On 16 December 2014, the Bank of England announced the results of its “stress test” of the UK banking system covering the following eight banks and building societies: Barclays Bank, Co-operative Bank, HSBC Bank, Lloyds Banking Group, Nationwide Building Society, Royal Bank of Scotland, Santander UK and Standard Chartered.

The stress test measured the resilience of the banking sector through a hypothetical scenario involving deep recession, an unprecedented collapse of 35% in house prices, a sharp 4% rise in interest rates, a 30% fall in the value of the pound, and unemployment over a three year period commencing at the end of 2013.

The test found that the Co-Operative Bank plc, whose projected common equity tier 1 (“CET1”) result was -2.6%, was required to submit a revised capital plan. The Royal Bank of Scotland and Lloyds Banking Group just passed the 4.5% threshold with projected CET1 scores of 4.6% and 5% respectively.

It is therefore not surprising that UK banks have provided opportunities for investors in 2014 by selling off loan portfolios in an effort to shore up capital and meet the standards required.

Distressed Portfolio Transactions

Loan portfolio sales often transfer a bank's entire exposure to a set of underlying borrowers, including any hedging arrangements and agency functions. The English law governed transaction documentation is usually bespoke, with limited representations and warranties and liability thresholds as compared to the standard Loan Market Association secondary trading documentation. Buyers will generally have an opportunity to conduct greater due diligence than a standard secondary loan transaction and loans are often bi-lateral in nature, which may incur more complex transfer requirements to assign the underlying security to the buyer and ensure perfection against the portfolio of borrowers.

Buyers should be aware of any bank accounts held with the selling banks to avoid a situation where a bank has continuing security or may set-off cash at completion against outstanding loans. As fund investors are generally not regulated and authorised to accept deposits, bank accounts cannot be transferred at closing and payments of overdrafts may be required to be effected by an increase in lending to the borrowers to close out all positions at completion.

English Regulatory Requirements

A banking licence is not required under English law for an investor to lend to a UK corporate. If the loan is made to or guaranteed by an individual however, the activity may fall within the Regulated Activities Order and be subject to the rules of the Financial Conduct Authority unless it is an "Exempt Agreement".

Tax: Withholding tax on payments of UK source interest by English borrowers to foreign lenders will apply at the rate of 20% unless reduced under a Double Tax Treaty, by a domestic exemption, (which may include interest paid to banks) or, for lenders resident in a European jurisdiction, an exemption may be available under the EU Interest and Royalties Directive 2003/49/EC (the “Directive”) (click here). Relief under a Double Tax Treaty or the Directive must be applied for in order to benefit from the reduced rates or exemption, as applicable. Otherwise, the borrower will have an obligation to withhold from payments of interest at source. Under a Double Tax Treaty, borrowers can apply for a “direction” from HM Revenue & Customs. In some circumstances, obtaining a “direction” will require the lender to have a Double Tax Treaty “passport” number. Click here for the DTT Passport register. For tax queries, please contact Adam Blakemore, Partner.

Secondary Debt and Claims Trading

The secondary debt and claims trading market outside of the United States is generally conducted under English law on the standard terms and conditions of the Loan Market Association ("LMA"). For further information on the LMA trading conventions, click here.

A “Trade is a Trade” – be careful what you say!

The High Court of Justice confirmed the position that oral agreements are binding under English law in its decision in Bear Stearns Bank Plc. v. Forum Global Equity Ltd [2007]EWHC 1576 (Comm) (link to judgment). The case concerned a claims trade of Parmalat private placement notes in July 2005, where Forum (the seller) subsequently entered into a transaction to sell its holding to another entity when the notes were converted into shares of new Parmalet SpA at a higher value, arguing it did not have a binding trade with Bear Stearns. In summary, the court found that when the Bear Stearns trader put forward a“firm bid” which was accepted by Forum, the intention was to conclude a contract and this was binding upon the parties, notwithstanding that the nature of the form of purchase (i.e. LMA documentation) and other related matters had not be clearly determined.

Par v Distressed

Counterparties designate whether a trade is par or distressed and this determination is market driven as opposed to a legal test. The main considerations for traders include whether or not a borrower is making regular payments of interest ("performing"), insolvency of the borrower (claims documents required), or whether the lender believes the value of the loan to be impaired. A par debt may be traded at more or less than the principal amount, and a distressed transaction is usually traded at a sum lower than its original face value.

The main differences between par and distressed trades from a legal perspective are; (i) extent and nature of the representations and warranties, (ii) interest treatment, (iii) voting rights and (iv) settlement timeframe.

Representations and Warranties

Condition 22 of the LMA Standard Terms and Conditions for Par and Distressed Trade Transactions (Bank Debt/Claims) incorporated into the LMA form of Trade Confirmation sets out the representations and warranties of the parties. Standard mutual representations apply to both par and distressed trades including, (i) due incorporation, (ii) power to enter into the transaction and (ii) legal, binding, and enforceable obligations. General representations regarding the ownership and impairment of the asset relate strictly to the Seller.

