Latham & Watkins operates worldwide as a limited liability partnership organized under the laws of the State of Delaware (USA) with affiliated limited liability partnerships conducting the practice in France, Hong Kong, Italy, Singapore, and the United Kingdom and as an affiliated partnership conducting the practice in Japan. Latham & Watkins operates in South Korea as a Foreign Legal Consultant Office. Latham & Watkins works in cooperation with the Law Office of Salman M. Al-Sudairi in the Kingdom of Saudi Arabia. Under New Yorkâ€™s Code of Professional Responsibility, portions of this communication contain attorney advertising. Prior results do not guarantee a similar outcome. Results depend upon a variety of factors unique to each representation. Please direct all inquiries regarding our conduct under New Yorkâ€™s Disciplinary Rules to Latham & Watkins LLP, 885 Third Avenue, New York, NY 10022-4834, Phone: +1.212.906.1200. Â© Copyright 2019 Latham & Watkins. All Rights Reserved.
The new framework should simplify the path for issuers seeking to market European
covered bonds to investors in the US.
ï‚· The new framework will create minimum product and technical standards for covered bonds,
focusing on high-quality cover pool assets.
ï‚· Covered bonds, which are not subject to â€œbail-inâ€ powers, will have reinforced transparency and
ï‚· Spanish covered bond programs will require the most updating, compared with the existing
ï‚· Issuers should consider amending their documentation to facilitate marketing in the US.
Covered bonds offer unique benefits to both issuers and investors. Banks and other credit institutions
have historically relied on covered bonds as an inexpensive source of funding and have purchased them
to use as eligible collateral with the Eurosystem credit window, while institutional investors have valued
the favorable risk-weighting of these stable and secure instruments, which typically combine a
bankruptcy-remote asset-backed security with the further support of a direct claim against the credit
institution issuer1. To date, covered bonds have been issued either pursuant to long-standing statutory
frameworks created by the national laws of several EU Member States or by more recent contractual
arrangements developed by market participants. However, the liquidity of the European covered bond
market has been complicated by such disparate legal regimes, which have provided for differing levels of
transparency in ongoing reporting and have generally made assessing credit quality across jurisdictions
difficult for investors and regulators.
In an effort to facilitate a broader EU-wide covered bond market, on November 23, 2018, the Council of
the European Union published compromise texts of a proposal for a Regulation of the European
Parliament and of the Council regarding the capital requirements for covered bonds (Covered Bond
Regulation) and a proposal for a Directive of the European Parliament and of the Council on the issue of
covered bonds and covered bond public supervision (the Covered Bond Directive and, collectively with
the Covered Bond Regulation, the European Covered Bond Framework)2, which were approved by the
European Parliament on April 18, 2019. Pursuant to European law, the Covered Bond Regulation, will be
directly binding upon the Member States, whereas the Covered Bond Directive will require Member
States to adopt its provisions into national law within a specified timeframe. The European Covered Bond
Framework is designed to harmonize minimum product standards based on existing national regimes,
Latham & Watkins April 22, 2019 | Number 2488 | Page 2
establish common regulatory treatment of covered bonds across Member States, promote investor
confidence, and foster greater inflows into this product class.
This Client Alert aims to summarize the European Covered Bond Framework focusing on the main
implications for European banks and investors (in particular Brexit and expected changes to the Spanish
covered bonds statutory framework, which stands to be most affected by the harmonization). The authors
then review the opportunities and constraints related to marketing European covered bonds in the United
States, and present a view of where this market is headed.
The European Covered Bond Framework: The Details
ï‚· Only credit institutions (including specialized mortgage credit institutions)3 may issue covered bonds.
ï‚· Covered bonds must be bankruptcy-remote,4 and creditors must have dual recourse, meaning the
bonds must provide: (a) a priority claim over the assets securing the covered bonds (cover pool) with
a minimum overcollateralization of 105% of the covered bondsâ€™ principal and interest; and, insofar as
the cover pool assets are not sufficient, (b) a claim against the credit institution issuing the covered
bond (which must be pari passu with claims of the credit institutionâ€™s ordinary unsecured creditors).5
ï‚· The cover pool must be limited to eligible assets, namely mortgage loans, certain high-quality loans,
and other liabilities subject to certain loan-to-value requirements.6
ï‚· Assets in the cover pool must be segregated7 and unencumbered by third-party claims.
