pool ultimately limits the degree to which small portfolios may be securitized, it may be expected that progressively smaller transactions will be achievable, and that the universe of banks that can profitably use the CLO technology will increase significantly.

This article summarizes the benefits to banks of undertaking a CLO, discusses important rating agency and legal considerations affecting the structuring of a CLO, and describes the steps required to complete a CLO transaction.

Before considering the benefits and costs of undertaking a CLO, it is useful to describe in a summary fashion the structure of a typical bank CLO ⁴. In a typical bank CLO transaction, the sponsoring bank transfers the subject loan portfolio in one or more steps to a bankruptcy-remote special purpose vehicle (an "SPV"), which in turn issues asset-backed securities consisting of one or more classes (sometimes referred to as "tranches") of rated debt securities, one or more unrated classes of debt securities that are generally treated as equity interests, and a residual equity interest. The tranches of a CLO typically have different interest rates and projected weighted average lives, and may have different credit ratings, to appeal to different types of investors. The SPV sells the rated debt securities and simultaneously uses the proceeds to purchase the loan portfolio from the sponsoring bank. ⁵ A portfolio manager, usually the sponsoring bank or an affiliate thereof, is appointed to service and manage the loans on behalf of the SPV.

Most bank CLOs are sponsored as "cash flow" transactions in which the repayment, and ratings, of the CLO debt securities depends on the cash flow from the underlying loans. ⁶ Some bank CLOs are self-liquidating, and provide for all loan payments to be paid through to investors as principal and interest on the debt securities. Other bank CLO transactions provide for the reinvestment of loan payments in additional loans to be purchased from the sponsoring bank or other sources. After the initial reinvestment period, the CLO enters an "amortization period" when loan proceeds are used to pay down the principal of the CLO debt securities.

In a prototypical CLO, the underlying assets collateralizing the CLO's debt securities consist of whole commercial loans. In real-world transactions, the underlying assets almost always consist of a more diverse group of assets which may include, participation interests, structured notes, revolving credit facilities, trust certificates, letters of credit, bankers' acceptances, synthetic lease facilities, guarantee facilities, corporate bonds and asset-backed securities. In addition, some recent transactions include "credit-linked notes", which are notes the payment terms of which relate to, but are not necessarily identical to, the payment terms of specific loans owned by the sponsoring bank, but which are not included in the transaction. Credit-linked notes can be used as collateral in lieu of the related commercial loans where the actual loans cannot be assigned without the consent of the borrower or another loan participant, or can be used to create derivative instruments with terms that more closely match the payment characteristics desired by investors than those of the actual loans.

One or more forms of credit enhancement are almost always necessary in a CLO structure to obtain the desired credit ratings for the most highly rated debt securities issued by the CLO. The types of credit enhancement used by CLOs are essentially the same as those used in other asset- backed securities structures -- "internal" credit enhancement provided by the underlying assets themselves, such as subordination, excess spread and cash collateral accounts, and "external" credit enhancement provided by third parties, principally financial guaranty insurance issued by monoline insurers. Most bank CLOs to date have relied on internal credit enhancement.

Bank CLOs can further be divided into "linked" and "de-linked" structures. In a linked structure, the sponsoring bank provides some degree of implicit or explicit credit support to the transaction as a means of improving the credit rating of some or all of the tranches in the transaction—that is, the credit rating of the debt securities issued by the CLO is "linked" to that of the bank. While such credit linkage may improve the pricing of a transaction, the provision of credit support by the sponsoring bank may constitute "recourse" for risk-based capital purposes, thus increasing the capital cost of the transaction to the bank and, if the transaction is being undertaken to reduce the bank's risk-based capital requirements, frustrating or even negating the intended capital benefit. In contrast, in "de-linked" structures, the CLO issuer relies entirely on the underlying loan assets and any third-party credit enhancement for its credit ratings—that is, the credit rating of the debt securities issued by the CLO is independent of that of the bank.

Finally, CLO issuers often use a variety of hedging instruments, including interest rate swaps, currency swaps and derivatives, to hedge against fluctuations in interest rates, currency values and other risks. Such instruments may also be used to address cash flow "mismatches" between the payment characteristics of the CLO debt obligations and the underlying loans, such as differences in frequency of payments, payment dates, interest rate indices (sometimes referred to as "basis risk") and interest rate reset risk.

The following chart shows the structure of a simple CLO transaction:

BENEFITS TO BANKS OF CLOs

Banks have used CLOs to achieve a number of different financial objectives, including the following:

1. Reducing Risk-Based Capital Requirements. Under the risk-based capital standards adopted by the banking regulatory authorities in the G-10 countries pursuant to the so- called Basle Accord formulated in 1988 by the Basle Committee on Banking Supervision, ⁷ banks in most developed countries are required to maintain risk-based capital of 8% of the outstanding balance of most commercial loans. ⁸ The 8% capital requirement is generally the highest percentage of capital required to be held against any asset type. Considering that margins on commercial loans are usually relatively small, the high risk-based capital requirement makes holding commercial loans, especially those of investment grade quality, not a particularly profitable or efficient use of capital for most banks. Using a CLO to securitize and sell a portfolio of commercial loans can free up a significant amount of capital that can be used more profitably for other purposes, including holding higher yielding assets, holding lower risk-weighted assets, making acquisitions, paying dividends and repurchasing stock.

By way of example, a bank with a $1 billion portfolio of commercial loans is required to maintain risk-based capital of 8%, or $80 million, against that portfolio. If the bank is able to complete a CLO transaction in which it is able to sell all of the debt and equity securities of the CLO for cash on a break-even basis, the bank will free up $80 million of regulatory capital that can be used for other corporate purposes or to support the origination or purchase of another $1 billion portfolio of commercial loans, or the origination or purchase of $2 billion of 50% risk-weighted assets (such as residential mortgage loans), or $5 billion of 20% risk-weighted assets (such as FNMA or FHLMC securities).

