01 | Global Financial Markets Insight
GLOBAL FINANCIAL MARKETS
Products • Analysis • Visionary Ideas
www.dlapiper.com | Issue 7, Q2 2015
EBA SETS OUT PRINCIPLES FOR QUALIFYING
THE EUROPEAN PERSPECTIVE
A CHANGING LANDSCAPE FOR SOVEREIGN
INTRODUCING FX DEAL CONTINGENT
CATCHING UP WITH TECHNOLOGY –
ELECTRONIC PUBLICATION AND
GET READY FOR LAUNCH –
WHAT STEPS CAN SPONSORS TAKE AT
THE OUTSET TO PREPARE FOR AN RMBS
THE ENASARCO CASE – HOW DO YOU
SECURITISATION IN NORWAY?
PRIVATE PLACEMENTS AND
THE NEW WITHHOLDING
TAX EXEMPTION – AN UPDATE
FINANCE-LINKED HEDGING –
REVIEW OF THE PROSPECTUS DIRECTIVE
02 | Global Financial Markets Insight
We understand global finance and the workings of the financial markets. For this reason we have grown to be one of the largest law firms in the world operating from every major finance centre. We use our understanding of law, regulations, market practice and financing techniques to work with you to arrange and complete on funding transactions and develop financing structures to optimise your financial objectives wherever you operate.
04 EBA SETS OUT PRINCIPLES FOR QUALIFYING SECURITISATION
14 RISK RETENTION
THE EUROPEAN PERSPECTIVE
18 A CHANGING LANDSCAPE FOR SOVEREIGN DEBT RESTRUCTURINGS
21 INTRODUCING FX DEAL CONTINGENT TRADES
22 CATCHING UP WITH TECHNOLOGY – ELECTRONIC PUBLICATION AND DISCLOSURE
25 GET READY FOR LAUNCH – WHAT STEPS CAN SPONSORS TAKE AT THE OUTSET TO PREPARE FOR AN RMBS TRANSACTION?
28 THE ENASARCO CASE – HOW DO YOU CALCULATE ‘LOSS’?
31 SECURITISATION IN NORWAY?
33 PRIVATE PLACEMENTS AND
THE NEW WITHHOLDING TAX EXEMPTION –
35 FINANCE-LINKED HEDGING – AN INTRODUCTION
38 REVIEW OF THE PROSPECTUS DIRECTIVE
This issue reflects the continuing pace of change in the global capital markets. We look at new initiatives published by the EBA to promote qualifying securitisations based on simple, standardised and transparent characteristics which may lead to reduced capital weightings and generate new activity in this market whilst additional guidance on “originator” and “sponsor” structures in European CLOs may lead to a more settled approach to this core element of the market. The hope is that these reports will now lead to measures providing a degree of stability allowing issuance to build up thereby providing additional liquidity in the European market. We also look at how best to prep a portfolio for sale or securitisation in the light of the increasing demands for simplicity and transparency.
At the sovereign level (pertinent given the existing situation in Greece) we look at new recommendations in respect of pari passu language and collective action provisions to address failed restructurings. We also look at loss and the calculation of loss in the derivatives context as the courts come to a pragmatic conclusion that in a highly structured trade it may require time and some restructuring to achieve a realisable replacement price and therefore to calculate the close out amount.
Lastly, we look at changes occurring as a result of the review of the prospectus directive and how companies will need to review their disclosure and communications policies and procedures to ensure continuing compliance with the fast changing data reporting regimes as regulators aim to keep up with changing technology and a globally integrated market requiring simultaneous data reporting and availability.
‘Global Financial Markets Insight’ is DLA Piper’s Financial Markets newsletter designed to keep you informed of products, techniques and developments in the financial market. Martin Bartlam
Editor, Head of Financial Markets Group
T +44 (0)20 7796 6309
[email protected] Mellon
T +44 (0)20 7796 6770
[email protected] Munnis
T +1 604 643 6343
[email protected] Delamere
T +44 151 237 4776
[email protected] Kantor
T +44 (0)20 7796 6034
[email protected] Godwin
T +44 (0)20 7153 7433
[email protected] Daley
Head of Knowledge Management (Finance & Projects)
T +44 (0)20 7796 6294
[email protected] Finlay
T +44 (0)20 7153 7328
[email protected] Lindblom
T +47 2413 1664
[email protected] Bae Kvendbo
T +47 2413 1558
[email protected] Lovegrove
T +44 (0)20 7796 6219
[email protected] Wright
T +44 (0)20 7153 7630
[email protected] Bodle
T +44 (0)20 7153 7246
www.dlapiper.com | 03
04 | Global F Financial Markets Insight
EBA SETS OUT PRINCIPLES
The European Banking Authority (EBA) have set out a number of recommendations
which if adopted by the European Commission could set the basis for a rebuilding of
the securitisation market based around a framework that reduces capital risk weights
for securitisation that meet a number of tests characterised as simple, standard and
THE SEARCH FOR THE MEANING OF
On 26 June the EBA published their technical advice on
Qualifying Securitisation. The industry was given the
oppor tunity to question the recommendations at a public
hearing at the EBA and a full repor t is now available.
As the dust clears following the financial crisis and
it becomes increasingly evident that many forms of
securitisation performed perfectly well* even through
stressed market conditions, regulators and policy makers
have been faced with a difficult position. Whilst it is
clear that penal capital requirements are displacing an
essential and valuable source of funding for consumers
and businesses at high costs to growth, it is far from
simple to go back on political decisions formed as the
financial system teetered on near collapse. The EBA
have attempted to find a middle path recognising that
securitisations that are structurally sound and which
provide for adequate investor analysis and understanding
of the data and risks involved should not be subject to
penal capital weightings whilst the overall treatment of
* The report highlights that according to Fitch EMEA RMBS and ABS products displayed almost zero losses during the
www.dlapiper.com | 05
the product should reflect the need for a stable financial system. On the positive front the EBA has accepted that in addition to term securitisation short term revolving structures such as Asset Backed Commercial Paper programmes (ABCP) can be included and they also expressed a willingness to consider synthetic structures in the future. The report notes that current market ABCP is almost exclusively focussed on real economy related exposures mostly financed by multi seller conducts rather than pre crisis arbitrage and hybrid conduits.
The EBA have dropped terminology relating to “quality” with the focus on qualifying characteristics recognising that applying a quality badge would stigmatise other forms of securitisation which may be structurally sound and effective to do what they are intended to do. As a result, the search for a definition of quality in the context of securitisation (somewhat reminiscent of the quest in Robert Pirsig’s Zen and the Art of Motorcycle Maintenance for the essential nature of “quality”) may be at an end.
The basic concept of securitisation is to take a pool of financial assets and legally isolate them from a range of exposures including general corporate risks that would otherwise apply to the originator. Operational risk is reduced by establishing clear servicing standards and servicer credit requirements and other related currency or interest rate risks are managed through swaps with appropriately rated counterparties and collateral management measures. Insolvency risk relating to the various entities is managed through title transfer and security arrangements. By tranching the exposure it is possible to issue notes that are subject to differing levels of risk and therefore generate differing levels of return.
This provides one of the most powerful forms of financial structuring instrument yet developed for matching funding needs with investment risk and yield objectives. The mechanics are however complex and depending on structure can be highly risk sensitive. The EBA has recognised that a one size fits all approach is not appropriate for regulating the market and has recommended a framework based on a two stage approach. Qualifying securitisation will benefit from a reduced capital requirement provided they satisfy a number of “SST” characteristics i.e. the securitisation meets standards of simplicity, standardisation and transparency. As a second stage, analysis of the underlying exposures will continue to apply based on underwriting standards, granularity and risk weights that aim to reflect the underlying asset risk. See table 1:
TABLE 1 TWO-STAGE APPROACH TO ‘QUALIFYING’ SECURITISATION
Qualifying Securitisation Framework  + 
■ No leverage
■ Legal true sale Homogenous assets
■ Retention rules
■ No acceleration or market liquidation triggers
■ Procedures on counterparty replacement
■ Identified person
■ Initial disclosure
■ CRR disclosure to investors (409 CRR)
■ Loan by loan data on underlying
■ Quarterly investor reporting
Mitigates risks of the securitisation process
Mitigates underlying risk
Underlying Credit Risk Criteria
■ Underwriting standards
■ Maximum risk weights
06 | Global Financial Markets Insight
The EBA recognised the need for the regulation of securitisation to follow an holistic approach and it is hoped that whatever the final technical standards are these reflect and avoid duplication of existing regulation as well as providing a framework that equates risk treatment across similar products and industries to avoid misalignment of capital treatment, product disclosure, costs and reporting requirements. Whatever approach is taken it should ideally be consistent with regulation in other jurisdictions (such as the US) and sectors (such as the insurance and funds market) to avoid market distorting affects. The EBA did however point out that this does not mean that the approach is necessarily exactly the same as the regulator may be addressing different risk factors in specified industry sectors.
The EBA approach is to build on key structural aspects through three pillars: simplicity; standardisation; and transparency.
PILLAR I – SIMPLICITY
The aim here is to rule out more complex structures that result in the underlying risk profile being difficult to analyse. Restrictions on leverage would rule out re-securitisations and highly geared structures whilst requirements for homogenous assets aim at clarity in the treatments of data tables and a clearer relationship between the data and likely impacts on assets resulting from changes in circumstances. See table 2.
TABLE 2 – PILLAR I – SIMPLICITY
Must be a securitisation defined in the CRR (Article 4(1) point (61)) and not a
re-securitisation (Art 4(1) point (63)).
Eligibility criteria consistently applied
Must be clearly defined eligibility criteria (including after closing) and no active portfolio management on a discretionary basis (substitutions for breach not counting as active portfolio management).
There must be a true sale or effective assignment of securitisation exposures with no significant claw back risk (confirmed by legal opinion). If later perfection, triggers are to include at a minimum (i) severe deterioration in seller’s credit quality; (ii) seller default or insolvency; (iii) unremedied breaches of obligations by seller. Need to include representations and warranties to a “best of its knowledge standard” that assets not encumbered and there are no circumstances to affect enforceability in respect of collections due.
Homogeneous exposures and originating process
The exposures must be homogeneous in terms of asset type, currency and legal system to which they are subject. The obligations arise from contractually defined periodic payment streams relating to rental, principal and interest payments or are rights to receive income from assets specified to support such payments. The exposures are originated in the ordinary course of business and are legal, valid and binding obligations of the obligor. (The report provides examples in the auto loan context of not mixing for example auto loans with auto leases).
At time of inclusion in the securitisation exposures should not include (i) disputed exposures “to the best of knowledge”; (ii) non-performing exposures (> 90 days past due or debtor assessed as unlikely to pay obligations); (iii) exposures to a credit impaired obligor;
(iv) transferable securities (as defined in Directive 2004/39/EC(MiFID) or derivatives
except derivatives used to hedge currency or interest rate risk arising in the securitisation.
TABLE 3 – PILLAR II – STANDARDISATION
At the time of inclusion at least one payment has been made by the borrower, except in the case of revolving securitisations backed by personal overdraft facilities, credit card receivables, trade receivables and dealer floor plan finance loans.
PILLAR II – STANDARDISATION
Risk-retention requirements under the Capital Requirements Regulation (CRR) address the moral risk that existed in the market pre crisis allowing poor origination standards to usher in low quality assets and inappropriate credit structures in the knowledge and expectation that these positions would be flipped to third party investors. The fact that many of the more successful and well performing ABS structures already had a degree of risk retention only highlights the point. This is picked up in the approach to standardisation along with skill requirements and treatment of counterparty risk and servicing requirements. See table 3.
The securitisation must comply with the retention requirements under the CRR (Art 405) or any non-EU jurisdiction rules assessed as equivalent.
Interest rate and currency risk mitigation
Interest rate and currency risks arising in the securitisation must be hedged or appropriately offset at all times (documentation to follow standard industry master agreements).
Interest payments to reference commonly encountered market interest rates (may include caps and floors but not reference complex formulae or derivatives).
