May 21, 2017
After a period of public consultation, the European Central Bank (the “ECB”) published its final Guidance on Leveraged Transactions (the “Guidance”) on 16 May 2017. Twenty-four organisations (comprising credit institutions and market associations) commented directly on the ECB’s draft guidance. Most comments focused on ensuring consistency between the ECB’s Guidance and the 2013 Interagency Guidance on Leveraged Lending in the US (the “US Guidance”) and ensuring market viability in Europe. We wrote about potential issues raised by the ECB’s draft guidance in our last briefing; here, we discuss the most relevant changes that made the final edit and, in addition, certain points that did not change despite representations from participants during consultation on the draft guidance. The ECB also published a feedback statement (the “Feedback Statement”), which presents an overall assessment of the comments received during the public consultation and should be referred to as a useful tool when interpreting the Guidance.
As in the draft version, the Guidance is applicable to all “significant credit institutions” supervised by the ECB under Article 6(4) of the Single Supervisory Mechanism Regulation, each of whom is expected to adopt the Guidance as an integral part of their internal policies. The Guidance officially enters into force on 16 November 2017, after which date affected institutions will be expected to implement the supervisory and monitoring expectations set out therein. Each significant bank has a dedicated Joint Supervisory Team (“JST”), comprising staff of the ECB and national supervisors; an internal audit report should be drawn up and submitted to the relevant JST regarding implementation in November 2018.
Credit institutions which are not classified as “significant” and credit institutions based in EU member states which do not participate in the Single Supervisory Mechanism Regulation, such as the United Kingdom, are not subject to the Guidance.
As its name suggests, the Guidance puts the spotlight on leveraged transactions. Banks are expected to define their risk appetite and governance, as well as monitor syndication risk and the fundamental credit quality of leveraged exposures. Not only that, but banks are further encouraged to apply the same supervisory expectations to other relevant (non-leveraged) transactions, which potentially widens the scope of the Guidance.
The Feedback Statement provides that while the Guidance is not binding, it will be enforced through ongoing supervision of significant credit institutions by JSTs and “dedicated on-site inspections”. The Feedback Statement clarifies that the Guidance is subject to the principle of proportionality and should be consistent with the size and risk profile of an institution’s leveraged transaction activities relative to its assets, earnings and capital.
As a minimum, credit institutions must treat as leveraged transactions, anything which meets at least one of the following tests:
The 4.0 times leverage test is to be calculated at the consolidated borrower level unless group financial support cannot be assumed in case the borrowing entity is experiencing financial difficulties and every deviation is to be justified and documented at the time of origination, modification or refinancing. “Fallen angels” (borrowers who have exhibited a deterioration in financial performance after loan inception) are not given special dispensation if their loan is modified, extended or refinanced. In contrast, the US Guidance makes clear that nothing therein “should be considered to discourage providing financing to borrowers engaged in work out negotiations”.
Despite requests to the ECB to remove the sponsor test due to it having no quantitative application and being out of sync with the US Guidance, this test remains unchanged from the draft guidance.
Encouragingly, the ECB has (in deviation from the draft guidance) allowed some helpful relaxations in the methods for calculating Total Debt and EBITDA.
Definition of “Total Debt”: The definition of “Total Debt” now applies to total committed debt (including drawn and undrawn debt) and “any additional debt that loan agreements may permit”. Salient points as to the calculation of Total Debt include:
Definition of EBITDA: Whereas the draft guidance referred to unadjusted EBITDA, the Guidance now permits enhancements to EBITDA to be made, following requests from market participants and in line with the US Guidance. Such enhancements must, however, be duly justified and reviewed by a function at the bank that is independent of the front office. This is an operational divergence from the US Guidance, which does not require such independent review. The ECB has reserved the right to look again at the issue of EBITDA enhancements, if it feels that overly optimistic adjustments with respect to pro forma “future synergies”, “future earnings” or “run-rate EBITDA” leave investors vulnerable to the next downturn in the credit default cycle.
Exemptions: The list of excepted transactions not falling within the definition of leveraged transaction has been expanded to include loans to SMEs irrespective of their amount (provided they are not owned by financial sponsors), investment grade borrowers, financial sector entities and public sector entities. Project finance and real estate, asset and commodities financing are classified as “specialised lending” and remain outside the scope of the Guidance.