It should be noted that the risk-based capital benefit of a CLO transaction may be reduced or altogether eliminated if the sponsoring bank or an affiliate retains all or a portion of the subordinated debt securities or equity securities of the CLO issuer, or otherwise guarantees or provides credit support to the transaction. Under the risk-based capital guidelines as in effect in the U.S., a bank that retains such a subordinated or equity security, or provides credit support for sold assets, is generally treated as if it had retained the credit risk of the entire portfolio of sold assets, unless the bank's retained interest is less than the capital requirement applicable to the sold assets, in which case, under the so-called "low level recourse" rule, ⁹ the bank must maintain capital on a dollar-for-dollar basis against the retained security or credit support liability. Thus, if the bank retains subordinated and/or equity securities of $80 million in the hypothetical $1 billion CLO, it will be required to maintain the same amount of risk-based capital as it would had it not done the CLO transaction at all. If, on the other hand, the bank retains subordinated and/or equity securities of $25 million, it will be required to maintain capital of $25 million, and will have freed up $55 million of risk-based capital in the transaction.

Obviously, the low level recourse rule provides a powerful incentive to banks to structure CLO transactions so that most, if not all, of the subordinated debt and equity interests of the CLO issue are sold or transferred to parties not affiliated with the bank. ¹⁰ As discussed below, the operation of the low level recourse rule must be considered in structuring any bank CLO transaction.

2. Increasing Liquidity and Lending Capacity. Banks can free up not only risk-based capital, but cash, by securitizing and selling a portfolio of commercial loans. The funds generated by a CLO can then be reinvested in additional commercial loans (which may be expected to result in origination fee income) or in other higher-yielding or lower-risk weighted assets or can be used for other corporate purposes. Depending upon market conditions, a CLO can be a very attractive source of funding for other bank lending activities.

3. Accessing More Favorable Capital Market Funding Rates. Banks with relatively low credit ratings can use CLOs to access higher-rated funding markets than would be available to them on a direct borrowing basis. Since many CLOs create one or more substantial tranches of AAA-rated securities, a bank with a rating of, say, "B" or "BB" can securitize a portfolio of loans with an implicit overall rating of "BBB", and create a "AAA" piece equal to perhaps 92% or 93% of the portfolio balance. Even if the smaller, lower-rated securities created in the CLO must be sold at a slight discount, the premium paid by the marketplace for the "AAA" piece can yield a "all-in" execution for a low-rated bank which is more favorable than the bank could achieve as a direct borrower.

4. Improving ROA and ROE. A bank may use a CLO to rapidly shrink its balance sheet if it uses all or a portion of the proceeds of the CLO issuance to reduce liabilities. A CLO's impact on a bank's balance sheet can be quite significant, especially when undertaken on the multi- billion dollar scale that has become the norm. Considering that commercial loan portfolios securitized in bank CLOs are often higher credit quality and therefore relatively low-yielding assets, the combined impact of reducing bank size and increasing the proportion of relatively higher-yielding assets on a bank's balance sheet can significantly improve a bank's return on assets, return on equity, and other financial ratios.

5. Reducing Exposure to Credit Concentrations. Banks in most jurisdictions are subject to "loans-to-one-borrower" or "lending limit" regulations that limit the amount of credit exposure a bank can have to a single borrower and its affiliates. ¹¹ Moreover, as a matter of general safety and soundness, most banks attempt to limit their exposures to particular concentrations of credit risk, which may include concentrations of loans to particular borrowers, or to groups of borrowers in particular industries or geographic regions. A CLO may provide banks with an efficient means of transferring credit concentrations to investors who are not over-exposed to such concentrations. (By the same token, a bank may consider purchasing CLO debt securities to obtain access to particular credit segments in which they are under-exposed, or generally to further diversify their own portfolios.)

6. Managing Other Balance Sheet Characteristics. Banks use CLOs to manage various balance sheet characteristics in addition to credit risk, such as spread, liquidity and concentration of assets tied to a particular index, such as LIBOR. By securitizing assets having characteristics which are over-represented in the portfolio, and originating or purchasing assets which are under-represented, bank managers can fine-tune the financial profile of the balance sheet.

7. Preserving Customer Relationships. CLOs permit banks to transfer credit risk while preserving relationships with borrowers. A significant disadvantage to a bank of selling loans on a whole loan basis is that the purchaser of the loans (usually another bank) will then have an opportunity to establish a relationship with the borrower and thus usurp the selling bank's customer relationship and prospects for future business. In a CLO, the portfolio manager or loan servicer is typically the sponsoring bank itself or an affiliate, so that the borrower generally need not even be aware that the loan has been sold. Even if the borrower must be notified of the transfer (as may be required in some jurisdictions to effect a true sale of the loan to the CLO issuer), the transfer will not usually give the investors (or any other bank) a basis for establishing a relationship with the borrower. Most banks consider the ability to continue to deal with their customers to be a major advantage of a CLO over other possible methods of disposing of their loans.