Triggers on revolving exposures
The following triggers should apply to prevent acquisition of additional exposures:
(a) insolvency related events applicable to originator as well as servicer;
(b) deterioration of credit quality of underlying exposures to or below a pre-determined threshold;
(c) unavailability of exposures.
The following triggers should apply early amortisation, in order of seniority:
(a) insolvency related events applicable to originator as well as servicer;
(a) deterioration of credit quality of underlying exposures to or below a pre-determined threshold;
(c) the fall in the value of the underlying exposures held below a required threshold.
Payments following event of default or acceleration event
Following an event of default or acceleration event (i) the securitisation positions must be paid in accordance with a sequential amortisation payment priority in order of seniority; and (ii) there should be no provisions requiring automatic liquidation of the underlying assets at market value. (Performance related triggers should be present in transactions which feature non-sequential priority of payments, including at least the deterioration in the credit quality of the underlying exposures to below a pre-determined threshold).
www.dlapiper.com | 07
08 | Global Financial Markets Insight
PILLAR III – TRANSPARENCY
Here the emphasis is on transparency and better reporting. Providing investors with data in a useable form for analysis of the underlying risks and a regular reporting format must improve standards for risk analysis and management. As a function of providing data in a form that can be analysed this in itself should restrict the type of highly complex mathematical structures involved in re-securitisations and CDO squared structures. Initial and on-going disclosure will be regulated by the CRR and securitisations will be subject to the CRA Regulation1 and loan templates for data reporting See table 4.
Clear duties and responsibilities of trustee, servicer and ancillary service providers
This should ensure that (i) the default or insolvency of the current service provider does not disrupt servicing of the assets; (ii) on default or specified events replacement of the derivatives counterparty is provided for; and (iii) on default or specified events replacement of liquidity provider and account bank is provided for.
Fiduciary and voting
Documentation to (i) clearly identify and specify duties of person with fiduciary responsibilities who acts in best interests of investors; (ii) deal with the resolution of conflicts; and (iii) clearly define voting rights which are allocated to noteholders.
Servicer and originator expertise
Management of the servicer should demonstrate expertise in servicing underlying loans. Policies, procedures and risk management controls are to be well documented. These elements to be substantiated by a third party review for entities not subject to prudential regulation. The originator and original lender should have sufficient experience in originating exposures similar to those securitised.
Disclosure requirements (Prospectus or Prospectus equivalent information)
The securitisation must meet the disclosure requirements of Regulation (EC) No. 809/2004 implementing the Prospectus Directive with regard to the minimum information a prospectus must contain (Annexes VII and VIII). Securitisations with underlying exposures originated in any non-EEA jurisdiction are to meet equivalent requirements of that jurisdiction. Private placements do not require a prospectus but should provide information, equivalent to that which the Prospectus Directive requires for public deals.
Disclosure requirements – Investor reporting
The securitisation must meet the requirements of Art 409 CRR and Art 8(b) of the CRA Regulation (disclosure to investors) or equivalent requirements for exposures originated in any non-EEA jurisdiction.
Availability of final and draft documents
Final offering documents should be available from the closing date. Where legally possible investors should have access to all underlying transaction documents, at the latest 15 days after the closing date. Initial offering and draft underlying transaction documentation to be made available before pricing.
1 Regulation (EU) No. 462/2013 of 21 May 2013, amending Regulation (EC) No. 1060/2009 on credit rating agencies.
TABLE 4 – PILLAR III – TRANSPARENCY
Information and cash flow model
Documentation to provide clear consistent terms. Priority of payments, triggers and changes to waterfall to be clearly set out. Any change in waterfall should be reported on a timely basis at the time of its occurrence. Originator or sponsor to provide investors directly or via third parties with a liability cash flow model both before pricing and on an on-going basis.
External verification of underlying assets data
A sample of underlying assets should be subject to external verification by an independent third party, other than a credit rating agency, to verify (applying a confidence level of at least 95%) that the data disclosed to investors in any formal offering document is accurate. Confirmation of verification is required in the offering document or transaction documentation.
Available historic data
Investors and prospective investors should have readily available access to data on static and dynamic historical default and loss performance, such as delinquency and default data, for substantially similar exposures to those being securitised, covering a historical period of, at least, a complete economic cycle and, in any case, no shorter than a period of seven years for non-retail exposures. For retail exposures, the minimum performance history should be five years. The basis for claiming similarity to exposures being securitised should also be disclosed.
Loan level data
Investors and prospective investors should have readily available access to data on the underlying individual assets at a loan-by-loan level as per Article 8(b) of the CRA Regulation before the pricing of the securitisation, and on an on-going basis. Cut-off dates for this disclosure should be aligned with those used for investor reporting purposes.
Investor reporting should occur at least on a quarterly basis.
As part of investor reporting the following information should also be disclosed:
■ all materially relevant data on the credit quality and performance of underlying assets, including data allowing investors to clearly identify delinquency and default of underlying debtors, debt restructuring, debt forgiveness, forbearance, repurchases, payment holidays, losses, charge offs, recoveries and other asset performance remedies in the pool;
■ data on the cash flows generated by underlying assets and by the liabilities of the securitisation, including separate disclosure of the securitisation’s income and disbursements, i.e. scheduled principal, scheduled interest, prepaid principal, past due interest and fees and charges;
■ the breach of any triggers implying changes in the priority of payments or replacement of any counterparties.
www.dlapiper.com | 09
10 | Global Financial Markets Insight
In reaching its recommendation the EBA did drop a number of problematic proposals as set out below.
Removed EEA restrictions to allow for any jurisdiction where the regulatory framework is assessed as equivalent;
Removed compliance with the Prospectus Directive2 and included minimum content of initial disclosure as in Annexes of Prospectus Regulation3;
Removed requirement of allocating voting rights to the most senior noteholders;
Modified asset performance history disclosure requirement: 5 years (retail) 7 years (other);
Introduced ‘to the knowledge of securitiser’ within credit impairment criterion;
Introduced sufficient expertise requirement for originator/original lender;Allowed for cash-flow model to be provide by third party.
Allowed for cash-flow model to be provide by third party.
The second stage is to address criteria that will impact the credit risk of the underlying exposures. See table 5.
TABLE 5 – CRITERIA ON CREDIT RISK OF UNDERLYING EXPOSURES
Any underlying exposures should be originated in accordance with sound and prudent credit criteria as required under Article 79 of the CRD IV.
Such criteria should include at least an assessment of the borrower’s creditworthiness in accordance with Articles 18, 19 and 20 of the Directive 2014/17/EU (Mortgage Credit Directive) or Article 8 of Directive 2008/48/EC (Directive on credit agreements for consumers), to the extent that such standards would, according to their terms, in any case apply to the individual underlying exposures. Exposures originated outside the EEA should be underwritten according to rules assessed as equivalent.
At inclusion the aggregated exposure value of all exposures to a single obligor in the pool do not exceed 1% of the exposure values of the aggregate outstanding exposure values of the pool of underlying exposures at that point in time. For the purpose of this calculation, loans or leases to a group of connected clients, as referred to in Article 4(1) point (39) of the CRR, should be considered as exposures to a single obligor.
At the time of inclusion the underlying exposures should fulfil each of the following conditions:
(i) They have to meet the conditions for being assigned, under the Standardised Approach and taking into account any eligible credit risk mitigation, a risk weight equal to or smaller than:
(a) 40% on an exposure value-weighted average basis for the portfolio where the exposures are loans secured by residential mortgages or fully guaranteed residential loans, as referred to in paragraph 1(e) of Article 129 of the CRR;
(b) 50% on an individual exposure basis where the exposure is a loan secured by a commercial mortgage;
(c) 75% on an individual exposure basis where the exposure is a retail exposure;
(d) or, for any other exposures, 100% on an individual exposure basis.
(ii) Under (a) and (b) loans secured by lower ranking security rights on a given asset should only be included in the securitisation if all loans secured by prior ranking security rights on that asset are also included in the securitisation.
(iii) Under (a) no loan in the securitised portfolio should be characterised by a loan-to-value ratio higher than 100%, measured in accordance with paragraph 1(d)(i) of Article 129 and paragraph 1 of
Article 229 of the CRR.
2 Prospectus Directive 2003/71/EC.
3 Commission Regulation (EC) No 809/2004 of 29 April 2004.
SHORT-TERM REVOLVING STRUCTURES
The EBA have recognised the importance and role of ABCP and similar short term revolving structures and these are included in the scope of qualifying securitisations. Flawed maturity transformation structures relying on cheaper short term funding to support longer term asset positions without adequate flexibility of liquidity such as Structured Investment Vehicles (SIVs) and related structures have been shunned.
The ABCP structures apply criteria based on the qualifying framework for term securitisation adapted to recognise specificities of the ABCP market.
The EBA highlighted the following:
market participants can become exposed to an ABCP securitisation either at (i) the transaction level or (ii) at the programme level and therefore different sets of requirements should be applied for each;
they recognise that in (multi)-seller programmes, several different “non- regulated’ corporate entities sell exposures into a conduit;
full liquidity support facilities provided by credit institutions benefit investors in ABCP programmes; and
the need to address the maturity of the liability issued by the ABCP conduit (as per CRR) to deal with maturity transformation activity embedded in the ABCP assets and liabilities structure.
The liquidity facility provider and other parties are exposed at the transaction level therefore transaction level requirements determine eligibility to qualifying regulatory capital treatment whilst the market investor and other parties are exposed at the programme level therefore transaction level and programme level requirements determine eligibility to qualifying regulatory capital treatment.
TRANSACTION-LEVEL SST AND UNDERLYING CREDIT RISK CRITERIA:
Based on term securitisation criteria with amendments including but not limited to:
Homogeneity of currency and legal system does not apply (asset type does apply);
Portfolio granularity threshold does not apply;
Disclosure: Annex VIII (not VII) of Prospectus Regulation/any requirement under CRA Art. 8b to be developed by European Securities and Markets Authority (ESMA)/investor reporting on monthly (not quarterly) basis; and
Mortgages are not eligible and any underlying maturity capped at 1 year.
PROGRAMME-LEVEL CRITERIA INCLUDING BUT NOT LIMITED TO:
Each transaction within a qualifying programme has to be a qualifying transaction (as above);
No programme-level credit enhancement should determine re-tranching (no potential re-securitisation);
Sponsor of the programme should provide full support (credit, liquidity, other costs) as liquidity facility provider to each transaction;
Disclosure: Annex VII (not VIII) of Prospectus Regulation/at least stratified data on underlying/investor reporting on monthly (not quarterly) basis; and
1% portfolio granularity threshold applies.
REGULATORY CAPITAL RE-CALIBRATION
The EBA have taken the Basel Committee on Banking Supervision (BCBS) December 2014 proposed securitisation framework as the base line and added a qualifying dimension to reduce capital allocation where appropriate based on risk sensibility. The parameters are applied to reduce weightings across both external credit rating models and internal models. The benefit of applying to external credit ratings and internal models is that they allow for sensitivity to differing levels of risk without being prescriptive (i.e. the rating reflects the asset profile, structure and credit enhancement) which then, with adequate transparency, generates a market price. This avoids applying a minimum regulatory rating or credit step which would result in a cliff edge effect as arrangers aim to meet the regulatory capital requirements rather than optimise credit protections for an appropriate price.
www.dlapiper.com | 11
12 | Global Financial Markets Insight
TABLE 6 RECOMMENDATION ON THE RE-CALIBRATION OF THE BCBS 2014 FRAMEWORK APPLICABLE TO ‘QUALIFYING’ SECURITISATION POSITIONS
The ‘p’ parameter is re-scaled by a factor of 0.5 while preserving the prudential 0.3 floor value: Pqualifying=max[0.3; 0.5 x (A+B * (1/N)+C*Kirb+D*LGD+E*Mt)].
The supervisory parameter p is rescaled from 1 to 0.5.
Risk-weights of the ERBA look-up table for each long-term rating grade are re-scaled to keep consistency with re-scaled average risk-weights in the SEC-SA approach resulting from proposal above. The 1250% requirements of the BCBS 2014 framework remain unchanged.