ï‚· The issuer must establish a liquidity buffer calculated on covered bond net liquidity outflows for 180
calendar days (which can be held in a variety of cash equivalents).
Supervision and the offering process requirements
ï‚· Each EU Member State must designate a competent authority or authorities to grant permission for
covered bond issuances; monitor compliance of covered bond programs; maintain a registry of all
covered bonds; supervise, investigate, and sanction covered bond-related matters; and take relevant
action in the context of an insolvency or resolution of the issuer.
ï‚· No cover pool monitor is required, but if Member States decide to impose one, it must be independent
of the credit institution issuer and its audit firm.
ï‚· Covered bonds satisfying the European Covered Bond Frameworkâ€™s requirements may use the label
â€œEuropean Covered Bondâ€ alongside any national denominations.
ï‚· Issuers must provide quarterly reporting to investors regarding, among other things, the value and
composition of the cover pool, the geographic distribution and type of assets in the cover pool, the
maturity structure of assets in the cover pool, the level of required overcollateralization, certain market
risk disclosures, and the percentage of loans in default.
Latham & Watkins April 22, 2019 | Number 2488 | Page 3
Entry into force and transition period
ï‚· The Covered Bond Regulation will be directly applicable 20 days following publication in the official
journal with regards to the regulatory capital standards contained therein (covered bonds issued prior
to December 31, 2007, or before the date of the application of the Covered Bond Regulation will be
grandfathered through maturity).
ï‚· The Covered Bond Directive will require Member States to adopt implementing laws and regulations
consistent with its terms no later than 18 months following its publication in the official journal, and
such implementing laws must enter into force no later than 12 months from such date (covered bonds
issued prior to the adoption date will be unaffected).
What Does a Harmonized â€œEuropean Covered Bondâ€ Mean for Issuers and Investors?
EU-wide market. One of the main achievements of the European Covered Bond Framework is the
creation of an EU-wide marketplace for covered bonds that establishes minimal technical and legal
requirements for covered bonds. Additionally, certain Member States that previously lacked covered bond
frameworks in their jurisdictions, such as Croatia, Estonia, and Malta, will be required to introduce the
instrument into their national laws, facilitating the use of covered bonds as a means of bank funding
throughout the EU. Moreover, the Covered Bond Directive permits banks to conduct intragroup pooling
and joint funding, which may stimulate covered bond issuances pooled from members of cross-border
EU-wide banking groups or joint issuances by smaller credit institutions. A more diverse mix of assets and
credit exposures is particularly topical considering that on January 1, 2019, the European Central Bank
(ECB) ceased purchasing covered bonds under its Third Covered Bond Purchase Program. Previously, it
was widely believed that the ECBâ€™s sustained purchasing activity had stimulated covered bond issuances;
that demand now needs to be replaced by other types of investors.
High quality, yet relatively simple-to-understand assets. The European Covered Bond Framework
sets out asset quality and cover pool underwriting standards that aim to establish the instrument firmly in
the camp of high quality, robust assets with medium- to long-term maturity profiles. Furthermore, by
institutionalizing dual recourse and removing the ability to include certain securitization assets in the
cover pool, the framework favors â€œsimplerâ€ covered bonds over so-called â€œstructuredâ€ covered bonds that
layered mortgage cover pools with holdings of securitization units and other types of mortgage-backed
securities to diversify risk, such as was common in France. In this way, the reforms reduce the number of
assets eligible to form the cover pool, particularly in the contractual covered bond space â€” aircraft leases
and equipment leasing receivables will no longer be permitted to bear the â€œEuropean Covered Bondâ€ label
or benefit from favorable treatment under the Capital Requirements Regulation.8
Brexit implications. The Covered Bond Directive provides that an equivalence regime for third-country
(non-EU Member State) covered bond frameworks â€” one that will potentially permit non-EU banks to
issue within the EU under their home laws and permit EU banks to issue under third-country laws and be
afforded the same regulatory treatment and other attendant benefits of the European Covered Bond
Framework â€” will be assessed following a two-year study period after entry into force. This delay creates
significant uncertainty with respect to covered bonds issued by UK banks, since such instruments will not
qualify for preferential risk weight until after 2022 in the event of a â€œhardâ€ Brexit and may not be used as
collateral for Eurosystem credit window purposes (absent specific derogations). Moreover, following
Brexit, the competent authorities may need to approve the use of English law for covered bond
issuances, since determining equivalency of investor protection, segregation, and enforceability
standards are the domain of the Member States.