8. Competitive Positioning for the New Financial Marketplace. One of the most compelling reasons for a bank to undertake a CLO is somewhat more subjective than the financial and regulatory objectives described above. It is widely observed that the commercial banking markets and the global capital markets are rapidly becoming integrated, fundamentally changing the mechanisms for funding business activities. Many of the world's premier investment banks have created formidable commercial lending units, and many of the world's largest commercial banks are actively involved in investment banking. In addition, as demonstrated by the pending Citicorp/Travelers combination, insurance companies are increasingly involved in both the commercial banking and investment banking arenas. Continuing regulatory reform in the United States and other countries is expected to foster the further melding of the commercial banking, investment banking and insurance businesses toward an integrated financial services industry. Equally as dramatically, the advent and evolution of the financial technology of securitization over the past 15 years or so have enabled banks and their customers to directly access the global capital markets through the asset-backed capital markets and the direct issuance of asset-backed securities.

A new, more efficient market for the funding of financial assets is clearly emerging.

In this new market, many banks are concluding that their expertise and strength lies in analyzing the credit of borrowers and structuring and originating loans, but not necessarily in holding the loans in portfolio. At the same time, there is an ever-increasing community of global investors— including mutual funds, large banks, pension funds, insurance companies and governments—that are eager to invest in structured securities backed by bank-originated financial assets.

Banks positioning themselves to be players in this emerging market may find it advantageous to establish a regular program of securitizing and selling their commercial loans through CLOs. The banks that pioneer the use of CLOs as an ongoing business strategy may be expected to have an advantage in establishing a market presence and reputation, and developing a diversified constituency of loyal investors that can be tapped in future transactions.

It should be acknowledged that many of the reasons set forth above for a bank to consider a CLO also apply to a traditional, straightforward sale of loans to another bank or investor. For example, traditional whole loan sales or participation sales can also be used to reduce risk-based capital requirements, increase liquidity, shrink balance sheets and reduce credit concentrations. However, CLOs provide many advantages over traditional loan sales, including access to a much broader investor base, the ability to package and dispose of a very large amount of assets in a single transaction, and the use of securitization technology—such as "tranching" on the basis of both maturity and credit risk—to meet the demands of particular investor groups and thus to increase the overall value of the portfolio. Moreover, several of the benefits listed above—namely, the ability of low-rated banks to access the upper reaches of the credit markets and the use of CLOs to establish an ongoing program of funding through the global capital markets—cannot be achieved through traditional loan sales.

The major investment rating agencies ¹² play a critical role in the structuring of CLOs, as the principal function of a CLO is to "convert" typically unrated commercial loans into highly rated debt securities that will be attractive to institutional investors. While each rating agency claims its own particular approach to analyzing CLO transactions, their approaches are very similar. In general, the rating agencies will evaluate the proposed structure, assess the expected default and loss performance of the loan portfolio, review the credit standing of third-party credit enhancers, hedge providers, portfolio managers and other transaction parties, and evaluate the various legal and bankruptcy risks posed by the transaction (discussed below).

The rating agencies have all published detailed guidance on their procedures for rating CLOs and CBOs, ¹³ which this article will not undertake to repeat. However, it is useful to highlight the principal rating agency concerns in rating CLOs.

1. Assessing Credit Risk of Underlying Commercial Loans. Obviously, a rating agency's assessment of the credit quality of the underlying commercial loans collateralizing a CLO transaction is a critical component of the rating determination. Historically, the difficulty of quantifying the credit quality of the commercial loans to be included in a CLO transaction has proved to be a major impediment to obtaining an acceptable rating for CLO transactions. In CBO transactions, which have structures that are virtually identical to those of CLOs, the underlying bonds collateralizing the CBO obligations usually have pre-existing credit ratings, which permit the rating agencies to analyze the proposed CBO structure by reference to the known ratings, thus simplifying considerably the credit analysis required to assign ratings to the transaction. In contrast, commercial loans are not generally rated by the rating agencies, and the task of assessing the credit quality of what may be a multi-billion dollar portfolio on a loan-by-loan basis can be quite daunting. Moreover, given the relatively high loan amounts and the differences in terms of commercial loans, the historical data maintained by banks with respect to delinquency and loss experience of their commercial loan portfolios are not generally considered by the rating agencies to be as reliable or predictable as such data may be for other, more fungible assets that are routinely securitized by banks, such as residential mortgage loans and credit card receivables.

This impediment to securitization of commercial loans has finally been removed in recent transactions because of new methodologies developed by the rating agencies to correlate their investment rating categories to a lender's internal credit rating system and/or loan underwriting criteria. Banks undertaking a CLO for the first time can expect to spend a considerable amount of time working with the rating agencies to establish this correlation. Nonetheless, this effort is far less time consuming than undertaking a loan-by-loan credit analysis of the borrowers in an entire portfolio and, once a correlation methodology has been established for a particular bank, the rating process on future transactions should be significantly simpler.

2. Diversity of Loan Portfolio. The rating agencies also take into account any concentration of loan characteristics that could affect the credit risk of the loan portfolio to be securitized. Concentrations of loans with the same or related borrowers, borrowers in the same or related industries, or borrowers in the same geographic area are viewed as increasing the risk of a portfolio, and usually result in rating agencies requiring additional credit enhancement. Generally speaking, the adverse impact of concentrations of loan types is decreased by diversification of the loan portfolio, which may be achieved by increasing the portfolio size and/or decreasing the average size of a loan. The desire to maximize the diversification of a CLO portfolio, and thus achieve favorable credit enhancement levels, may partially explain the large size of CLO transactions to date.

3. Due Diligence. The rating agencies and other participants in the transaction (particularly the underwriter or placement agent) will undertake extensive due diligence of the sponsoring bank, the portfolio manager (if not the sponsoring bank) and the loan portfolio. The due diligence of the sponsoring bank is likely to include an in-depth review of the bank's underwriting, origination and collection policies and practices, and its historical portfolio performance. This portion of the due diligence usually includes in-person interviews with bank officers and employees and a field inspection of the bank's facilities, as well as a review of policy guides and statistical information.