Risk-weights of the ERBA look-up table for each short-term rating grade are re-scaled to keep consistency with re-scaling proposed for the SEC-ERBA approach for long-term ratings. The 1250% requirements of the BCBS 2014 framework remain unchanged.
For senior qualifying tranches only:
SEC-IRBA and SEC-SA: the risk-weight floor is lowered from 15% to 10% SEC-ERBA: the one-year and five-year risk weight floors are reduced from 15% to 10% and from 20% to 15%, respectively.
Non-senior (thin) tranche
Authored by: Martin Bartlam
All other ratings
THE EBA APPROACH
The approach adopted by the EBA to reduce proposed regulatory capital requirements by building on a set of characteristics and principles is a welcome approach provided implementation allows a mechanism for knowing that a structure achieves the required characteristics during the structuring process (rather than being subject to subjective analysis afterwards). Criteria must be sufficiently clear without being prescriptive. For example, the legal structural aspects of securitisation are often based on decades of development and are relatively well tested and robust. Differences in structure are often crafted to meet particular features of a legal system and cultural history that may have evolved over long periods of time and are often not fully suited to standardisation. Setting criteria to standardise legal structure therefore is understandable but should be sufficiently flexible to allow for already well tried solutions to adapt structures to meet specific country differences.
Hopefully the final report will provide the delicate balance between flexibility and clarity to allow the securitisation market to rebuild and re-establish itself as a trusted and stable product that can contribute to lending and growth in the European and global economies.
www.dlapiper.com | 13
14 | Global Financial Markets Insight
THE EUROPEAN PERSPECTIVE
The course of European risk retention never did run
smoothly1, from 2009 when Article 122a first raised its
head2 to the most recent installation3 where the European
Banking Authority (EBA) identified potential loopholes
caused by what it considered to be the abuse of the broad
“originator” definition under Regulation (EU) No 575/20134
(the CRR). It has been a journey of false dawns and frequent
disappointments but more recently there has been a general
feeling in the European CLO industry that we may be
entering a period of relative stability in which the industry will
have a chance to bed down some of the regulation that has
been percolating for the past 6 years. As we enter this period
it is a good opportunity to take stock of developments and
assess where European risk retention currently stands.
After a false start represented by the “Guidelines to Article
122a of the Capital Requirements Directive”5 and the
related “Q&A to Guidelines to Article 122a of the Capital
Requirements Directive”6, which although well intended
were ultimately rejected by the European parliament and the
subsequent u-turn by the EBA in its consultation paper on
the draft regulatory technical standards7 (which effectively
put an end to the then CLO industry-wide accepted
approach of allowing a third party, whose interests were
most optimally aligned with those of investors from making
the requisite retention under the CRR). The regulatory
technical standards8 published by the European Commission
on 13 June 2014 (the Regulatory Technical Standards)
finally allowed the European CLO industry to enjoy a relative
degree of certainty and created a basis on which European
CLOs (and more recently, US CLOs) could be structured.
Broadly two routes have emerged for European CLOs
to comply with the requirements of the CRR and the
Regulatory Technical Standards (together, the European
Retention Requirements), the “sponsor” route and the
“originator” route. US CLOs are limited to the “originator”
route for the reasons discussed below.
1 The course of true love never did run smoothly – A Midsummer Night’s Dream Act 1, scene 1, 132–140
2 Ultimately through amending Directive 2009/111/EC
3 European Banking Authority – opinion and report on securitisation risk retention, due diligence and disclosure dated
22 December 2014
4 Regulation (EU) No 575/2013 on prudential requirements for credit institutions and investment firms
5 Committee of European Banking Supervisors dated 31 December 2010
6 European Banking Authority – 29 September 2011
7 Published by the EBA on 22 May 2013
8 Specifying the requirements for investors, sponsors, original lenders and originator institutions relating to exposure to
Under the CRR, a “sponsor” is defined as an institution other than an originator institution that establishes and manages an asset-backed commercial paper programme or other securitisation scheme that purchases exposures from third-party entities. An “institution” can be either a credit institution or an investment firm. Collateral managers which are regulated under the Markets in Financial Instruments Directive9 (MiFID) and authorised to conduct certain regulated activities satisfy the definition of “investment firm” under the CRR and are therefore able to act as a sponsor for the purposes of satisfying the European Retention Requirements whereas non-MiFID regulated collateral managers and other non-EU regulated collateral managers (i.e. US collateral managers) are unable to satisfy the definition of “investment firm” and are therefore unable to act as a sponsor.
Although a collateral manager may have the requisite regulatory status and authorisations to act as a sponsor it is not the case that it will always have the ability or desire to finance the particular vertical or horizontal strip required under the European Retention Requirements (the Retained Interest) particularly for multiple European CLOs. The fact is that such an investment does not represent the best return on capital for a collateral manager particularly given it represents an unlevered investment.
Seeing an opportunity, a number of market participants, particularly Scandinavian pension funds, began offering secured funding to collateral managers with a reported duration of anything from 6 months to the life of the CLO.
The CRR allows the Retained Interest to be used as collateral for secured funding purposes as long as such use does not transfer the credit risk of the Retained Interest to a third party10, so any such funding must be provided on a full-recourse basis to the relevant collateral manager.
Retention funding does not come without its issues though. Should the relevant collateral manager default on its obligations under the full-recourse facility and the Retained Interest passes to the relevant lenders the CLO is likely to become non- compliant with the European Retention Requirements. In addition, collateral managers can be required to pledge fees to the lenders until the funding has been repaid.
In December 2014, Cairn CLO IV took a novel approach to the sponsor route. By establishing a new entity and ensuring that it had the relevant MiFID authorisations it has enabled Cairn Capital to raise third party funding without being subjected to the same level of scrutiny and uncertainty as the “originator” structure discussed below. Although this approach has its positives, it can take 6-9 months to go through the costly exercise of getting the authorisation and there is no guarantee that the Financial Conduct Authority (FCA) will ultimately grant the required authorisations to qualify as a sponsor.
As mentioned above, non-MiFID regulated collateral managers and other non-EU regulated collateral managers are unable to satisfy the definition of “investment firm” and therefore unable to act as a sponsor. The result is that European investors are effectively prevented from investing in US CLOs or European CLOs managed by US collateral managers. Given the strength and depth of the US CLO market it was only a matter of time before US collateral managers and European investors looked to find a solution to this situation, the result was the “originator” structure.
Under the CRR, “originator” means an entity which (a) itself or through related entities, directly or indirectly, was involved in the original agreement which created the obligations or potential obligations of the debtor or potential debtor giving rise to the exposure being securitised; or (b) purchases a third party’s exposures for its own account and then securitises them.
In most cases the relevant entity will not have been “involved in the original agreement which created the obligations” in connection with the collateral obligations that it proposes to sell to the CLO and therefore such entity will need to fall within part (b) of the CRR definition of “originator” described above i.e. an entity that “purchases a third party’s exposures for its own account and then securitises them”.
FOR ITS OWN ACCOUNT
The key question in determining whether an entity can be classed as the “originator” hangs on the meaning of “for its own account”. This term is not defined in the CRR, there are a number of similar concepts in MiFID11 and used by the FCA/PRA12 but the term itself is not defined.
9 Directive 2004/39/EC
10 Regulatory Technical Standards Article 12(2)
11 “Dealing on own account”
12 “Own account trading firm” and “own account transaction”
www.dlapiper.com | 15
16 | Global Financial Markets Insight
Given the lack of clarity, a consensus developed in the CLO market that the relevant entity would need to be exposed to the credit risk and market risk of the relevant collateral obligations being securitised for a certain period of time, this requirement became known as “seasoning”. Seasoning periods vary from deal to deal, historically these were as low as 1-2 days/business days but are now typically in excess of 10 days/business days. The duration tends to increase where the perceived alignment of interest is not robust e.g. the entity is fully funded by third party investors with little or no collateral manager funding.
It was also accepted that the entity would also need to have substance. The concept of substance also led to a lot of discussion but again a consensus developed that substance required the entity to have e.g. its own capital, various on-going lines of business (which could include providing the warehouse) and potentially earn fees, basically it needed to look more like a permanent capital vehicle than a SPV set up purely to purchase collateral obligations for on-sale to a CLO.
MEETING THE “SPIRIT” OF THE CRR
Without clear guidance under the CRR the requirements of the “originator” structure were based on market standards and consensus developed through discussions between law firms, arrangers and collateral managers. It was not until the EBA published its opinion and report on securitisation risk retention, due diligence and disclosure on 22 December 2014, that the EBA publicly aired some views on how the “originator” structure was developing. The EBA confirmed the basic premis but expressed concern in respect at overly aggressive structures where securitisation transactions had been structured so as to meet the legal requirements of the CRR but did not always meet the “spirit” of the CRR or align the interests of the originator, sponsor or original lender, as applicable, of the relevant securitisation with the interests of the investors. In particular, the EBA identified potential loopholes caused by what it considered the abuse of the broad “originator” definition under the CRR.
While the EBA did not specifically rule out the possibility of third party investors in an originator, it did state that it was of the opinion that the “originator” definition should in principal ensure that the entity claiming to be the “originator” is of “real substance and holds actual economic capital on its assets for a minimum period of time”. However, the EBA did not issue any guidance on the meaning of “real substance” or “actual economic capital” and did not specify what “a minimum period of time” would entail, other than indicating that one day would not be sufficient.
This confirmed a number of previously accepted principles in relation to the use of the “originator”. There needs to be seasoning, capital and substance and although none of these concepts were defined, market standards continue to develop based on collaborative discussions within the industry including law firms, arrangers and investment managers.
REGULATORY TECHNICAL STANDARDS
The Regulatory Technical Standards introduced a degree of certainty once finally adopted. They also introduced the concept of multiple originators which provided further flexibility for originator structures.
Article 3(4) of the Regulatory Technical Standards provides that “where the securitised exposures are created by multiple originators or multiple original lenders, the retention requirement may be fulfilled in full by a single originator or original lender provided that either of the following conditions are met: (a) the originator or original lender has established and is managing the programme or securitisation scheme; (b) the originator or original lender has established the programme or securitisation scheme and has contributed over 50% of the total securitised exposures.”
If the relevant entity set up to act as originator is not providing 100% of the securitised exposures, there will be multiple originators in respect of the CLO.
ESTABLISH AND CONTRIBUTE OVER 50% OF THE TOTAL SECURITISED EXPOSURES
The approach under Article 3(4)(b) of the Regulatory Technical Standards is the most common route used in respect of European originators. The requirement to contribute over 50% of the total securitised exposures is an on-going requirement for the life of the CLO and needs to be considered when collateral obligations are purchased and sold.
13 Initial deals implied credit risk was sufficient but recent deals indicate that investors want to see both credit and market risk
Authored by: Ronan Mellon
ESTABLISH AND MANAGE
The approach under Article 3(4)(a) of the Regulatory Technical Standards is popular for US originators. Unlike Article 3(4)(b) which applies to originators that are not managing the related securitisation scheme and requires such originators to contribute over 50% of the total securitised exposures, there is technically no minimum percentage of securitised exposures that are required to be contributed by the originator/manager, although, transactions which follow this approach can require anything from 5% to 15% (5% is becoming increasingly more common) of the total securitised exposures to be contributed by the originator/manager either on day one or over the life of the CLO, depending on the transaction.
It is important that the originator/manager has a management function and is not simply following the directions of a sub-manager (typically the relevant collateral manager), this management function also adds to the “substance” argument of the entity acting as originator/manager. It is important that activities such as selecting collateral obligations for purchase and sale and the price at which such purchase or sale occurs is made at the originator/manager level and is not delegated. The originator/manager should also be liable to the CLO in respect of any collateral management breaches relating to the duties and obligations to be provided by the originator/manager to the CLO.
Where a US originator is used the management function of the originator/manager should also be reinforced by making the originator/manager a registered investment advisor under the Investment Advisers Act of 1940 or alternatively, if full registered investment advisor status is not forthcoming, a “relying advisor”.