Latham & Watkins April 22, 2019 | Number 2488 | Page 4
Spanish covered bonds. Spanish covered bonds currently have two forms: (a) cÃ©dulas hipotecarias,
which are issued pursuant to a framework consisting of Law 2/1981 of 25 March (Law 2/1981), as
amended and Royal Decree 716/2009 of 24 April (RD 716/2009), and (b) cÃ©dulas territoriales, which are
issued pursuant to Law 44/2002 of 22 November (Law 44/2002, and together with Law 2/1981, Law
41/2007, and RD 716/2009, the Spanish Covered Bond Framework). The European Covered Bond
Framework will require reworking the Spanish Covered Bond Framework in the following ways:
ï‚· Todayâ€™s Spanish covered bonds are secured by the issuing bankâ€™s entire residential and commercial
mortgage loan book in the case of cÃ©dulas hipotecarias (excluding mortgages securing securitized
loans or mortgage securing mortgage bonds (or bonos hipotecarios, an instrument provided by law
secured by specific mortgages that has not been widely used)) and the issuing bankâ€™s entire public
sector loan book in the case of cÃ©dulas territoriales. In contrast, the European Covered Bond
Framework will require issuers to allocate specific cover pools for individual issuances or programs
(as the case may be) as well as provide initial and ongoing disclosure on the relevant cover pools,
which previously was not required.
ï‚· The Spanish Covered Bond Framework incorporates a high degree of minimum overcollateralization
(a 125% statutory requirement). This threshold may be decreased upon the transposition of the
European Covered Bond Framework given the harmonized 105% minimum overcollateralization
requirement (excluding the liquidity buffer).
ï‚· Instruments issued under the Spanish Covered Bond Framework will not be secured by mortgages
allocated to any new issuances of covered bonds under the European Covered Bond Framework,
since mortgages allocated to the new cover pools will no longer automatically secure existing
instruments as part of the whole-bank mortgage book.
ï‚· Additionally, the Spanish Covered Bond Framework permits cÃ©dulas hipotecarias to be secured by
real estate developer mortgage loans, which the Covered Bond Directive will not permit to form part
of the cover pool.
ï‚· The European Covered Bond Framework introduces a liquidity buffer that does not exist under the
current Spanish Covered Bond Framework.
Given the degree of change, Spanish covered bond issuers may need more comprehensive transitional
mechanisms to be put into place. Alternatively, Spanish covered bond issuers may consider liability
management or exchange offers to avoid or reduce the coexistence of covered bonds issued under the
two regimes during the transition period.
Marketing the â€œEuropean Covered Bondâ€ in the United States
Credit institution issuers that are changing their existing programs, or are establishing new programs, in
compliance with the new EU framework should consider amending their documentation to permit
marketing their covered bonds in the United States, to further enlarge the addressable investor base.
Although the US lacks a covered bond framework, there has been growing investor interest in covered
bonds issued by non-US banks. European, Canadian, Australian, and Korean banks have issued
approximately US$195 billion in US$-denominated covered bonds in the United States since 2010. In
order to readily access the US market, covered bonds must (a) be exempt from the registration
requirements of the US Investment Company Act of 1940 (Investment Company Act) and (b) avoid
classification as a â€œcovered fundâ€ under Section 619 (Volcker Rule) of the Dodd-Frank Wall Street Reform
and Consumer Protection Act of 2010, since covered funds cannot be held by US banks. While the
Latham & Watkins April 22, 2019 | Number 2488 | Page 5
European Covered Bond Framework does not, at first glance, alter the current state of affairs, issuers and
investors should review the circumstances and constraints under which European covered bonds can
effectively be offered in the United States.