The rating agency may also undertake a limited review of sample loan files to identify documentation issues and to confirm that the information in the loan files matches the loan schedules and other data provided to the rating agency. Generally, the underwriter or placement agent and the issuer's counsel will require an even more in-depth review of the loan files to confirm, or even to generate, the detailed information that will be required to be included in the private placement memorandum and other disclosure materials regarding the transaction, to verify that the loans comply with established eligibility criteria and to review requirements for a transfer of an interest in the loan through assignment or participation. For a further discussion of the items likely to be reviewed in this detailed loan file review, see "Implementing a Bank CLO Transaction" below.

LEGAL CONSIDERATIONS

Banks contemplating a CLO transaction should be aware of several significant legal issues that need to be considered in structuring a CLO. The rating agencies generally require satisfactory legal opinions addressing these issues.

1. Bankruptcy/True Sale Issues. As is typical for asset-backed securities transactions, the rating agencies will require that the CLO issuer be established as a bankruptcy-remote SPV. The charter documents of the CLO issuer will limit its activities to acquiring loans to be used as collateral, issuing debt and equity securities, entering into contracts with third party service providers such as credit enhancers, and related ancillary activities.

As is the case in most asset-backed securities structures, the rating agencies will usually require a legal opinion to the effect that there has been a "true sale" of the underlying loans from the sponsoring bank to the SPV issuing the CLO debt securities and, if the sponsoring bank retains any interest in the CLO issuer, a "nonconsolidation opinion" to the effect that, in the event of the insolvency of the bank, the assets of CLO issuer will not be consolidated with those of the bank under the "substantive consolidation" doctrine of applicable bankruptcy law. The point of these opinions is to provide comfort that, in the event of the receivership or bankruptcy of the sponsoring bank, the receiver, the bankruptcy trustee or the creditors of the bank will not be able to claim an interest in the loan collateral and thereby defeat or interfere with its value as collateral for the CLO debt securities.

In most jurisdictions, the question of whether loans have been "sold" in a manner that puts them beyond the reach of creditors of the transferor is complex, and requires analysis of all of the facts and circumstances of the transfer. The law firm issuing the true sale and nonconsolidation opinions will examine and analyze all aspects of the structure and proposed operation of the CLO, and typically will deliver a lengthy, "reasoned" opinion to the rating agencies. Most of the true sale issues raised by a CLO structure are the same as those posed by asset securitization structures generally, and do not require separate discussion here. ¹⁴ However, there are several "true sale" related issues that are particularly associated with bank CLO structures and that should be considered by any bank contemplating a CLO. These are discussed below:

A. Inclusion of Loan Participations. The loan portfolios of many banks include participation interests in loans originated by themselves or others. In a typical participation, the bank originating a loan will sell a "participation interest", representing a partial ownership interest in the loan to another bank. Typically, the creation and sale of such a participation is done without the agreement of the borrower to be bound by the arrangement, so the borrower remains in contractual privity with only the originating bank. If a bank transferring a participation interest to a CLO issuer or the originating bank (if different) becomes insolvent, there is a concern that, if the participation interest were not truly sold to the CLO issuer, the participation would be deemed by a bankruptcy trustee or receiver to be property of the selling or originating bank's estate, and amounts paid by the borrower to the selling or originating bank would be captured in the insolvent bank's estate, and therefore would be unavailable to support payments on the CLO's debt obligations.

There is no easy solution to this problem. Generally, the perceived risks posed by participations are most easily dealt with in "linked" CLO transactions, in which the bank's credit rating (and thus the likelihood of insolvency) is considered in the rating of the CLO debt obligations. However, in an increasing number of de-linked transactions, including the recent NationsBank CLO, the rating agencies have permitted the inclusion of so-called "100% participation interests" issued by the selling bank in reliance on legal opinions to the effect that the CLO issuer, as holder of the 100% participation interests, had an enforceable ownership or security interest in the related whole loans. ¹⁵ Banks considering the inclusion of loan participations in a CLO transaction should consult the rating agencies and counsel early in the process to determine the extent to which the participations may be included, and how their inclusion will affect the rating analysis.

B. Set-off Rights. Under long-standing common law and, in some jurisdictions, statutory law, a borrower from a bank may have the right to "set-off" the amount of any deposits of such borrower held by the bank against the amount of the loan. This principle is an example of the doctrine of cancellation of mutual debts, which holds that when two parties owe money to each other, one party may offset his obligation against the amount owed to him, so that only the net amount is owed. While borrowers usually waive their set-off rights as part of standard loan documentation, there is a concern that the waiver may not be effective in all circumstances. Moreover, the FDIC, as receiver of U.S. banks, has been known to permit (and, indeed, encourage) borrowers to offset deposits against their loans, effectively canceling outstanding deposits and thereby reducing the FDIC's liability to repay depositors pursuant to federal deposit insurance. In CLO transactions involving U.S. sponsoring banks, there is a concern that the FDIC has a strong incentive to challenge the true sale characterization of loans or participations transferred to CLO issuers in order to keep such loan assets available to create set-off rights against deposits.

The rating agencies may address these issues in two ways. First, as is the case with participations, in "linked" structures the rating agencies may factor the risk of the sponsoring bank's insolvency into the rating determination. In addition, with respect to both "linked" and "de-linked" structures, the rating agencies may require the establishment of reserves as part of the CLO structure to provide coverage for borrower and FDIC set-off risk.