SO WHERE DO WE CURRENTLY STAND?
The European CLO industry is enjoying a period of relative regulatory stability, particularly in contrast to the US CLO industry which is only now grappling with risk retention and issues such as retention funding. New issuance for European CLOs is approaching €6 billion for 2015. The industry will however need to take into account comments by the European Central Bank and the Bank of England in relation to the “originator” debate and will need to monitor discussions on shadow banking which are picking up steam and a green paper and two consultation papers in circulation in relation to a Capital Markets Union. It is only a matter of time perhaps before we are digesting further changes.
14 Joint response from the Bank of England and the European Central Bank to the Consultation Document of the European Commission: “An EU framework for simple, transparent and standardised securitisation”. March 2015
15 Building a Capital Markets Union – Green Paper – 18 February 2015
16 Review of the Prospectus Directive – Consultation Document – 18 February 2018
An EU framework for simple, transparent and standardised securitisation – Consultation Document – 18 February 2018
www.dlapiper.com | 17
18 | Global Financial Markets Insight
A CHANGING LANDSCAPE
FOR SOVEREIGN DEBT RESTRUCTURINGS
The terms of sovereign debt instruments are changing. The successful attempts to holdout on Argentina’s bond restructuring in NML Capital v. Argentina and related cases, as well as the perceived ineffectiveness of collective action clauses (CACs) in Greece’s restructuring, have spurred initiatives to ensure that minority holders do not frustrate efforts to restructure sovereign debt. Both the IMF and the International Capital Market Association (ICMA) are promoting aggregation clauses as a means to address these concerns. However it remains to be seen how effective these clauses will be, and whether issuers of sovereign debt will be prepared to adopt them.
The NML Capital cases concerned the interpretation of a pari passu clause. Following its 2001 default on US$82 billion in sovereign debt, Argentina entered into negotiations with its creditors. It eventually agreed with holders of 93% of the bonds to reduce the debt to 30 cents on the dollar. In the midst of the restructuring, NML Capital, Ltd. bought bonds with a face value of US$220 million for US$49 million and demanded repayment at their full value. NML Capital then argued that the pari passu clause contained in the bonds guaranteed equal treatment for investors and therefore the holders of the exchanged debt could not be paid before the holdout creditors. The New York courts ultimately agreed. To avoid paying the holdout creditors or renegotiating with them, Argentina sought to retake control of the exchanged bonds through a debt swap to bring them under Argentinian law (and out of the jurisdiction of the New York courts). The plan was unsuccessful. Ultimately, Argentina missed its payments and went into selective default on June 30, 2014.
The pari passu clauses at the centre of the NML Capital dispute are not unique. Other sovereign bonds contain similar clauses. One response to NML Capital has been a turn from New York law to English law in bond issuances. However, English law may only be a partial solution. The IMF published a paper last year, entitled Sovereign Debt Restructuring: Recent Developments and Implications for the Fund’s Legal and Policy Framework (26 April 2013) (the IMF Paper), which notes that when Greece attempted to restructure in 2012, investors holding €6 billion in bonds would not accept the deal. 36 bonds were governed by English law and contained CACs. CACs, which had not been included in the Argentinian bonds, generally obligate holdout creditors within a particular series to accept the terms agreed to by the majority of the creditors within the series. Of the 36 Greek bonds which contained CACs, only 17 were successfully restructured because of holdouts blocking restructuring within particular series. In all, 30% of the debt governed by English law that included CACs was not restructured.
The IMF Paper notes that creditor participation has been high in recent restructurings and restructuring terms frequently differentiate in their treatment of those creditors. For example, differential treatment between long-term and short-term bond holders and between domestic and foreign creditors has been common. Notwithstanding NML Capital, litigation has also been relatively rare. The trouble is that if holdouts do occur, the New York court decisions
in NML Capital indicate that payments will not be made on restructured debt unless the parties holding out are also paid in full. This may discourage creditors from participating in involuntary restructuring and by allowing the holdout party to seek recovery outside of a voluntary debt restructuring, creates a disincentive to participate. CACs are a partial solution, but the experience in Greece indicates that such clauses may not be effective where holdout creditors establish a majority in a series.
The IMF Paper therefore favours the use of aggregation to prevent minority creditors from blocking restructuring across series of notes. Contractually, aggregation clauses are a relatively new tool; they have only been used since 2003. In essence, they allow for aggregate voting across series of notes in the event of an amendment that would affect two or more series. Generally, these clauses are drafted so that two voting thresholds must be met in the event of an amendment: 75% or 85% of the outstanding principal of all series to be affected and 66.6% of the outstanding principal of each individual series to be affected. This “two limb” approach means that blocking votes can still occur with respect to a particular series, though generally holdout positions must be stronger and restructurings with respect to the other series are less likely to be frustrated. A “single limb” approach, which provides for one vote aggregated across all series, prevents holdout positions within a series, but may lead to concerns with respect to the equitable treatment of creditors.
ICMA picked up on these considerations in a consultation paper released in December 2013 and has drafted new standard provisions for sovereign bond issues, which include an aggregation clause.
Under the proposed provisions, aggregation clauses do not apply when one series of notes is being amended. In such cases, a change in the date for the payment of principal or interest, a reduction or cancellation of the amount of principal or interest, or a change in currency, among other changes, requires a written resolution or a resolution at a meeting of the noteholders of at least 75% of the aggregate principal amount of notes outstanding.
When two or more series of notes are being amended, the aggregation clauses apply. A resolution respecting the matters listed above requires a resolution of 66 2/3% of the aggregate principal amount outstanding of all affected series and more than 50% of the principal amount outstanding in each affected series (taken individually).
The original ICMA proposal only provided for a two limb voting approach which approach leaves open the risk that a dissenting minority can block a restructuring by developing a significant holding in a particular series. ICMA released a supplement to its draft, which has incorporated a single limb voting approach as the default.
The single limb approach arguably provides more certainty, in particular for issuers and creditors who would wish to circumvent minority holders blocking restructurings by developing a holdout position on a particular series. One perceived difficulty with such a scheme is the lack of protection that single limb voting provides minority interests. In order to offer added protection, the ICMA proposal builds into the single limb voting approach a high voting threshold (75% of the aggregate principal amount of the outstanding debt securities of all affected series, regardless of what is being voted on) and provides that the issuer’s restructuring plan must be available to all the bondholders prior to the restructuring proposal in order to encourage consultation. It also requires that the proposal provide all the bondholders with the same consideration or would result in the amended instruments having identical provisions (further amendments in May 2015 have clarified the conditions that must be identical when two or more series are modified) and requires the issuer to abstain from voting notes that the issuer controls. In the alternative, the issuer can opt into the two limb voting mechanism or the series by series
Furthermore, as a direct response to the decisions of the New York courts, the ICMA draft also updated the pari passu provisions. The revised ICMA provision states that any payments made by the issuer do not need to be made rateably with payments on other external debt:
The Notes are the direct, unconditional and unsecured obligations of the Issuer and rank and will rank pari passu, without preference among themselves, with all other unsecured External Indebtedness of the Issuer, from time to time outstanding. Provided, however, that the Issuer shall have no obligation to effect equal or rateable payment(s) at any time with respect to any such other External Indebtedness and, in particular, shall have no obligation to pay other External Indebtedness at the same time or as a condition of paying sums due on the Notes and vice versa.
By contrast, the pari passu clause at issue in NML Capital took the following form:
he Securities will constitute… direct, unconditional, unsecured and unsubordinated obligations of the Republic and shall at all times rank pari passu without any preference amongst themselves… The payment obligations of the Republic under the Securities shall at all times rank equally with all its other present and future unsecured and unsubordinated External indebtedness.
www.dlapiper.com | 19
20 | Global Financial Markets Insight
In short, the new pari passu clause indicates that bondholders will not necessarily receive equal payments from the issuer and provides clarification around its scope.
It remains to be seen just what effect these new provisions will have. Aggregation clauses, single or two limb, raise questions for the protection that will be available to minority holders. One limb aggregation clauses in particular may be seen as oppressive where the vote affects the rights of a particular series. Historically, these clauses have typically been seen as a method of protecting issuers and restricting creditors’ rights.
Questions also arise as to the efficacy of aggregation. In the case of a two limb approach, it may not be difficult for investors to acquire a potential holdout position when a series is issued, and thus frustrate the use of the clause for that series. A lack of certainty that notes will be restructured across series may deter creditors from participating in a restructuring. In addition, either single or two limb aggregation requires broad support from creditors, which may spur issuers to agree to unsustainable programmes. An international statutory mechanism to sovereign debt restructuring, similar to domestic bankruptcy, might better ensure that the interests of minority stakeholders are not simply trumped by majority rule and lead to more realistic results. The Board of the IMF has advocated for such an approach since the early 2000s. The feasibility of such projects is, of course, a significant hurdle.
The provisions would not be effective where the majority of the debt is held by a particular issuer, or groups of issuers. Ukraine’s debt restructuring may be challenged by the fact that one third of the debt being restructured is held by a single party. Aggregation is unlikely to work in circumstances where large institutional investors and partnerships among them control the majority of the issue.
The ICMA’s collective action and pari passu clauses have received a mixed reception. On October 15, 2014, Kazakhstan became the first nation to use them in a sovereign issue. Other sovereigns have since issued debt with these clauses, including Mexico, Vietnam and Ethiopia. However, others may be hesitant to include them. Recent issuances by the Philippines and the Ivory Coast omit the collective action and pari passu clauses. The reason why is speculative, but as the effectiveness of the clauses has yet to be determined, it is possible that there is uncertainty on how to price and sell bonds that include them. Notably, major credit rating agencies have indicated that the clauses are unlikely to affect the rating of bonds which include them, since defaults are usually governed by the issuer’s ability to pay due to economic and financial developments, rather than the specifics of the bond terms.
The author would like to thank Jeffrey Bichard for his contributions to this article.
Authored by: John Munnis
What is FX deal contingent hedging?
Deal contingent trades are typically structured as FX
forwards or options and are found in the context of public
cross-border share acquisitions. Typically entered into
following signing of the SPA, the FX element locks in the
exchange rate where funds are to be paid in a foreign
currency on completion of the acquisition. The contingency
element means that settlement of the FX forward or option
is dependent on completion of the underlying acquisition
occurring. It is this contingency element that drives the
relative complexity and pricing of these trades as dealers
have to assess the likelihood of relevant approvals (including
regulatory and shareholder approvals) being forthcoming
and the price dynamics of the acquirer and the target
While this product has been available in the market for some
time, it fell out of favour during the recent financial crisis
because the market uncertainty and the relatively high level
of deal failures resulted in less competitive pricing. However,
we have seen a resurgence of these trades since 2011 given
the increased volatility in the FX markets (particularly vis-à-vis
the euro and the Swiss franc).
Deal contingency trades are not limited to FX risk in an
M&A context: for instance, the same technology is used for
securitisation and debt financing when managing interest rate
What are the key benefits of FX Deal Contingent
■■ It gives the buyer protection against the risk of adverse
FX rate movements between a bid/deal signing and closing
as the buyer can lock in an exchange rate at the time of
■■ It gives the buyer protection against the risk of deal
failures: with a deal contingent structure, the hedge will
only exist if the deal is completed; there is no termination
fee if the deal is cancelled.
■■ No upfront premium: for a large notional trade, the
upfront premium can be prohibitively expensive for
Deal contingent trades have traditionally been the preserve
of internationally-focussed private equity sponsors, but
corporates have recently been buying this protection.
Typically, the hedge is sold to the buyer to ensure certainty of
funds, but a deal contingent hedge can sometimes be sought
by the seller or a third party investor.