Unlike in the U.S., the Seller in an LMA transaction makes representations as to itself and to its Predecessors-in-Title, therefore a Buyer has recourse against its immediate counterparty for a breach by a prior seller. This structure can assist liquidity of a distressed asset and avoids the legal diligence review of upstream trades. There are additional Seller representations in a distressed transaction to address the greater insolvency risk of the Borrower, including: (i) no connected parties as such term is defined in the Insolvency Act 1986 (transactions with connected parties are open to greater risk of challenge by a liquidator or administrator for being a preference or at an undervalue and have an extended risk period of two years from the date of the preference compared to six months where parties are not connected), (ii) no bad acts, (iii) no rights of set-off, (iv) no impairment, (v) no funding obligations and (vi) no proceedings against the Seller which would adversely affect the Purchased Assets.

Transfers – novation or assignment

Where a loan is made to a Borrower resident in England, security will usually be held on trust for the syndicate lenders by an Agent / Trustee in accordance with the terms of an English law governed intercreditor agreement. Novation is the appropriate method of transfer under English law as it provides for a new agreement which binds the existing lenders, the borrower and the new lender to rights and obligations equivalent to those that are released by the existing lender. Whereas assignments transfer rights, but cannot effect the transfer of obligations without the consent of the Borrower. Novations can be problematic however in countries that do not recognise trusts (for example, Spain) and may result in the release of security and the resetting of hardening periods. Careful consideration of the location of security and Borrower group is required to determine whether an assignment is more suited to the particular transfer.

LMA Funded Participations and other types of participation are a regular feature of the European secondary market due to requirements in some jurisdictions for a lender to hold a banking licence, or where a borrower withholds consent to a transfer, or to preserve voting rights in insolvency.

The LMA terms and conditions are a helpful starting point for negotiation, but distressed situations may have specific requirements that should be addressed separately by traders and which may not automatically be covered by the standard terms (for example, voting rights in restructuring prior to the settlement date, borrower jurisdiction specific legal requirements for lenders or the treatment of premium under a credit agreement).

December Update

  1. Rio Forte Investments S.A. - (“RioForte”) – on 3 December 2014, the Luxembourg Court of Appeal confirmed the decision of the court of first instance to reject Rio Forte’s application for controlled management. Bankruptcy proceedings opened on 8 December 2014, and Alain Rukavina and Paul Laplume have been appointed as liquidators. The first filing deadline for claims is 29 December 2014 and claims can be filed until 31 March 2015 (click here for the receivers’ announcement). Interest may be claimed up to 8 December 2014. For a link to the documents required and a claim form, click here. The first claims hearing is set for 15 January 2015 and disputes hearing on 26 January 2015. A public website in English and French provides information regarding the bankruptcy procedures and relevant updates. Please contact David Cottle or Tracy Dariane if you require assistance with filing claims against Rio Forte.
  2. Novo Banco – on 8 December 2014, the Banco Espírito Santo "good bank" Novo Banco announced that it has agreed to sell its interest in Banco Espírito Santo De Investimento, S.A. to Haitong Securities of China for the sum of EUR 379m. The sale is subject to regulatory approval by the Bank of Portugal and the European Commission Click here for further information.
  3. Iceland – Expectations for the Glitnir creditors' meeting on 18 December 2014were high as creditors wait on information regarding the relaxation of Icelandic currency controls or exemption for distributions in the composition proceedings. Analysts were left disappointed however, as the situation is no clearer and further details are now expected in January 2015. The Glitnir website will be updated in January to allow for information gathering from creditors with a view to making distributions.

Exit Tax - Mr. Benediktsson (head of the Icelandic Independence Party) said in a parliamentary debate that a formal decision on applying an Exit Tax would not be made without government approval. Parliament reconvenes on 20 January 2015.

The Central Bank of Iceland's economic indicators were published on 19 December 2014 (click here).

  1. Cyprus – Listing of ordinary shares: Bank of Cyprus ordinary shares were listed and admitted to trading on the Main Market of the Cyprus Stock Exchange (“CSE”) and Athens Exchange (“ATHEX”) on 16 December 2014. Shareholders trading these shares are required to have an active Investor Share Code and Securities Account with the CSE or the Dematerialised Securities System (“DSS”) of the Hellenic Exchanges.

Retail offer - The Bank also announced that “Qualifying Shareholders” may now subscribe for retail shares under the third and final phase of the share capital increase, which is intended to raise a further EUR 100 million. The subscription period is from 15 December 2014 to 9 January 2015, and the subscription price isEUR 0.24 per retail share. The retail offer is only open to shareholders on the share register of the Bank as at 21 November 2014 and is not open to shareholders who have a registered addresses in, are incorporated in, registered in or otherwise resident or located in Australia, Canada, Japan, South Africa or the US. Further details are set out in the Prospectus dated 26 November 2014.