C. Application of FIRREA to U.S. Banks. In the U.S., banks and savings associations are generally excluded from the coverage of the federal bankruptcy laws. Rather, depository institutions whose deposits are insured by the Federal Deposit Insurance Corporation (the "FDIC") are subject to the receivership provisions of the Federal Deposit Insurance Act (the "FDI Act"). The FDIC has issued a policy statement indicating that it will not seek to avoid an otherwise legally enforceable and perfected security interest, provided that certain requirements are met. ¹⁶ Accordingly, when a U.S. bank or savings institution is the transferor of assets in an asset-backed securities transaction, the rating agencies generally require, in lieu of a "standard" true sale opinion, a so-called "FIRREA opinion" (named after the Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA"), which amended the receivership provisions of the FDI Act) to the effect that the SPV has a perfected security interest in the securitized assets and that, upon the insolvency of the bank, the FDIC, as the receiver of the bank, would respect the security interest therein granted to the SPV. Similarly, the nonconsolidation opinion required when the parent of the CLO issues is an FDIC-insured bank is somewhat more complicated than is the case when the parent is subject to the U.S. bankruptcy laws, and must take into account significant jurisdictional and doctrinal issues regarding the extent of the FDIC's powers with respect to failed banks and their subsidiaries.

D. State Law Receivership Issues. As previously noted, banks and savings associations domiciled in the U.S. are generally excluded from the coverage of the general corporate bankruptcy laws, but are subject to federal receivership laws administered by the FDIC. The banking laws of most states of the U.S. also empower state banking authorities to seize and administer insolvent or grossly mismanaged banks under the their jurisdiction; however, through a combination of federal and state laws, the FDIC is virtually always appointed as the receiver for FDIC-insured banks. State bank receivership laws may also be relevant for state banks since the FDIC, as conservator or receiver of a state chartered bank, has the powers and duties conferred by applicable state law.

State banking laws are of particular importance, however, when the bank entity transferring assets to a CLO is located in the U.S. but is not subject to the FDIC's receivership provisions— principally, where the transferor is a U.S. branch or agency of a foreign bank. In these cases, the powers of the state banking authorities must be scrutinized to determine whether additional steps should be taken to ensure that the transferred loans will be treated as truly sold, will not be substantively consolidated with the assets of the sponsoring bank or its affiliates, and will not otherwise become subject to any extraordinary power of the state banking authorities. In some states—including New York, whose state banking law gives the New York Superintendent of Banks powers similar to the "automatic stay" of the U.S. Bankruptcy Code—these laws may require the use of "two-step" or "two-tier" transfers of assets to effectively remove the transferred assets from the jurisdiction of the state banking authorities. In such structures, the assets are first transferred in a true sale from the selling bank to a separate bankruptcy-remote SPV, which then transfers the assets to the CLO issuer.

2. Perfection Issues. As described above, rating agencies and investors are concerned that transfers of the underlying commercial loans from the sponsoring bank or other loan sellers to the CLO issuer constitute "true sales", such that the CLO issuer obtains the ownership interest in the loans. A similar concern arises with respect to the transfer of the commercial loans from the CLO issuer to the trustee for the CLO trust. In this case, the transfer of the loans is for security purposes only, to provide collateral for CLO debt securities, and the legal objective is to ensure that the CLO trustee will have a perfected security interest in the pledged commercial loans and any related collateral. Both types of transfers (i.e., transfers of outright ownership interests and of security interests) must be undertaken in a manner that ensures that the interest of transferee is "perfected," or generally protected from the claims of other purported owners or transferees of the collateral. This requires the identification of the jurisdiction or jurisdictions whose law applies to the perfection of the security interests. This determination is often a complicated issue in CLO transactions, which typically involve many jurisdictions. Second, the determination requires an analysis of the types of property that make up the commercial loan and related collateral. In fact, these questions are inter-related, as the determination of the property type of the collateral will often determine the jurisdiction whose law governs the perfection of the ownership interest or security interest.

While a commercial loan is often perceived from a business standpoint as a single, discrete item of property, from a commercial law standpoint a commercial loan may be characterized as a bundle of related property rights and types, evidenced by a number of agreements and other documents constituting a loan file. The most important loan document, of course, is the promissory note or other agreement by which the borrower agrees to repay the loan. In most cases, this is in fact a promissory note, which constitutes an "instrument" under Article 9 of the Uniform Commercial Code (the "UCC") as in effect in most states of the United States. In some cases, however, the loan may be evidenced by a contract or agreement which does not meet the technical definition of an "instrument", in which case it will likely be viewed as a "general intangible". In the case of most commercial loans, there are a number of ancillary documents and rights, such as security agreements, assignments of leases and rents, guarantees, lock box agreements and the like, most of which are likely to be characterized as general intangibles.

In the United States, perfection of a security interest in an "instrument" is generally accomplished by transferring possession of the instrument to the secured party or its agent. Accordingly, in a CLO transaction in which whole loans, rather than participation interests, constitute the collateral, the underlying promissory notes are required to be physically delivered to the CLO trustee or to a custodian acting on behalf of the trustee. In the United States, perfection of the security interest in the ancillary rights categorized as "general intangibles" is accomplished by filing a so-called "UCC-1 financing statement" with a governmental filing authority in the jurisdiction in which the chief executive office of the debtor (in this case, the CLO issuer) is located.

If, as is often the case, the debtor has connections with more than one jurisdiction and there is therefore a concern that the debtor may be deemed to have a chief executive office in more than one state, UCC-1 filings are made in several jurisdictions. In the event non-U.S. law is determined to govern these perfection issues, an analysis must be made of the applicable commercial law. In most cases, the critical issue under non-U.S. law will be whether the borrower needs to be notified of, or even consent to, the transfer of the security interest to the trustee.