When considering deal contingent trades, key factors to take
into account include:
■■ how the bank would hedge itself against the volatility
of the underlying foreign exchange rate. This could be
achieved by entering into a vanilla FX forward, but with an
offsetting put or call option;
■■ the ambit of the contingency provision (i.e. the pre-agreed
triggers for trade settlement), and how to evidence
■■ the length of the anticipated contingency period (with a
possible pricing ratchet for longer contingency periods)
and other relevant early termination or cancellation
■■ the need for a Phoenix provision (i.e. allowing the trade
to come alive again where the share acquisition or a
similar deal is effected outside the contingency period or
otherwise following trade cancellation); and
■■ the need for a funds return provision (i.e. allowing
settlement of the trade to be unwound where completion
of the acquisition subsequently falls through, with
both parties being put back to their original economic
Authored by: John Delamere
INTRODUCING FX DEAL
www.dlapiper.com | 21
22 | Global Financial Markets Insight
Advances in technology are providing ever greater opportunities
for quicker and more efficient data delivery combined with
significantly enhanced data storage capacity and search and
analysis functionality. This in turn is delivering opportunities for
improved transparency through initial disclosure and on-going
reporting but it also brings challenges as issuers need to deal
with new means of data delivery and storage while complying
with more onerous reporting requirements.
When a material event occurs, it is crucial that issuers are
familiar with regulatory requirements and procedures so
as to act swiftly to meet their disclosure requirements.
Preparing a press release has been the default response, yet
with regulations and data delivery techniques changing rapidly
there is a need to be sure that such disclosure meets the
requirements as to format, forum and time limits, to name
The development of new information technology systems
is paving the way for greater integration of capital markets.
The European Commission is, to some extent, playing catch
up as it aims to strengthen cooperation between regulators,
harmonise rules and introduce more technologically advanced
services to deal with consistent information disclosure and
storage that meets the needs of today’s markets. It is widely
agreed that a simpler and more standardised documentation
system utilising current technology for disclosure and the
use of publication warehouses will allow for faster and
more transparent exchange of information and storage
benefitting regulators, investors and issuers. In this article
we look at the steps that are being taken and some of the
concerns in meeting the continuously increasing technological
requirements that such systems demand.
Historically, public dissemination of information consisted of
notices to the relevant stock exchange and circulation via
traditional methods of publication (such as newspapers) and
that would satisfy the requirements for disclosure. Today,
the mere publication of information to a stock exchange or
in newspapers, where investors are asked to actively seek
content out, does not satisfactorily meet the requirements of
appropriate public disclosure.
Advances in technology mean that investors are more likely
to search for updated information on an issuer’s website
or, if applicable, on nominated sites provided for official
regulatory updates. For issuers, knowing where information
can and must be published is essential and for investors
knowing where to look is equally important. Knowledge
of a material event by some investors but not others may
constitute inside information. A starting point therefore
would be reporting obligations under the Market Abuse
regime. This is aiming to apply a consistent EU wide approach
to dissemination of information.
The standards have been set high; dissemination of information
must be EU wide, accessible simultaneously across Member
States and with precise synchronisation whilst security of
communication and data is ensured. The new Market Abuse
Regulation1 (MAR) will be applicable from 3 July 2016, giving
issuers a year to identify where their current public disclosure
methods lack conformity with the updated rules.
CATCHING UP WITH
ELECTRONIC PUBLICATION AND
1 Regulation (EU) No 596/2014 of the European Parliament and of the Council of 16 April 2014 on market abuse (market
abuse regulation) and repealing Directive 2003/6/EC of the European Parliament and of the Council and Commission
Directives 2003/124/EC, 2003/125/EC and 2004/72/EC
Article 17 of MAR sets the criteria for disclosure of inside information by issuers. It requires issuers of financial instruments to publicly disclose inside information as soon as possible and in a manner which enables fast access and complete, correct and timely assessment of information by the public. The European Securities and Markets Authority (ESMA) is currently mandated to draft Implementing Technical Standards (ITS) for the adoption of MAR, where the obstacle of national differences in information technology and interfaces will be addressed.
With regards to listed securities, understanding the disclosure requirements under the Prospectus Directive2 (PD) and Transparency Directive3 (TD) as well as the applicable requirements of the stock exchange on which the securities are listed will also provide guidance on the disclosure that is necessary. Following the most recent review of the PD, the published Prospectus Directive Consultation Document4 has highlighted the opportunity for improved capital markets transparency whilst having a lower administrative burden for investors. In the PD Consultation Document, the creation of ‘a single, integrated EU filing system for all EU prospectuses and regulatory disclosures’ is discussed, with requirements for such system to include filings that are automatically incorporated by reference into a universal base document, which an issuer can use as part of their disclosure in any future debt or equity issue. The target is for enhanced investor protection, easier and more efficient access to relevant issuer information, all in one place whilst avoiding duplication of information and reducing the costs for both issuers and EU regulators. Essential features for this new proposed system should include hyperlinked prospectuses which can be used for other regulatory disclosure purposes and enabling cross-reference to other prospectuses in accordance with the PD or other EU regulatory requirements.
Notification to the paying agents and trustees under the terms of the bonds themselves may be required. This will require reporting through the clearing systems direct to bondholders (or at least to their nominee account holders). Such direct notification is likely to be additional to any regulatory reporting described above. However, if an integrated database for regulatory reporting is developed it may make sense to link notifications to the applicable site and at least allow for regulated disclosures to be incorporated by reference into base disclosure documents so as to avoid costly supplements and updates.
A further requirement may be reporting to rating agencies in respect of rated securities. This may apply, particularly in respect of some of the company’s securitisations, where the impacts may be more complex.
A single repository for all investor reports is considered as a ‘useful evolution’, and such proposal is already being reviewed by ESMA under Article 8b of the Credit Rating Agencies Regulation5 to come about in the form of a website. It however remains questionable whether the introduction of a new website will meet the demands or will simply lead to a duplication of efforts under the existing regime. It has become evident that even existing data warehouses no longer satisfy the requirements for market operations. There is now a focus on improving them, to allow for more structured and efficient analysis of the tremendous amount of data now available. IT difficulties currently faced when dealing with the existing data warehouses make accessing and downloading files an onerous endeavour, as downloading large amounts of data obstruct a continuous use of the system. The sheer amount of loan data currently added to existing data warehouses cause hardware to overload and the Association for Financial Markets in Europe (AFME) is suggesting that perhaps additional or new hardware is needed to manage the load6.
2 Prospectus Directive 2003/71/EC of July 2005 and Commission Regulation (EC) No 809/2004 of 29 April 2004
3 Directive 2004/109/EC of 15 December 2004
4 Consultation Document ‘Review of the Prospectus Directive’ and Consultation Document ‘An EU framework for simple, transparent and standardised securitisation’ both of 18 February 2015
5 Commission Delegated Regulation (EU) 2015/3 of 30 September 2014 supplementing Regulation (EC) No 1060/2009 of the European Parliament and of the Council with regard to regulatory technical standards on disclosure requirements for structured finance instruments
6 Executive Summary of AFME response to the Consultation Document ‘An EU framework for simple, transparent and standardised securitisation’ of 13 May 2015
www.dlapiper.com | 23
24 | Global Financial Markets Insight
Authored by: Mikaela Kantor
Reporting the circumstances and likely remediation measures on a company’s website will provide investors with immediate feedback on events and likely impacts and it is the place most likely to be searched by investors for further information. This must however be consistent with and published in time with regulatory reporting requirements described above. The notifications should also be careful to avoid constituting investment advice or financial promotions that would otherwise be prohibited under the Financial Services and Markets Act7 (FSMA) or other regulatory requirements.
The need to provide fast, effective and accurate information in accordance with numerous pan-European regulations and in a timely manner is a challenging prospect and failure to properly comply can have significant consequences. As hyperlinks, directional searching, time dated and time expired notifications, access to data sites and the potential for wider incorporation by reference of official information become more prevalent in the digital disclosure age; the onus will be on companies to stay on top of the rapidly changing technological regime. Having an updated checklist and a game plan for dealing with disclosure and reporting allows a company to prepare information and press the send button faster, simultaneously providing all the necessary disclosure to the right recipients, in the right place, in the correct form and on a timely basis allowing a company to move on to the rest of the day’s work.
7 Financial Markets and Services Act 2000
Whether planning a portfolio sale or securitisation,
understanding and appropriate preparation of the underlying
assets is essential to achieve the best pricing and deliver an
efficient process. This article looks at the preparation of
a residential mortgage backed loans portfolio for sale and
The final few weeks before the launch of an Residential
Mortgage-Backed Security (RMBS) transaction are
invariably the busiest, as final discussions are held with
investors, ratings and listing are confirmed and documents
are finalised. However, an enormous amount of preparation
may need to be done weeks or even months in advance in
order for the sponsoring business to be ready to launch its
securitisation. We have taken a high level look at some of
the processes that a sponsoring business may undergo during
these earlier stages, in order to be best placed to focus on
crossing the ‘t’s and dotting the ‘i’s in the final moments
leading up to launch.
Preparation of loan-level data can be one of the most
challenging and time-consuming processes for a sponsor.
Sufficient loan level data will be required by the rating
agencies in order for the RMBS to achieve the required
rating, and also by the Bank of England/ECB in order for
the RMBS to be eligible for the respective central banks’
operations. We see two particular challenges for a sponsor
in this regard. Firstly, the definitions of the various data fields
used by the sponsor (or servicer) as part of its day-to-day
operations must be aligned with those used by the relevant
rating agencies and central banks. Secondly, the sponsor
should take necessary measures to ensure that the data is of
sufficient accuracy to underpin the transaction.
The data definitions for the rating agencies and the
central banks are publicly available, and can be provided
by mandated arrangers or legal counsel. These definitions
generally use mortgage-industry terminology, and should
be familiar to most potential sponsors. However, there may
be differences between the terminology used by the sponsor
(or the servicer) in its operations and those used by the
rating agencies, central banks or elsewhere in the mortgage
industry. Obvious examples include whether the data fields
“Original Balance” and “Current Balance” include or exclude
fees, or whether “Regulated Loan” mean a loan regulated
under FSMA, or the Consumer Credit Act, or both? Where
definitions do not align, there is scope for a business to
use their preferred definition, provided that an adequate
explanation can be provided.
The rating agencies and central banks also distinguish
between ‘mandatory’ and ‘optional’ data fields. It is usually
recommended that the optional data is provided, as this may
impact the rating agency or central bank’s overall view of the
transaction from a data standpoint. However, a business may
abstain from providing optional data where the business does
not use such data fields for its general operations.
WHAT STEPS CAN SPONSORS TAKE AT THE
OUTSET TO PREPARE FOR AN RMBS TRANSACTION?
GET READY –
www.dlapiper.com | 25
26 | Global Financial Markets Insight
None of this sounds complicated, however the Bank of England currently has 205 data fields, of which 112 are mandatory, and there is not always direct overlap with the ECB and rating agency data fields.
One further point to consider is the source of the data that is to be submitted. If the business obtains its data from the credit bureau agencies, it is likely that the service agreements with those agencies do not permit the sharing of data with third parties, in which case consent from the agencies should be obtained before data such as credit scoring is shared externally. The sponsor (or servicer) should take care when using credit bureau agency data even where the data is also publicly available (for example, County Court Judgement (CCJ) records), and we would suggest that prior consent is always obtained.
The degree of validation that should be taken when looking at data accuracy may be determined by several factors, including (1) the consistency of the originations and servicing processes for the mortgages, for instance there may have been policy or IT system changes during the relevant period, (2) whether there are reasons to suspect that data might not be 100% accurate, particularly if there are known historic data or systems errors, (3) the materiality of the data fields in question (e.g. data fields described as ‘mandatory’ by the Bank of England are likely to be more fundamental than those described as ‘optional’ and (4) the internal governance and general approach to risk of the business, taking into account the costs and resources available for such validation.
There are several risks of moving to launch with inaccurate data, particularly where the data errors are systemic (rather than outliers). Warranties concerning accuracy of the data are given by the sponsor to various interested parties, including the rating agencies, the underwriters and the issuer. In addition to general damages claims, misrepresentation of a warranty made to an issuer under a sale agreement may result in repurchase of the affected mortgages by the sponsor. Data errors may also result in the disclosure of materially inaccurate information to investors (primarily via the stratification tables in the prospectus), which among other things can lead to a breach of regulatory rules and damage the sponsor’s reputation for future capital markets transactions.