The Guidance reiterates the importance of institutions’ attention to risk appetite and governance of credit, syndication and underwriting risks of all syndicated loans (both on underwritten and best efforts basis), club deals and bilateral loans. Risk functions must have sufficient time to review all transactions and ensure that they are in line with the institutions’ respective risk appetites. The Guidance does not extend to bonds (although bonds must be included in the calculation of Total Debt). The deletion of a reference to high yield bonds with respect to the monitoring of syndication risk previously found in the draft guidance is a welcome change and is now in line with the US Guidance.
Institutions are expected to define their own acceptable leverage levels as part of their risk appetite statement. Highly leveraged transactions—those with a leverage ratio exceeding 6.0 times EBITDA—should remain “exceptional” and be “duly justified”. Although not a “bright line”, where transactions exceed approved risk thresholds or total debt is in excess of 6.0 times EBITDA, additional evidence of the involvement of senior management and the risk function is required. Deletion of a previous (harsher) requirement in the draft guidance to requiring approval from the “highest level of credit committee” allows more alignment with institutions’ own risk and governance management frameworks.
Many of the comments submitted to the ECB during the consultation period centred around consistency with the US Guidance and creating a level playing field with US banks as far as the rules are concerned. Some adjustments to details in the Guidance have allowed this to happen vis-à-vis significant credit institutions affected by the Guidance. However, some would argue that fewer European banks on the whole are affected by the ECB’s Guidance compared to the US Guidance, which applies to all federally regulated banks and US branches of non-US banks and is, therefore, wider-reaching. Furthermore, in March 2017 a US congressional representative asked the US Government Accountability Office to review certain technical questions regarding the US Guidance with a view to Congress overturning or substantially changing the US Guidance. If this goes forward, the ECB’s Guidance and the US Guidance may diverge further in the future.
Deal statistics in the US show that tighter leverage constraints have led to sponsors increasing the size of their equity contributions in leveraged buyouts, which is seen as positive. However, there has been little improvement in lending terms despite the US Guidance containing similar standards for the terms of leveraged transactions set out in the Guidance.
Another observation by reference to the US is that concerns have been raised in some quarters that the Office of the Comptroller of the Currency (overseeing national banks) has taken a more stringent approach to the implementation of the US Guidance than the Federal Reserve (which regulates major Wall Street banks), even though the US Guidance was issued by both bodies jointly. How each JST will apply the ECB Guidance will be seen over the coming periods, but there is certainly the possibility that divergences in approach between different JSTs may appear.
As regards non-bank lenders, the ECB does not explicitly address comments made by respondents who argued that the Guidance benefits non-bank lenders. The ECB’s justification is that the Guidance seeks to ensure sound risk management and supervisory expectations for leveraged transaction activities and does not establish absolute “non-pass thresholds” for banks when originating transactions.
We note that in 2015 the ECB had asked banks to submit details of leveraged loans arranged and underwritten in May 2015, and it gave lenders feedback on how their portfolios compared with other banks. This move followed a similar exercise by the Bank of England in late 2014, which concluded that no action was required. We will wait to see whether or not the Bank of England will now follow in the ECB’s footsteps; if such guidance comes to be regarded as the international norm then the Bank of England may follow.
In the meantime, whilst many Eurozone credit institutions are already likely to be following some, if not most, of the Guidance as a matter of good business practice, institutions subject to the Guidance should now assess their internal processes from the perspective of ensuring compliance. The ECB’s explicit clarification that implementation of the Guidance should be proportionate with the size and risk profile of credit institutions’ leveraged lending businesses can give banks a limited amount of comfort. However, there are many new aspects to consider, ranging from independent functions approving highly leveraged transactions and terms that might present weak structures or protections during the life of a deal, to monitoring and managing hold book exposures and secondary market activities. The ECB expects institutions to have adequate information systems capable of enabling management to identify, aggregate and monitor leveraged transactions and capture all aspects of the Guidance within the next 18 months.
 The full Guidance is available at https://www.bankingsupervision.europa.eu/ecb/pub/pdf/ssm.leveraged_transactions_guidance_201705.en.pdf
 Our article on the draft guidance is available at http://www.shearman.com/en/newsinsights/publications/2016/12/ecb-publishes-guidance-on-leveraged-transactions
 The Feedback Statement is available at https://www.bankingsupervision.europa.eu/legalframework/publiccons/pdf/leveraged_transactions/leveraged_transactions_feedbackstatement.en.pdf