Where loan participation interests, rather than whole commercial loans, are being securitized, the issues become even more complex. In these cases, there will be a desire to obtain a perfected security interest in the related participation agreement, which will most often be characterized as a general intangible, but which may have a related "participation certificate" that could be characterized as an instrument. The rating agencies will usually require an opinion that the CLO trustee has a perfected security interest not only in the participation agreement, but also in the underlying commercial loans. Not surprisingly, these perfection issues are the subject of extensive legal opinions provided at the closing of the CLO transaction.

3. Risk-Based Capital Issues. As discussed above, a likely motivation for many banks to pursue a CLO is to reduce their risk-based capital requirements. Generally speaking, a true sale of a loan portfolio from a bank to a CLO issuer which is not a subsidiary of the bank will result in the loans being removed from the bank's balance sheet for both financial reporting and regulatory accounting purposes. In the case of a straightforward sale of assets with no continuing involvement or responsibility on the part of the selling bank, the removal of the assets from a bank's balance sheet will terminate any regulatory requirement that capital be maintained against such assets. Under the risk-based capital rules in effect in most developed countries, however, a bank may be required to maintain risk-based capital even against assets sold by the bank to a third party if the transferring bank retains or accepts "recourse" with respect to the sold assets. ¹⁷

Accordingly, if a bank is undertaking a CLO transaction to reduce its risk-based capital requirement, it must take care to structure the transaction in a manner that eliminates or at least minimizes (in the case of U.S. banks subject to the low-level recourse rule) recourse to the bank. Recourse issues typically arise in bank-sponsored securitization transactions when the sponsoring bank either retains a subordinated interest in the sold loans or an equity interest in the issuer (whether or not evidenced by a security) or provides credit enhancement to the transaction through a guarantee or other credit support obligation.

In a typical CLO transaction, the equity interest in the CLO or an unrated subordinate debt obligation issued by the CLO would be viewed as recourse if retained by the bank or a bank affiliate. Thus, in planning a bank CLO transaction, the sponsoring bank will probably need to satisfy itself that most, if not all, of any subordinated interest in the loan portfolio can be sold economically to unrelated third parties. Structurally, this is usually accomplished by tranching the subordinate interests into senior subordinated interests and a junior subordinated interest, with the senior interests being sold to investors and the junior interest being retained by the bank or its affiliate.

4A Tax Issues. The most important objectives in a CLO transaction related to taxation are (i) to avoid any potential tax impairment of the securitization vehicle itself (i.e., to prevent the risk of any imposition of a vehicle-level tax, including any withholding tax, even though it might be refundable) and (ii) to maximize tax neutrality (i.e., to minimize or eliminate any incremental tax costs in implementing and maintaining the CLO structure by comparison to an "on-balance sheet" financing). Tax neutrality requires minimization or elimination of (i) taxation of the transfer of the collateral as a "sale" upon funding of the vehicle, (ii) adverse tax consequences with respect to payments from the vehicle to investors or the sponsoring bank, (iii) adverse peripheral effects upon the tax calculations of the overall non-securitization operations of the sponsoring bank, and (iv) significant administrative burdens. Achievement of these objectives typically requires intense analysis in the initial stages of structuring the transaction.

The most favorable tax structure depends on numerous variables, including (a) with respect to the loan portfolio, the booking location, situs of the borrowers, and nature of the security for the loans (e.g., real estate vs. non-real estate), (b) the nature and extent of the ramp-up or reinvestment period, if any, (c) the legal status and residency of the sponsor (e.g., domestic bank vs. branch of non-U.S. bank) and, to some extent, of the investors, (d) the relationship among (and degree of subordination of) the securities to be issued by the CLO issuer, (e) whether or not the sponsor can retain the residual (in the form of debt or otherwise) or must market it in whole or in part to investors, and (f) the administrative flexibility of the sponsoring bank. Although there are foreign marketing advantages for an offshore (typically Cayman Islands) CLO issuer and recent tax legislation has made such an issuer more administrable, traditional constraints which have remained unchanged may challenge the use of an offshore issuer in given circumstances. Alternative domestic structures include a limited liability company ("LLC"), a "financial asset securitization investment trust" ("FASIT") or, in limited circumstances, a "real estate mortgage investment conduit" ("REMIC") or real estate investment trust ("REIT"). All the circumstances must be considered in the determination of the optimum tax structure.

5A Securities Law Issues. Bank CLO transactions raise a number of issues under U.S. securities laws. ¹⁸ The principal U.S. securities law issues are discussed

below:

Ai Securities Act of 1933. The U.S. Securities Act of 1933, as amended (the "1933 Act"), generally requires the registration of public securities offerings with the U.S. Securities and Exchange Commission (the "SEC"), and imposes disclosure obligations (and related statutory liabilities for non-compliance) on issuers and underwriters. Most bank CLO offerings to date have been structured to take advantage of exemptions from the registration requirements of the 1933 Act, generally pursuant to the exemptions provided by Regulation D and Rule 144A (for certain private placements) and Regulation S (for offshore offerings to non-U.S. persons). These non-public forms of distribution have been used to reduce exposure to securities law liability, to avoid difficult SEC disclosure requirements and to provide a basis for further exemptions under the Investment Company Act of 1940, as amended (the "1940 Act"), discussed below.