Data accuracy may be validated in the following ways:
Verifying that the information in the data tape is consistent with the source documents (typically on a sample basis). Legal counsel will often perform a similar review, again typically on a small sample basis.
Verifying that the information in the data tape is consistent with the information provided by the sponsor’s (or servicer’s) IT systems – this may not identify inconsistencies between the source documents and IT systems, but is less resource-intensive than the source check.
An ‘Agreed-Upon Procedures’ or ‘AUP’ report is typically provided by the financial advisors/auditors for the transaction. The report examines a sample of mortgages in order to ensure that the data contained in the source documents, IT systems and RMBS data tape match-up. It should identify areas where information is missing and data inconsistencies.
Before commencing such processes, the sponsor should determine the required level of accuracy that must be achieved in order to accept the data. This may vary between data fields depending on the materiality of the data. The sponsor should also decide how to react to the findings, for example if a sample reveals a level of accuracy below the required level, then outliers may be fixed (or excluded from the portfolio) and a broader sample may be tested.
Of course, such data validation may not be possible where the sponsor did not originate the assets, and will likely be relying on data provided by the previous seller. It is unlikely that the data warranties given by the previous seller will be as extensive as those required for the RMBS. They are also likely be subject to caps on amount and duration, and without accompanying repurchase rights. These limitations should be disclosed to investors, rating agencies and central banks.
In addition to data warranties, RMBS sponsors will also be required to make various other warranties in relation to the mortgage loans. The warranties may relate to mortgage business functions such as originations, legal and regulatory compliance and operations and servicing. It is advisable for the sponsor to begin its warranty validation process early in order to uncover potential issues for the transaction. Here are a few examples of mortgage warranties and potential validation processes involved:
A valuation was obtained from a qualified valuer for each mortgage property – validated by a file review, or examination of originations.
No mortgage was granted to an employee of the originator – validated by reviewing underwriting policies and procedures in place at the time of origination, which may evidence that restrictions were in place to ensure that no mortgages were granted to employees.
LEGAL AND REGULATORY COMPLIANCE
The mortgages are enforceable – validated by legal counsel due diligence of mortgage documents and files.
The sponsor and servicer are compliant with Financial Conduct Authority (FCA) and/or Consumer Credit Act (CCA) regulation – validated by review and disclosure of on-going and historic regulatory enquiries and actions. A judgement of materiality may be required here.
OPERATIONS AND SERVICING
There are no claims or litigation challenging the enforceability of the mortgage loans – validated by the claims/litigation department cross-checking their caseload against the portfolio data.
No customer is in breach of the terms of their mortgage – it is first necessary to assess what mortgage terms exist that could be breached. Separate validation may be required for such terms. For example, if the mortgage terms contain a ‘residential purposes only’ requirement, it may be prudent to review a sample of field notes taken from various properties to determine whether customers are frequently breaching this requirement by using their property for commercial purposes.
These are just a small number of the warranties that are typically given, and there may be other ways to validate the warranties, but hopefully this gives a general impression of the work that may be involved.
Other areas which require early engagement from a sponsor may include:
Operational cashflows and investor reporting – among other things, a sponsor will need to consider what amounts should be included in the servicing balance of a loan, for example by determining when overdue interest and fees are deemed to be capitalised, and what amounts should be excluded from available principle receipts e.g. ground rent or insurance premiums paid by the servicer on behalf of a customer.
Prospectus disclosure – the RMBS prospectus should normally contain a description of the sponsor’s (and, if separate, the originator’s or previous sellers’) businesses and a description of the underwriting criteria adopted by the originator when originating the portfolio. Although the end product is usually a succinct summary, it is important that information is validated where possible, for example by referring to the annual returns of the relevant entities or, in the case of underwriting criteria, reviewing the underwriting policies in place for the relevant period (particularly where these may have changed over time). This information may also be shared with the rating agencies as part of that process.
Servicing standards – in addition to providing a description of the servicer in the Prospectus, a servicer will typically be required to demonstrate to the rating agencies, and undertake to the issuer, that it will service the portfolio to an acceptable minimum standard (particularly if the mortgages are non-performing). In order to comply with this requirement, a review and consolidation of current servicing standards and procedures may be advisable. If a third party servicer is being appointed, it may also be necessary for the sponsor to perform diligence on the incoming servicer (compliance with the FCA’s “Treating Customers Fairly” requirements should be a particular focus here).
This is only a high-level look at some of the work to be done by a sponsor in the early stages of preparing for an RMBS transaction. Hopefully the front-loading of these and other work streams will leave more time and resource available for inevitable challenge of bringing everything together in the immediate build-up before launch. Professional advisors working on the transaction, including the arrangers, legal counsel and financial advisors, should be consulted at the earliest possible stage as they should be familiar with the challenges described above and able to provide the sponsor with assistance from the outset.
Authored by: Chris Godwin
www.dlapiper.com | 27
28 | Global Financial Markets Insight
THE ENASARCO CASE –
HOW DO YOU CALCULATE ‘LOSS’?
There is nothing like a major bankruptcy to stimulate advances in the common law. The demise of Lehman Brothers has produced a stream of cases on the interpretation of ISDA Master Agreements as well as legal principles such as anti-deprivation.
The latest case settles some important points about the calculation of close out amounts. In Fondazione Enasarco v Lehman Brothers Finance SA and another1, David Richards J had to consider the consequences of the re-establishing of some structured put options written by Lehman Brothers Finance SA (LBF) in December 2007 (9 months before the Lehman holding company went into Chapter 11) in connection with its “Anthracite” programme.
As diagram 1 shows, Enasarco wanted exposure to hedge fund returns but with principal protection for its investment of €780 million. This was achieved by an indirect investment, via two Lehmans group companies, in hedge funds, coupled with a put option written by LBF at a price equal, broadly speaking, to any shortfall in the value of the investments below €780 million. The underlying derivatives contract was a 1992 ISDA Master Agreement with “loss” as the chosen close-out calculation method, and a selection of “automatic early termination” if LBF were to default; as it did on 15th September 2008 when its parent company went into Chapter 11.
1  All ER (D) 106, judgment 12 May 2015
Post-default, Enasarco discovered that the security structure underneath ARIC was sound, and it was eventually able to collapse the ARIC/Balco arrangements and, in May 2009, to enter into a new option with Credit Suisse, at the same strike price. The value of the hedge fund investments had fallen considerably over the period since Lehmans’ collapsed, and the annual premiums payable to Credit Suisse for the option were considerably higher than those which would have been payable to LBF if the original put had not been terminated. The net present value was about $61 million, which Enasarco claimed from LBF.
Unsurprisingly given the size of the claim, LBF resisted; firstly, arguing that Switzerland was the proper forum (despite English governing law and a choice of the English courts) and then running a series of arguments based on the wording of the 1992 Master Agreement which led to it claiming that, far from owing Enasarco $61 million, in fact Enasarco owed
LBF $42 million. Judge David Richards found for Enasarco.
WHY SUCH A BIG DIFFERENCE BETWEEN THE TWO SUMS CLAIMED?
The value of the hedge fund assets underwent a sustained collapse over the period between September 2007 and May 2008. LBF argued that the correct date as of which “Loss” should have been calculated was sometime in September – or, at the latest, October – 2007. At that time, the value of the investments was comfortably more than €780 million and so the put would have been worthless (for ARIC) and consequently would have been an asset of LBF because of the annual premia ARIC was paying for it. By May 2008, once the dust had begun to settle, the reverse was the case, and when eventually Credit Suisse agreed to write the replacement put, higher premia were inevitably payable.
WHAT WAS THE CORRECT DATE TO CALCULATE “LOSS”?
Because of the fall in values of the investments, LBF unsurprisingly wanted to identify an earlier calculation date, and produced evidence to show that values in the market around September or October 2007 should have been used as the basis of the calculation. However, the Judge accepted that although there may have been people willing to give valuations, there was nobody in the market prepared to do deals.
ISDA 1992 Master
200 hedge funds
Put option at
EUR780 less prefs
www.dlapiper.com | 29
30 | Global Financial Markets Insight
Authored by: Mark Daley, John Delamere and Tim Finlay
LBF’s argument on this point had previously been made in a July 2014 judgment (Lehman Brothers Finance SA v Sal Oppenheim JR & Cie KGAA). That case had held that, for the purposes of “Market Quotation”, the quotations had to be real, “live”, actionable quotations capable of being accepted.
An “indicative” quotation was not good enough; it might suffice as a valuation, but not for the purpose of calculating a close-out amount. In Enasarco the Judge adopted the same approach under “Loss”. He then found that it was simply unfeasible for Enasarco to have obtained actionable quotations before May 2008. The evidence was clear that nobody was simply going to write a replacement option on the basis of the old ARIC/Balco structure. That had to be restructured first, and then a new option would be considered.
The evidence showed that Enasarco had not deliberately delayed the process and had proceeded as quickly as it could, and had entered into serious discussions with four “leading dealers” in the market before finally agreeing terms with Credit Suisse. LBF had argued that Enasarco (a) had not “reasonably” determined its loss and (b) had not determined its loss “as of the earliest date [after the automatic early termination date] as is reasonably practicable”. The Judge held that Enasarco had.
On a point of law, the Judge confirmed that to show that Enasarco had not acted reasonably, it would have been necessary to show that its behaviour had been so unreasonable that no reasonable person could have come to it (known legally as “Wednesbury unreasonableness” after a much earlier case, Associated Provincial Picture Houses Ltd v Wednesbury Corporation2. There was no single objective standard of “reasonableness” which Enasarco had to match but, rather, a broad range within which its behaviour would be accepted.
At the time of writing it is unknown whether LBF might appeal.
It was argued that common law principles of mitigation should apply to the calculation of Loss. If this were the case it was suggested that the gain made by the Issuers as a result of not being required to pay LBF an ETCSA should be taken into account in the calculation of Loss.
This is not the first time LBF has been to court over this option. In 2011, it put forward other arguments against Enasarco, including that its approach to calculating its loss by reference to the cost of a replacement transaction was inconsistent with the overall concept of “Loss”, and that common law principles such as the duty of mitigation were relevant. Briggs J rejected these arguments in Anthracite Rated Investments (Jersey) Ltd v Lehman Brothers3 (Ch): the definition of “Loss” expressly permits a calculation done by reference to the cost of a replacement transaction, and the provision is not in substance about the recovery of damages at common law for breach of contract; it is a contractual provision for determining a close-out payment, which both “Loss” and “Market Quotation” being intended to achieve broadly the same result.
Structured finance derivatives are never simple: they usually involve at least one SPV which generally has no significant net worth, and the recourse of the derivatives provider is via a complex set of pre and post-enforcement waterfalls set out in a security trust deed. In structures such as Anthracite, the presence of so many LBF companies means that the demise of the financial engineer will necessitate a complex restructuring which is not going to happen overnight. The ultimate investor can take comfort that the courts have accepted the principle that it may take time to establish a valid realisable close out amount and so long as it was not irrational and played things by the book, its calculation, once it is able to obtain actionable quotes and so crystallise its loss, will be accepted by the courts.
“Loss” means, with respect to this Agreement or one or more Terminated Transactions, as the case may be, and a party, the Termination Currency Equivalent of an amount that party reasonably determines in good faith to be its total losses and costs (or gain, in which case expressed as a negative number) in connection with this Agreement or that Terminated Transaction or group of Terminated Transactions, as the case may be, including any loss of bargain, cost of funding or, at the election of such party but without duplication, loss or cost incurred as a result of its terminating, liquidating, obtaining or reestablishing any hedge or related trading position (or any gain resulting from any of them). Loss includes losses and costs (or gains) in respect of any payment or delivery required to have been made (assuming satisfaction of each applicable condition precedent) on or before the relevant Early Termination Date and not made, except, so as to avoid duplication, if Section 6(e)(i)(l) or (3) or 6(e)(ii)(2)(A) applies. Loss does not include a party’s legal fees and out-of-pocket expenses referred to under Section 11. A party will detem1ine its Loss as of the relevant Early Termination Date, or, if that is not reasonably practicable, as of the earliest date thereafter as is reasonably practicable. A party may (but need not) determine its Loss by reference to quotations of relevant rates or prices from one or more leading dealers in the relevant markets.
