The European Banking Association last night released a consultation paper that seemingly threatens to derail the European CLO market’s revival. The paper seeks to clarify the risk retention requirements set out in Article 122(a) of the Capital Requirements Directive, and on initial reading it appears to remove the possibility of using a third party to provide and retain the 5% equity requirement, sources said.

On first read, it seems the paper will have significant ramifications for the nascent CLO market given the majority of those currently ramping, and some of those who have priced vehicles, have looked to a third party to provide a solution to the skin requirement.

On page 40, the paper states that the terms ‘originator’ or ‘sponsor’ as used in Article 122a of the CRD do not fit the roles played by any of the parties involved in a managed CLO transaction. As a result, the new consultation clarifies the definition of ‘sponsor’ to include not only credit institutions but also investment firms, thereby addressing the legal problem by clearly including CLO asset managers that are investment firms into the scope of retention requirements.

In short, the consultation is tightening up the definition of ‘sponsor’ so that it can only be the CLO manager that retains the 5% equity, sources said. Furthermore, the paper stipulates that the credit institution or investment firm must be regulated.

The paper is likely to reverberate around market for some time as players assess its impact, and some are seeking to push back against the proposal, with managers already in consultation with their lawyers to get more clarity on its implications. Many questions remain, including the issue of grandfathering. “Given that [the] consultation paper does not refer to grandfathering for existing arrangements, the compliance position of these recent transactions (and of any coming relevant transactions proposed to be structured on the same basis) is not clear,” said Allen & Overy in a publication released last night.

It will take time to fully understand the impact of the proposal, and this is likely to put a halt on those managers in ramp up mode, who were intending to draw on a third party provider for the equity portion. “This is the worst case scenario for the market, which was just re-opening, and will now shut down again,” said one source.

Others are more circumspect, however, stating that while the paper will change the way managers address the risk retention issue, it will not kill the market. Some managers have warned that raising new vehicles based on the interpretation of ‘sponsor’ to allow the use of third party providers was a risky strategy from the outset, given the potential for the proposals to be changed.

Interestingly, the EBA appears to understand the consequences this new paper could have on the European market as it states that “taking into account the existing structure of the market, the identification of the retainer with the CLO asset manager may lead to a number of CLO managers facing capital constraints in fulfilling the 5% retention requirement.” It goes on to say that “…most managers of CLOs are structured so as to operate with relatively small balance sheets and, therefore, are likely to struggle to provide the resources necessary to fulfil retention requirements. This could potentially translate in the long term into a modification of the currently existing managed CLO model.”

The consultation invites comments on all the proposals put forward in the paper to be submitted by Aug. 22, 2013, and initial feedback suggests there will be a strong response from the European leveraged loan market. A public consultation hearing has been scheduled to take place in London, on July 22.

It may be that the market is thrown back into limbo until the directive is finally implemented on Jan. 1, 2014, some sources said, with the tight schedule leaving little time for market participants to prepare before the CRD IV provisions take effect. –  Sarah Husband / Sohko Fujimoto