Bi Investment Company Act of 1940. The 1940 Act generally applies to "investment companies" — that is, companies whose business is investing in securities, such as mutual funds. Since loans fall within the definition of "securities" for many federal securities law purposes, a CLO issuer could be viewed as an investment company subject to the 1940 Act if an exemption were not available. Investment companies subject to the 1940 Act are subject to a number of burdensome and costly restrictions regarding reporting requirements, limitations on borrowings, corporate governance and other matters, and issuers of CLOs and other types of asset-backed securities typically structure their transactions to fall within 1940 Act exemptions whenever possible. At least three 1940 Act exemptions are frequently used in CLO transactions:

(i) Section 3(c)(1): This section, which was included in the 1940 Act as originally enacted, excludes from the definition of "investment company" any company "whose outstanding securities (other than short-term paper) are beneficially owned by not more than 100 persons and which is not making and does not presently propose to make a public offering of its securities." One advantage in certain contexts of Section 3(c)(1) over the other exemptions described below is that there is no requirement that the investors have a minimum financial capacity or level of investment experience. However, this advantage is of little importance in the CLO market in its present state of development, since CLO investors are almost always very substantial, financially sophisticated institutions. The principal disadvantage of Section 3(c)(1), of course, is that it imposes a rather strict limitation on the ability of investors to sell off partial positions and thus severely limits the liquidity of the trading market for such securities. Moreover, the difficulty of tracking the number of beneficial owners imposes a practical constraint on the usefulness of this exemption.

(ii) Section 3(c)(7): This section, which became effective in 1997, excludes from the definition of investment company any company, "the outstanding securities of which are owned exclusively by persons who, at the time of acquisition of such securities, are qualified purchasers, and which is not making and does not at that time propose to make a public offering of such securities." The term "qualified purchasers," in turn, is defined to include individuals who own at least $5 million in investments, certain companies that own at least $5 million in investments, certain trusts, and, subject to certain exceptions, "qualified institutional buyers" ("QIBs") as defined in Rule 144A. While Section 3(c)(7) imposes financial capacity and sophistication requirements that are not present in Section 3(c)(1), it represents a significant liberalization with respect to the potential size of the investor group. Since the number of prospective investors is not limited under Section 3(c)(7), the use of Section 3(c)(7) may be expected to increase the liquidity of the market for CLO securities.

(iii) Rule 3a-7. Rule 3a-7 under the 1940 Act, adopted in 1992, excludes from the definition of "investment company" any company that issues non-redeemable investment grade, fixed income securities that entitle holders to receive payments that depend primarily on the cash flow from a pool of financial assets. The Rule further permits, subject to certain conditions, the sale of non-investment grade fixed income securities to certain types of accredited investors as defined in Regulation D under the 1933 Act and the sale of any securities to QIBs. Where the requirements of Rule 3a-7 are met, it is the most flexible exemption with respect to the nature of the offering because it effectively permits public offerings of at least the investment grade debt securities of a CLO. Moreover, even non-investment grade fixed income securities may be sold to "accredited investors," generally a broader category than the more restrictive "qualified purchaser" category permitted under Section 3(c)(7). This latter advantage provides greater flexibility in the initial offering of the securities since the issuer does not need to comply with the onerous private placement restrictions of the federal securities laws, and it also permits secondary trading with fewer restrictions than under other possible exemptions.

Unfortunately, however, Rule 3a-7 also embodies a significant disadvantage as compared to the other possible exemptions. Specifically, the Rule imposes several restrictions on the ability of the portfolio manager to engage in trading activities with respect to the CLO's assets, including most importantly a prohibition on acquiring or disposing of assets for the primary purpose of recognizing gains or decreasing losses resulting from market value changes. These trading restrictions limit the utility of the Rule 3a-7 exemption in CLO transactions in which active management of the CLO's asset portfolio is contemplated.

6A ERISA Issues. A thorough discussion of the application of the Employee Retirement Income Security Act of 1974, as amended ("ERISA") to securitization transactions in general, and to CLOs in particular, is beyond the scope of this article. ¹⁹ However, it should be noted that CLO transactions may give rise to a number of possible "prohibited transactions" under ERISA if securities are sold to plans because of the application of ERISA to the CLO issuer and its underlying loans or other assets. Moreover, the U.S. Department of Labor has not issued any generally applicable exemption for CLOs similar to the exemptions it has issued with respect to certain other types of asset-backed securities. Accordingly, each CLO structure must be analyzed to determine the applicability of ERISA and its exemptions to prospective investors. In general, debt securities issued by a CLO issuer will not pose difficult ERISA issues so long as the debt is highly rated and does not have substantial equity features. On the other hand, equity interests in a CLO issuer are not entitled to any generally applicable ERISA exemption, and offerings of CLO equity securities typically either prohibit or substantially limit investments by U.S. pension plans.

IMPLEMENTING A BANK CLO TRANSACTION

1A Professional Team Members. Structuring and completing a bank CLO is, particularly in the case of the initial transaction undertaken by a sponsoring bank, a significant undertaking requiring the attention of bank management and staff as well as numerous service providers. Usually, the effort will be coordinated by the investment bank that proposes to act as underwriter or placement agent in placing the CLO securities with investors (sometimes referred to in this discussion as the "structuring agent"). The sponsoring bank's outside law firm will also play a critical role in structuring and documenting the transaction and in ensuring that the legal opinions required by the rating agencies and investors can be provided. Other service providers necessary to complete a CLO may include a portfolio manager, credit enhancers, accountants, a trustee, a custodian, a paying agent and a collateral agent.

2A Structuring and Documenting the CLO Transaction. The investment bank designated as the structuring agent will usually assume the lead role in structuring the transaction. It will analyze the projected cash flows from the pool of underlying loans, and attempt to "carve" the aggregate cash flows into specific bond classes, or "tranches", that are designed to meet the then current desires of prospective investors with respect to yield, weighted average life and credit quality, among other characteristics. If one of the sponsoring bank's motivations is to reduce its risk-based capital requirement, the structuring agent will have to take care to minimize the size of any subordinated debt securities or equity interests to be retained by the bank or its affiliates. The structuring agent will work closely with the rating agencies to ensure that the securities formulated by the structuring agent will qualify for the desired ratings.

