New opportunities in the Italian CDO market

In brief…

Over the last few years, the Italian legislature has enacted several measures which have provided more flexibility in the structuring of securitization transactions as well as removing crucial barriers to the access to capital markets for Italian companies. As a consequence, the Italian securitization market has recently witnessed the realization of certain collateralized-debt-obligation (CDO) transactions.

CDO transactions allow Italian companies to have access to a new financing channel. In addition, investors may subscribe for the CDOs and rely on the securitization transaction structure, instead of having an exposure only vis-à-vis the relevant issuer. As a result, CDOs can be a new way of funding and a new opportunity to invest in the Italian market.

For this reason, considering the positive feed-back received from market participants, it is very likely that more transactions will be carried out in the next few months (including in the energy sector). However, CDOs can be quite complex and characterized by certain specific legal issues that need to be addressed.

An overview of the Italian legal framework

Italian CDO transactions took advantage of both the amendments to Law No. 130 of 30 April 1999 (the Italian Securitization Law) and the provisions relating to so-called Italian ‘minibonds’.

In particular, the new provisions of the Italian Securitization Law specified that (in addition to monetary receivables) bonds, similar securities and commercial paper are capable of being securitized, introducing the possibility for special purpose vehicles (SPVs) to directly subscribe or purchase such bonds/securities (and, therefore, allowing the realization of CDO transactions).

On the other hand, the Italian ‘minibond’ provisions removed certain barriers for Italian small and medium enterprises (SMEs) to have access to capital markets, introducing certain tax benefits and removing the quantitative limits for SMEs to issue debt instruments set out under the Italian civil code. In addition, insurance companies and pension funds are now allowed to invest in such securities.

The recent Italian collateralized-debt-obligation transactions

Following the measures described above, in July 2014 the first Italian CDO transaction took place. In particular,certain in-house providers of the integrated water service in the territory of municipalities located in the Italian Regione Veneto had side-stepped the bank loan market by (issuing and) pooling minibonds and using them as collateral for a CDO transaction (the Viveracqua transaction).

In January 2016, further in-house providers of the integrated water service of the territory of municipalities located in the Italian Regione Veneto joined the Viveracqua consortium, and therefore, such transaction structure was repeated.

By December 2017, ELITE (the London Stock Exchange Group’s business support and capital raising programme) launched the first ‘ELITE Basket Bond’. In the context of such securitization transaction, the CDO issued by the relevant SPV was made up of ten well-performing Italian ELITE companies. The ELITE Basket Bond was the first CDO transaction where the relevant issuers were not involved in the energy sector.

It should be noted that in the context of the securitization transactions described above, the relevant SPVs issued a single class of asset-backed security and, therefore, the relevant provisions (such as provisions on risk retention) of the EU regulations - which apply to securitizations whereby the credit risk is tranched in different classes of notes and there is subordination amongst such classes of notes - did not apply.

All the CDOs issued in the context of the transactions described above are credit enhanced through a mutual guarantee of the relevant companies, with such issuers leaving a certain amount as a cash reserve in the structure from the proceeds of their minibonds. These minibonds cross-collateralize the structure, covering for any potential losses. In particular, in the event of payment default of a company, the SPV is entitled to use the cash reserve provided by such defaulted company; in case such collateral is not sufficient, the SPV can also use pro rata the amounts deposited by the other companies, in accordance with the relevant transaction documents. In addition, in the two Viveracqua transactions, a further guarantee (as cash reserve) was provided by the financing arm of the Regione Veneto (in these cases, the relevant SPV is entitled to use such amount if the cash reserve provided by the relevant defaulted company is not sufficient, therefore the public entity provides a further cash reserve which is available before using (if still necessary) pro rata the sums deposited by the other companies).

The main advantages of the CDO structure for Italian companies and investors

CDO transactions may lead to many advantages for both issuers and investors, as briefly summarized below.