2 (1948) 1 KB 223)
3  EWHC 1822
BACKGROUND AND NEW FRAMEWORK
The FUA does not, as opposed to the existing financial institutions act of 1988, contain specific provisions on securitisation of loan portfolios. This means in practice that after the FUA’s entry into force, a special purpose vehicle (SPV) used for securitisation purposes will no longer be exempt from the requirement to be licensed as a finance institution and would be subject to all the requirements under the FUA applicable to finance institutions in general, such as license, supervision, capital and reporting requirements.
The FUA contains a general transitional rule stating that finance institutions must comply with the FUA’s requirements within a year after its entry into force (thus 1 January 2017). In addition, during autumn this year, the legislator has stated that it will initiate a consultation process for the purpose of concluding whether transitional regulations protecting finalised securitisation arrangements is required, and what the content of any such regulations should be. Affected and interested parties will have the opportunity to give their view during this process.
The legislator’s main reasons for removing the rules on securitisations are that they have only been used to a very limited extent and only by one financial institution. Securitisation of loan portfolios should thus be limited to the (still existing) rules relating to preference bonds (which on certain conditions are available to credit institutions that finance real estate mortgages). Another stated reason was that securitisation may have negative effects on financial stability, with reference to, inter alia, the latest financial crisis.
The amended framework creates uncertainty in respect of finalised, on-going and planned securitisation processes. We will address the main issues below.
SECURITISATIONS FINALISED BEFORE 1 JANUARY 2016
Securitisation arrangements (and corresponding investments) that are finalised before the FUA enters into force should not be affected by the new framework, whereupon the instruments in themselves and investments in such instruments will not be illegal, void or similar and the transactions will likely benefit fully from the current (pre 1 January 2016) regime for the life of the relevant securitization. This applies in our view regardless of whether
SECURITISATION IN NORWAY?
On 10 April 2015 the Norwegian legislator adopted a new act on financial undertakings (the FUA) which abolishes the rules on securitisation of loan portfolios. Consequently this financing form will not be available in Norway after the FUA enters into force on 1 January 2016. The amended framework creates uncertainty in respect of finalised, on-going and planned securitisations.
www.dlapiper.com | 31
32 | Global Financial Markets Insight
there are any outstanding bonds at the time the new act enters into force. We would deem a securitisation arrangement finalised where (i) the establishment of the
SPV (pursuant to any required authorisations), (ii) the transfer of the loan portfolio, (iii) the required notices to debtors and (iv) the issuance of bonds have been effectuated and any other requirements pursuant to the financial institutions act clauses 2-36 to 2-39 have been complied with. Both legally and in practice it is difficult to see how the new rules may affect arrangements finalised before the FUA’s entry into force.
In the (however surprising) event that the legislator is of the view that the new framework applies to securitisation arrangements that are finalised prior to the entry into force of the FUA but where the relevant bonds are not fully redeemed within the expiry of the transitional period (i.e. before 1 January 2017), we expect that, to the extent there are outstanding bonds as per 1 January 2017, transitional regulations will be adopted to clarify that such transactions fall under the pre 1 January 2016 framework.
SECURITISATIONS INITIATED – BUT NOT FINALISED – BEFORE 1 JANUARY 2016
For securitisation arrangements that have been initiated and reached a certain advanced stage, but are not yet fully finalised (as we interpret this term, cf. above) before the date of entry into force of the FUA, it is also a question of whether these transactions will be affected by the new framework. In our opinion, especially in consideration of the general one year transitional rule, predictability, the amount of investments going into a securitisation process and the relatively weak reasoning for repealing the securitisation rules, there are strong arguments favouring that such arrangements shall also benefit from the transitional rules (the general one year transitional rule and/or any adopted transitional regulations). We find it likely, however, that 1 January 2017 would be an absolute cut-off date, which means that any securitisation arrangements which are not executed at this date will not benefit under the transitional rules. Any adopted transitional rules might give more clarity on this and may also, if the legislator finds there is a legitimate need, extend the cut-off date to arrangements that are not fully in place within 1 January 2017.
SECURITISATIONS INITIATED AFTER 1 JANUARY 2016
The FUA contains, as mentioned above, a general adaptation period of one year, but we find it unlikely that arrangements initiated after the FUA enters into force will be protected with reference to this transitional rule. If transitional regulations are adopted we would not expect that these would cover transactions that are initiated after 1 January 2016, i.e. any such arrangements would likely not benefit from any exemptions or ‘softer’ treatment.
NEW RULES ON SECURITISATIONS IN THE FUTURE?
The Norwegian Ministry of Finance has stated that they might revert with a proposal for new rules on securitisation at a later date, taking into account feedback during the law proposal’s consultation process. The Norwegian legislator will probably wait and consider other EU countries’ practice and rules on this area before adopting any new rules.
Authored by: Fredrik Lindblom and Tonje Bae Kvendbø
33 | Global Financial Markets Insight
PRIVATE PLACEMENTS AND
THE NEW WITHHOLDING
TAX EXEMPTION –
HMRC have now issued a consultation draft of the
regulations for the “qualifying private placements”
exemption for limited circulation amongst
As you may recall, the Government is proposing to
introduce a new exemption from UK withholding
tax for interest payments made on “qualifying private
placements”. The Government issued a Technical Note
on 10 December 2014 for consultation on the applicable
conditions for the exemption. Put simply, the extensive
conditions meant that the relief would be of limited
application despite being extended to loans as well as bonds
during the course of that consultation.
HMRC have now issued a consultation draft of the
regulations (setting out the applicable conditions) for limited
circulation amongst interested parties. In a welcome
boost to the banking sector, the draft regulations show a
significant relaxation of the conditions for the exemption
from those envisaged by the Technical Note. The breadth
of the exemption is now far wider than first thought.
It effectively eliminates UK withholding taxes altogether
on loans made, and bonds held by, lenders in countries such
as South Korea, Thailand, Mexico and Australia.
HMRC are holding a working group meeting on 31 July
to gather feedback on the draft regulations. Whilst there
is a risk that the conditions may again change before the
regulations come into force, the form of the draft regulations
are very encouraging and should further stimulate lending
into the UK.
Why does this matter?
UK withholding taxes at 20% apply to payments of UK source
interest on loans of one year or more. They represent a real
cost for debtors. However, where the lender or bondholder
is a UK bank or UK tax resident company, domestic
exemptions are usually available.
If domestic exemptions are available, what is the
They are “domestic” exemptions. They do not generally
apply where the lender or bondholder is a non-UK bank
or non-UK company. A claim must be made under a
double taxation treaty with the UK or the HMRC Treaty
Passport Scheme used instead. The use of the HMRC Treaty
Passport Scheme is preferable, as the processing time is
www.dlapiper.com | 33
| Global Financial Markets Insight
If a claim can still be made under a double taxation treaty or the passport scheme is available, what is the problem?
Not all double taxation treaties provide for full exemption from withholding taxes. Therefore, neither claims under a double taxation treaty nor the use of the passport scheme may fully eliminate any withholding cost. This is the case with countries such as South Korea, Thailand, Mexico and Australia, where a rate of around 10% continues to apply. You end up having to use things like the quoted Eurobonds exception, or there is withholding, which generally deters lenders, bondholders and debtors.
What sort of securities does this new exemption apply to?
Both loans and bonds may qualify, provided the debt is not listed or convertible. The security must also be issued for genuine commercial reasons and not as part of a tax avoidance scheme.
Are there any conditions on the debtor?
There are no longer any conditions on the debtor, save that it must be a company. The Technical Note had required that the debtor be a trading company. This means that real estate loans now qualify for relief.
Are there any conditions on the lender or bondholder?
The lender or bondholder must issue a certificate to the debtor providing that:
it is not connected to the debtor (shareholder loans are not within the regime);
it is in a country with a “proper” double tax treaty with the UK (no tax havens – but pretty much everywhere else); and
it holds the security for genuine commercial reasons and not as part of a tax avoidance scheme.
The condition that the lender or bondholder must be a UK-regulated financial institution (or foreign equivalent) has also been removed. This represents a significant relaxation as all lenders and bondholders can rely on it.
Is there a maximum debt amount?
No. This condition has been removed too.
Is there a minimum debt amount?
Yes. The debt must still be at least £10 million (which can be met cumulatively).
Is there a minimum term for the debt?
Is there a maximum term for the debt?
Yes. The maximum term of the debt has been increased to 50 years, catching pretty much everything.
When will this be in force?
HMRC are holding a working group meeting on 31 July to gather feedback on the draft regulations (which are likely to be very much welcomed by the finance sector) so we expect the exemption to be in force very shortly. However, that said, there is still a risk that the conditions may again change before the regulations come into force. The draft regulations provide that they will have effect in relation to securities issued or loan relationships entered into on or after the date they come into force (which is not yet specified).
Will this benefit previous transactions?
On face value, no. However, the benefits may be available on a refinancing eg on an amendment and restatement.
What about current transactions?
If you are acting on a transaction right now where this may potentially be of benefit, please think about delaying…
Why does this matter for me?
It encourages new lenders and bondholders from Australia, South Korea etc to lend to the UK free of withholding tax which is good news. The LMA templates should also be changing when this becomes law.
Authored by: Kelly Lovegrove and Neville Wright
FINANCE-LINKED HEDGING –
“Uncertainty” has become a by-word to describe the current
global economic outlook: from unsustainably-bullish equity
markets – and unpredictable shifts in energy prices – to
volatile foreign exchange rates. However, a business can
minimise the impact on its cash flow of financial variables
beyond its control by using derivatives products to hedge its
exposures to interest rates, foreign exchange (FX) rates,
commodities and other asset classes, which would allow it to
allocate assets more efficiently and adopt a pro-active rather
than a reactive strategy.
In this article, we will look at how a company may use
derivatives to protect itself against fluctuations in interest
rates and FX rates where it has, or wishes to secure,
multi-currency bank debt financing. Given that adverse
movements in exchange rates, and interest rates could affect
a Borrower’s ability to service the loan, it is imperative from
both the lender and the Borrower’s perspective that the
Borrower is not taking excessive risk. Finance-linked hedging
is equally important where a company is wishing to access
the debt capital markets, and here it is common for the
bondholder or noteholder to use a reverse derivative in
order to achieve a minimum return on its investment.
A derivative is commonly defined as “a bilateral contract
or payments exchange (between a principal and a hedge
counterparty) whose value derives from the value of an
underlying asset, rate or index”.
The key products found in the finance-linked hedging
A. Interest Rate Risk:
Term and revolving loan facilities are typically structured using
a floating rate of interest (e.g. LIBOR plus an agreed spread
or margin) in order to match the inter-bank funding market.
As such, an unexpected rise in this rate may create difficulties
for the Borrower in servicing its debt. An interest rate swap,
entered into between the Borrower (as fixed rate payer) and
the lender or a third party (as floating rate payer) mitigates
this risk by effectively allowing the Borrower to pay an agreed
fixed rate of interest throughout the term of the loan rather
than the floating rate, as shown in diagram 2 below. It is
important that the calculation periods and payment dates
under the swap match the loan so that the Borrower is not
exposed to any basis risk.