The transaction documentation for a bank CLO is conceptually the same as that for any other asset-backed securitization, but in practice may be somewhat more extensive because of the complexity of transferring large loan assets and the typical presence of multi-jurisdictional legal issues. One important document will be the offering memorandum describing the CLO debt securities and, if they are to be sold, the CLO issuer's equity securities. The offering memorandum will include detailed information regarding the transaction structure and the underlying commercial loans. This document may be prepared by either the sponsoring bank's counsel or the structuring agent's counsel, but all principal parties will of necessity be heavily involved in its preparation and review. A firm of independent accountants (which may be the sponsoring bank's regular outside accountants or, if different, the accounting firm that undertook the loan file due diligence) will be required to deliver a "comfort letter" confirming the statistical data that is shown in the offering memorandum.

The transaction documents will also include the corporate documentation required to establish the CLO issuer as an SPV, and the various asset transfer and servicing agreements required to administer the CLO trust and securities. These will include an asset purchase or contribution agreement by which the sponsoring bank will transfer the commercial loans to the CLO issuer, an indenture governing the terms of the CLO debt securities, a servicing agreement, and numerous other ancillary documents. Responsibility for drafting these documents will most likely be divided between counsel for the sponsoring bank and the counsel for the structuring agent, but, as with the offering memorandum, all of the principal parties will need to closely review and comment on the draft documents. For the actual closing, numerous assignments, consents and other documents will need to be prepared and executed to effectuate the actual transfer of loan assets to the CLO issuer.

As should be evident from much of the preceding discussion, the consummation of any CLO transaction will require the delivery of a number of legal opinions regarding, among other things, the structure of the transaction, the proper organization and legal status of the CLO issuer, trustee and other related parties, the tax consequences of the transaction, the effectiveness of the various transfers of commercial loans and related property, the perfection of security interests in the commercial loans and related property, and compliance with applicable securities law. If, as is almost always the case, the commercial loans were originated in or made to borrowers in different jurisdictions and/or the securities are being offered in more than one jurisdiction, lawyers from several or many jurisdictions will be involved in providing the required legal opinions.

While the delivery of the legal opinions is technically an event that occurs at closing, the required legal opinions need to be considered from the earliest planning stages of the CLO transaction, and the ability of the various lawyers involved to give the required opinions will often drive structuring decisions and key provisions of the operative documents. Obviously, the involvement of a number of different lawyers and law firms from the early stages of a transaction can give rise to substantial expense. To minimize this expense, it is important that a CLO issuer or sponsor involve lawyers who are familiar with securitization transactions generally and CLO transactions in particular.

3A Due Diligence. A major difference between a CLO and a CBO is the level of due diligence generally required with respect to the loan portfolio. While a CBO is typically collateralized by bonds with easily verifiable payment and credit characteristics, a CLO is usually collateralized by a large number of individual loans with non-uniform loan terms, each of which may have been modified or have a history of legal problems or complications. As discussed above, the rating agencies will either perform limited due diligence itself or rely on the more extensive due diligence undertaken by other deal participants. Similarly, the structuring agent and the sponsoring bank's counsel will want to ensure that all relevant facts about the loans are gathered, considered in structuring the transaction, and adequately disclosed to prospective investors. The loan file due diligence will generally be performed by a professional due diligence firm or the due diligence unit of an accounting firm. The items to be reviewed will include the following:

Ai Confirmation of Payment Terms. The due diligence firm will review each file to confirm that the payment amounts, payment dates, interest rates, maturity dates and other key payment terms of each loan conform to the data in the computer records provided by the sponsoring bank to the rating agencies and the structuring agent. Of course, these terms are central to projecting the cash flows from the transaction which, in turn, drive many structuring decisions.

Bi Funding Schedule. The due diligence firm will confirm that all funds have been disbursed under each loan or, if they have not been disbursed, will so note so that provision may be made to assure that any future funding obligations are satisfied.

Ci Prepayment Provisions. The due diligence firm will review each loan for any relevant prepayment penalty, yield maintenance or other similar provision that could impact cash flows and the likelihood of a loan pre-paying, so that such factors may be considered in structuring the transaction and making disclosures to investors regarding the rate at which loans are likely to be repaid.

Di Transfer Provisions. The due diligence firm will review the loan documents and any loan participation agreements for restrictions on the ability of the selling bank to transfer the related loan or participation interest that could impair the bank's ability to assign the loan to the CLO issuer. The presence of such restrictions could give rise to a requirement of obtaining the consent of the borrower or of other loan participants to the transfer or, at a minimum, a disclosure to the prospective investors regarding the consequences of not obtaining such consent.

Ei Environmental Issues. The due diligence firm will review the loan files for any indication that the loan presents any environmental issues which could interfere with the borrower's ability to repay the loan or create liability for the owner of the loan.

Fi Lender Liability. The due diligence firm will review the loan files for any evidence that the sponsoring bank could be subject to a lender liability claim by the borrower which could result in a right of offset by the borrower against the loan, or which could result in the CLO issuer being drawn into litigation regarding the lender liability issue.

Gi Servicing Issues. The due diligence firm will review the file for any evidence of improper servicing any other problems with the loan.

CONCLUSION

Considering the benefits that CLOs can provide to both sponsoring banks and investors, the CLO market will almost certainly continue to grow and evolve. Banks that enter the market early in this process may have a competitive advantage over those who wait.

This article presents a very general overview of bank CLOs. Actual transactions vary considerably with respect to structure and asset types. Banks interested in pursuing CLOs should contact an experienced investment bank or law firm for additional information on this important new securitization tool.