• In relation to Italian companies/ issuers: Certain companies in light of their financial indebtedness situation or their size, may not be able to provide a complete set of guarantees to (and, consequently, to be funded by) the potential investors. By implementing a CDO structure, this limit may be overcome, as investors may rely directly on the securitization transaction structure (and, therefore, on the overall security package and financial soundness of the relevant collateral), instead of having an exposure only vis-à-vis the relevant issuer.
• In relation to investors: Certain institutional investors (especially non-Italian entities which do not meet the legal criteria to grant direct lending in Italy) may be interested in investing in Italian bonds. By implementing a CDO structure, the relevant investor may invest in the Italian market by carrying out a single (and larger) transaction, instead of having to subscribe for each bond issued by the relevant companies in separate transactions.

Main legal issues in Italian CDO transactions

On the other hand, Italian CDO transactions are characterized by certain legal issues that need to be considered while structuring such transactions, as briefly summarized below.

• Legal requirements for the issue of bonds: The Italian legal framework provides for certain limits or for a special regime in relation to the issue of debt securities by certain types of companies (as limited liability companies (Italian società a responsabilità limitata) and companies owned by public entities). If such types of companies are to be be involved in the CDO transaction, the transaction needs to be structured (also from a legal perspective) in order to overcome such limits.
• Number of parties involved: Considering that many companies may pull together in order to conduct a CDO transaction, such structures may be characterized by a large number of issuers (as opposed to a typical securitization transaction where the transferor/ originator is generally a single entity or few entities), which may lead to more complexity (especially in terms of timing and negotiations) in the transaction.
• EU regulation provisions: Starting from 1 January 2019, the provisions of Regulation (EU) 2017/2402 (the European Regulation) will apply to European securitizations. Such measure provides for, inter alia, risk retention and due diligence requirements, a ban on re- securitizations and in relation to simple, transparent and standardized securitizations, the prohibition to include transferable securities (other than corporate bonds that are not listed on a trading venue) as underlying exposures. As at the date hereof, it is uncertain how the prohibition to include transferable securities will affect the Italian provisions relating to securitization of bonds transactions and, therefore, some guidance could be provided by Italian authorities in the coming months. In any event, the provisions of the European Regulation apply only to those securitizations whereby the credit risk associated with an exposure or a pool of exposures is tranched and, inter alia, the subordination of tranches determines the distribution of losses during the ongoing life of the transaction. As a consequence, these provisions shall not apply if a single class of CDO is issued in the context of the relevant transaction (therefore using the same scheme adopted in the previous Italian CDO transactions described above).
• Documentation of the bonds: Considering the (potential) large number of issuers/companies involved, it is crucial that the terms and conditions of all the relevant bonds are aligned with each other and with those of the CDO.
• Rating: Considering the nature of the collateral backing the CDO (ie, the bonds), it might be difficult to obtain a rating on the CDO.
• Security package: In addition to a standard security package (ie, mortgages and pledges), a mutual guarantee, as described above, may be a valid solution to be implemented in the context of such types of transactions. However, given the negotiations needed between each issuer/company and between the issuers/ companies and the investors, such a guarantee might lead to more complexity in the transaction.
• Public/energy sector: In the context of CDO transactions where companies owned by public entities are involved, the specific provisions of public/ administrative law should also apply.

Conclusion

CDO transactions are a financial structure that allows Italian companies to have access to a new financing channel. Considering the recent legislative measures and the positive feedback received from market participants, it is expected that CDOs will be consistently realized in the coming years, particularly in relation to Italian SMEs or in the energy/public sector. In particular, from both the issuers and the investors perspective, CDO transactions lead to many advantages and might be a valid tool to overcome certain limits and requirements set out under the Italian legal framework. Policymakers and market participants have been looking at ways to boost lending to the SME market across Europe, and this could provide a useful means by which to do so. On the other hand, such transactions are quite complex and are characterized by certain specific legal issues that must be taken into account by the arranger and the legal advisor during the relevant structuring process.