The swap has two cash flows:
1. the Borrower pays the hedge counterparty an amount
equal to the fixed rate of interest (based on the hedge
counterparty’s projections of future interest rate
movements, but also reflecting a credit charge and a fee
for the hedge counterparty entering into the swap); and
2. the hedge counterparty pays the Borrower an amount
equal to the floating rate of interest under the Borrower’s
loan agreement (which may move above or below the
In practice, there will be one payment for each interest or
calculation period, as the payment or settlement netting
mechanics under the ISDA Master Agreement mean that
only the net difference between the two cash flows is
£10 million loan
Repayment of principal and interest
at floating rate (LIBOR + margin)
Floating rate ≈ LIBOR rate
Notional: £10 million
Fixed rate of 3.5%
National: £10 million
www.dlapiper.com | 35
36 | Global Financial Markets Insight
payable by the party that is “out-of-the-money”. In the above example, if the floating rate for a period is 6% and the fixed rate is 3.5%, then the hedge counterparty will pay to the Borrower an amount equal to 2.5% p.a. on the notional amount of £10 million. Conversely, where the floating rate is 2%, the Borrower will pay to the hedge counterparty an amount equal to 1.5% p.a. on the notional amount of £10 million; this will be in addition to the amount of interest payable under the loan agreement.
If the loan and the swap are terminated prior to maturity, the Borrower might be liable to pay (in addition to the loan repayment amount) a swap close-out amount based on the then mark-to-market value of the swap. Conversely, if it were in-the-money, it would be owed an equivalent amount from the hedge counterparty. You would therefore expect the lending syndicate to take security over the swap to the extent that it is a secured financing. As a result, and assuming the hedge counterparty is entitled to share in the security package, there is little value in having additional collateral or credit support.
An alternative solution is to put in place an interest rate cap. Under a rate cap product, the Borrower would not pay a fixed rate, but instead would be charged a premium (which is typically paid upfront) for buying the cap. Conversely, the hedge counterparty as seller of the cap would (for any relevant calculation or interest period) pay to the Borrower an amount equal to the applicable floating rate to the extent that it exceeds the pre-agreed cap rate. Again, to avoid any basis risk, it is important that the calculation periods and payment dates under the rate cap match the loan. See further diagram 3 below.London Bank (as Lender)London Bank (as Hedge Counterparty)Plastic Co (Borrower)£10 million loanRepayment of principal and interest at floating rate (LIBOR + margin)Floating rate if in excess of Cap RatePremiumDIAGRAM 3
In this example, if the floating rate for a period is 6% and the cap rate is 3.5%, then the hedge counterparty will pay to the Borrower an amount equal to 2.5% p.a. on the notional amount of £10 million; no periodic amount will be payable by the Borrower but it would already have paid an upfront premium for buying the product. Conversely, where the floating rate is 2% and the cap rate is 3.5%, no periodic payment will be payable by either party under the cap, but again the Borrower would already have paid an upfront premium for buying the product. Where the premium is paid in full at the outset of the transaction, the hedge counterparty will have no contingent exposure to the Borrower. In other words, on an early termination, the close-out amount (if any) would only be payable by the hedge counterparty to the Borrower. For this reason, while it is important from a lender perspective that the rights of the Borrower are properly secured in favour of the lending syndicate, there is no need for the hedge counterparty to share in the general transaction security package. Similarly, it is common for Rate Caps to be documented by way of long-form confirmations.
B. Foreign Exchange Risk:
The increasing globalisation of business has led to a growing trend in borrowing in foreign currencies. However, where a company has exposure to different currencies in terms of its asset and liability profiles, it is vulnerable to exchange rate fluctuations.
Take the example of a UK-headquartered business that sells the majority of its goods in Europe, and secures a US dollar-denominated loan facility (partly to exploit favourable US dollar interest rates). A Greek exit from the Eurozone and resulting depreciation of the euro against the dollar could impact on the Borrower’s ability to service its debt.
One potential solution to protect against exchange rate volatility would be to enter into a currency swap. This functions in a similar way to the interest rate swap product (as discussed above), but fixing the exchange rate that applies to the interest and principal payments due under the facility, as shown in diagram 4 below.
Swap Exchange Rate:
$1: €0.884 (exchange rate fixed under the swap)
$500,000 loan interest payment €442,000
(Borrower pays counterparty €442,000)
(Counterparty pays Borrower $500,000)
Euro Devaluation Scenario:
$500,000 loan interest €700,000
(Borrower pays counterparty €442,000)
(Counterparty pays Borrower $500,000)
Borrower net saving: €258,000
This is a contract to buy foreign currency at a future date, but for a price agreed at the outset (typically at current market value). This enables a Borrower to lock in the current price of foreign currency and hedge against the risk of the exchange rate becoming less advantageous in the future.
This is therefore a similar product to a currency swap but for a one-off payment. In other words, a currency swap is simply a series of related currency forwards.
Under a currency forward or swap, both parties are committed to buy or sell the relevant currency at the agreed price and on the agreed date(s) regardless of disadvantageous movements in the FX market. A currency option avoids this: under a currency option, the buyer of the option has the option to acquire, or to sell, the foreign currency in the future and for a pre-agreed price. This product therefore gives a Borrower some flexibility in terms of its FX planning as it is then free to buy the foreign currency at the market spot rate if that is more favourable than the “hedged” rate – in which case, the Borrower would only have lost the premium for buying the option (as opposed to being forced into an unfavourable trade).
Where a company has interest rate or FX exposure, careful consideration of the products available in the market is essential in order to ensure that it hedges such exposure as efficiently as possible.
Authored by: John Delamere and Sam Bodle
The currency swap would create the following periodic cash flows:
1. the Borrower pays the hedge counterparty an amount in euro equal to the US dollar amount payable under the loan agreement at the agreed, fixed exchange rate under the swap; and
2. the hedge counterparty pays the Borrower the US dollar amount payable under the loan agreement, regardless of movements in the exchange rate.
As shown in the table 7 below, the Borrower is now protected if the euro depreciates in value against the US dollar:
London Bank (as Lender)
(as Hedge Counterparty)
Plastics Co (Borrower)
$10 million loan
Repayment of principal and *fixed interest of 5% ($500,000)
Pays $500,000 (to match loan interest) regardless of exchange rate changes
Pays $442,000 (rate of $1 = 0.884€)
*fixed rate to simply the example only
www.dlapiper.com | 37
38 | Global Financial Markets Insight
On 18 February 2015, in a major development, the European
Commission published a green paper1 and two consultation
papers2 that will shape the Capital Markets Union agenda.
The Review of the Prospectus Directive consultation
paper (the PD Consultation) contained 51 sets of
questions through which the European Commission is
seeking to identify the needs of market users with regard to
prospectuses concerning scope, form, content, comparability,
the approval process, liability and sanctions. The PD
Consultation also provided the opportunity to provide
feedback about aspects of the existing prospectus regime
which unduly hinder access to capital markets, and which,
if amended, could reduce administrative burden without
undermining investor protection.
The development of the prospectus framework
The Prospectus Directive 2003/71/EC has applied since
July 2005 (the Prospectus Directive) and together with
Commission Regulation (EC) No 809/2004 of 29 April 2004
(PD Regulation) lays down the rules governing the
prospectus that must be made available to the public when
a company makes an offer or an admission to trading of
transferable securities on a regulated market in the EU.
Major changes were made to the Prospectus Directive in
November 20103 that were designed to (i) increase investor
protection by improving the quality and effectiveness of
disclosure and by facilitating comparison between products
through the summary, (ii) increase efficiency by reducing
administrative burdens through various proportionate
REVIEW OF THE
AN OPPORTUNITY TO TAKE STOCK, ALIGN MARKET AND
REGULATORY DEVELOPMENTS AND LOOK TO THE FUTURE
1 Building a Capital Markets Union
2 Review of the Prospectus Directive and An EU framework for simple, transparent and standardised securitisation
3 Directive 2010/73/EU of 24 November 2010 and Directive 2010/78/EU of 24 November 2010
disclosure regimes and (iii) recalibrate the thresholds below which no prospectus is required (the 2010 PD Amendments). At the same time changes were made authorising the European Securities and Markets Authority (ESMA) to undertake a variety of roles in respect of the Prospectus Directive including the development of draft regulatory technical standards. Further changes were made in April 20144 to reflect the roles of the European Banking Authority (the EBA), the European Insurance and Occupational Pensions Authority (EIOPA) and ESMA. These changes concerned the scope of certain of their powers, the integration of certain powers in existing processes established in relevant EU legislation and amendments to ensure a smooth and effective functioning of the EBA, EIOPA and ESMA.
In January 2011, the European Commission mandated ESMA to provide technical advice on possible “delegated acts” concerning the Prospectus Directive which resulted in the PD Regulation being amended in relation to the format and content of the final terms to a base prospectus; and prospectus summaries (required to be included in retail debt and equity prospectuses)5 and separately in relation to the consent to use a prospectus in a retail cascade and certain other provisions of the PD Regulation relating to indices composed by an issuer and related parties and profit forecasts and estimates6 (together the 2012 PD Regulation Amendments). The 2010 PD Amendments and the 2012 PD Regulation Amendments came into effect in July 2012.
The European Commission was next due to review the Prospectus Directive in January 2016 but brought the review forward to coincide with the discussion on Capital Markets Union. So almost 5 years since the previous review the capital markets industry has been given the opportunity to take stock of how the 2010 PD Amendments and the 2012 PD Regulation Amendments have worked in practice, align many of the regulatory and market developments which have occurred in that period7 and look to the needs of the capital market industry in future.
The PD Consultation acknowledges that in the context of Capital Markets Union the prospectus is the gateway to the capital markets and that it is crucial that the prospectus does not act as an unnecessary barrier and it should be as straightforward as possible to raise capital throughout the EU. It is also acknowledged further, that there are several potential shortcomings of the prospectus framework as it stands today.
The fundamental aspects of the Prospectus Directive under review in the PD Consultation are grouped under the following headings:
When a prospectus is needed;
What information a prospectus should contain; and
How prospectuses are approved.
When a prospectus is needed
The PD Consultation requested views on a possible recalibration of the obligation for issuers to draw up a prospectus, based on the existing exemption thresholds, as well as the favourable treatment granted to issuers using high denominations. Views were also sought on whether a prospectus should be required for secondary issuances and for the admission of securities to trading on multi-lateral trading facilities.
What information a prospectus should contain
Feedback was requested on ways to expand the existing tools that were intended to introduce some flexibility in the drawing up of a prospectus and enhance its effectiveness, striking an appropriate balance between effective investor protection and the alleviation of administrative burden.
4 Directive 2014/51/EU of 16 April 2014
5 Commission Delegated Regulation (EU) No 486/2012 of 30 March 2012
6 Commission Delegated Regulation (EU) No 862/2012 of 4 June 2012
7 Such as the development of multi-lateral trading facilities (MTFs), creation of SME growth markets and organised trading facilities (OTFs), and the introduction of key information documents for packaged retail and insurance-based investment products (PRIIPs).
www.dlapiper.com | 39
40 | Global Financial Markets Insight
Authored by: Ronan Mellon
Views were sought on the usefulness of the prospectus summary, as well as on possible limitations which could be introduced on prospectuses.
The PD Consultation also invited comments on certain issues already addressed in previous amendments to the Prospectus Directive – e.g. the prospectus exemption for employee share schemes and the determination of the home Member State for issues of non-equity securities – with a view to ensuring that these amendments had achieved their objectives.
How prospectuses are approved
The PD Consultation sought views on ways to make the scrutiny and approval process more transparent to the public and more flexible for the issuers seeking to react quickly to market windows.
The closing date for comments was 13 May 2015. Comments were submitted by a very diverse set of market participants, such as the International Capital Markets Association, the European Crowdfunding Network, the European Private Equity & Venture Capital Association to name but a few. The next step is for the European Commission to process these views with the aim of producing a roadmap of proposed amendments which will invariably be circulated for further consultation.
www.dlapiper.com | 41
This publication is intended as a general overview and discussion of the subjects dealt with. It is not intended to be, and should not be used as, a substitute for taking legal advice. DLA Piper will accept no responsibility for any actions taken or not taken on the basis of this publication.
DLA Piper is a global law firm operating through various separate and distinct legal entities.
Further details of these entities can be found at www.dlapiper.com
Copyright © 2015 DLA Piper. All rights reserved. | JUL15 | 2965239