Loan Market Association (“LMA”) Update

  1. Seminar – The LMA held a seminar on the state of the market on 2 December 2014. In Europe, they were of the view that 2015 appears to be a largely positive year for investors, with a trend towards the diversification of portfolios and an increase in issuances in the leveraged primary market. Notwithstanding regulatory challenges in Europe and a challenging macro-economic outlook, there is an emergence of new deals in the pipeline. The investor base is growing and deal structures have become a tool for demand and pricing. Compared to the European market, the US market has greater volume, higher pricing and remains more liquid, standardised and stable. Cautious investors will continue to invest in the US market.
  2. CLO Market – The CLO market for 2014 has seen a marked improvement since 2013. CLO issuance volume in Europe reportedly topped EUR 14 billion, almost twice as much as for 2013. This is in-spite of increased regulation introduced this year, such as the new EU capital requirements regulation requiring CLOs to retain a minimum level of “risk retention” at 5%. According to a survey conducted by the LMA of its members in November 2014, the majority predicted a similar level or moderate increase in CLO issuance volumes in Europe for 2015. Please click here for the results of the LMA survey. For CLO queries, please contact Stephen Day, Partner.
  3. Document Update – On 2 December 2014, the LMA updated the template Funded Participations (Par/Distressed) and the Risk Participations (Par), to include the FATCA riders published by the LMA in July 2013. There were no other changes made to the Secondary Trading Documentation. Further information can be found in the User Guide (login required).

Deal Pipeline

European Outlook 2015

ECB President, Mario Draghi, has suggested that the ECB will introduce further measures aimed at stimulating the European economy in 2015. In addition analysts predict that the Euro will fall a further 6% against the dollar, driven by the ECB focus on quantitative easing. Finally, the fall in oil prices, which will continue into 2015, will assist growth across Europe and the global economy.

We set out below some jurisdictions we expect to be of continued interest to investors in 2015:

  1. Russia – In 2014 Russia suffered due to sanctions relating to its military action in Ukraine, plummeting oil prices and a loss of investor capital. This has been compounded by the government's failure make structural reforms or to take the necessary action to tackle the financial crisis quickly. Last week saw the rouble plummet 80% against the dollar, despite a hike in interest rates of 17%, and on 22 December 2014 the Russian Central bank announced the first bailout following the rouble crisis of 230 billion roubles (USD 540 million) to Trust Bank.

Alexei Kurdin, Russia's former Finance Minister, has forecast a series of defaults among medium and large companies in 2015, and whilst he has confirmed that Russia’s banks will likely be supported by the state, he has warned that this will likely result in Russia having its debt downgraded to junk status.

A Reuters poll of 11 economists predicted that in 2015 Russia's GDP would fall 3.6%, this has been confirmed by both Mr. Kurdin and the Central Bank of Russia who have opined that at USD 60 per barrel GDP will decline by 4% or more.  

  1. Italy – Italy is struggling to emerge from the country's longest economic recession. This resulted in the country's long-term credit rating being lowered BBB- by S&P. However, it's not all bleak, as S&P predicted that the Italian economy would exit the recession in early 2015 with a modest 0.2% GDP recovery.

The primary concern for investors relates to the sustainability of Italy's debt. S&P forecasts Italy's general government debt to peak at above 133% of GDP in 2016, excluding European Financial Stability Facility guarantees, and that it will amount to 2.3 trillion Euros (USD 2.8 trillion) by 2017.

In 2014, the Italian government took steps to stimulate the lending market through the introduction of new legislation making it easier to invest in loans known as the Destinazione Italia Decree. In addition, local banks continue to provide opportunities as they seek to sell off portfolios, which may result in Italy becoming more attractive to investors.  

  1. Greece – After seven consecutive years of financial recession the Greek government had predicted that the recession would come to an end in 2014. In their World Economic Outlook the IMF confirmed that in 2015 Greece can expect to see growth and a reduction of unemployment.

The IMF’s October 2014 report has predicted that GDP will grow at a rate of 2.9% in 2015, which is up from a 0.6% GDP prediction for 2014, and the rate of inflation is set to increase to 0.3%, from the -0.8% prediction for 2014. It is also expected that the rate of unemployment will decrease to 23.8% from the 25.8%.  

  1. Portugal – For 2014 Portugal expected economic growth of 1% and was forecast at1.5% for 2015, with export growth increasing from this 3.7% in 2014 to 4.7% in 2015 and import growth slowing to 4.4% from 4.7%. Portugal’s Economy Minister, Antonio Pires de Lima, has also confirmed that the Portuguese economy may grow at the fastest rate in 2015 since before the financial crisis, if oil prices don’t rebound. If Portugal are able to buy oil 20% below the USD 96.70 a barrel budgeted, the economy would grow by more than 2% instead of 1.5% originally forecast.