Investment Company Act
The main exemptions typically used by covered bond issuers include the following:
ï‚· Rule 3a-6 exempts non-US entities regulated as banks that are â€œengaged substantially in commercial
banking activity,â€ posing a problem for specialized mortgage companies that do not take deposits but
rather purchase and package mortgages for the purpose of issuing covered bonds (such as in
France) as well as SPV structures in which the SPV is not otherwise eligible for another exemption
(such as public debt cover pools in Italy).
ï‚· Rule 3a-7 exempts certain structured finance vehicles that issue primarily debt or debt-like securities
backed by â€œeligible assetsâ€ (which could include mortgage loan and non-mortgage related assets,
such as credit card receivables); however, this exemption only applies insofar as holders of such
instruments are entitled to receive payments that â€œdepend primarilyâ€ on the cash flow from the
securitized assets, posing a problem as dual recourse means that the credit institution issuer may
make the payments from its other resources rather than solely from the cover pool.
ï‚· Section 3(c)(5)(C) exempts securitizations and mortgage-backed securities for issuers that have at
least 55% of their assets consisting of interests in real estate and at least 25% of the remaining
assets being real estate-related, qualifying many SPV structures (such as in the UK and Italy) with
mortgage loan cover pools, but posing a problem for public debt and maritime mortgage cover pools.
ï‚· Section 3(c)(1) exempts securities held by 100 or fewer persons.
ï‚· Section 3(c)(7) exempts securities offered solely to â€œqualified purchasersâ€ (i.e., investors that meet a
standard that is higher than the â€œqualified institution buyersâ€ standard for Rule 144A offerings under
the US Securities Act of 1933).
However, any entity that relies on Section 3(c)(1) or 3(c)(7) exemptions under the Investment Company Act is considered a covered fund under the Volcker Rule â€” limiting the type of offering that can be made or requiring the issuer to seek an exemption from the Securities and Exchange Commission (SEC).
Latham & Watkins April 22, 2019 | Number 2488 | Page 6
The graphic below depicts the two main structures of covered bond issuances in Europe along with
constraints posed by the Investment Company Act that, depending on the structure, may prevent or
reduce the ability to market such covered bonds in the US.
In connection with the creation of a wider European covered bond market and updates to programs that
credit institutions may need to make prior to the European Covered Bond Frameworkâ€™s entry into force,
there are numerous potential solutions for both one-tier and two-tier structures that would permit
marketing covered bonds in the United States, either for offerings registered with the SEC or for those
limited to certain types of qualified or similar investors, depending on the circumstances. In addition, SEC
no-action or exemptive relief could be sought; similar relief has been granted to certain French and
According to the European Covered Bond Council, the amount of European covered bonds outstanding
was equivalent to â‚¬2.1 trillion as of December 31, 2017; these bonds comprised instruments secured by
cover pools consisting of mortgage loans, public-sector loans, and maritime vessel mortgages. The
largest issuing countries were Denmark, Germany, France, Spain, and Sweden.9 The European covered
bond market is large and liquid, and with the adoption of the European Covered Bond Framework, the
market has the potential to become more globally relevant. The ECB 2018 stress test â€” which was
published in February 2019 and covered 87 banks â€” indicated that financial institutions are better
capitalized than they were in 2016, with average common equity tier 1 capital (CET1) at 10.1%, up from
8.8% in 2016, This data suggests that many institutions are on track to meet the full CET1 phased-in
requirement under Basel III starting in 2019 (10.5%, including the capital conservation buffer).10
Latham & Watkins April 22, 2019 | Number 2488 | Page 7
Nonetheless, European financial institutions, like many banks worldwide, may continue to face difficulties
in raising and maintaining capital adequacy, especially in connection with sovereign debt-related shocks,
Brexit, and other macroeconomic or geopolitical events. As recent headlines have shown, smaller EU
credit institutions can find it difficult to raise funds; they may especially benefit from joint covered bond
capital raising as a means of spreading risk and reducing the cost of funding. In addition, a harmonized
European covered bond instrument could permit a more coordinated approach to obtaining no-action
relief or other exemptive relief from the SEC, expanding the market for offerings of European covered
bonds in the United States.
If you have questions about this Client Alert, please contact one of the authors listed below or the Latham
lawyer with whom you normally consult:
M. Ryan Benedict
email@example.com +39.02.3046.2035 Milan
firstname.lastname@example.org +34.91.791.5075 Madrid
Thomas Vogel email@example.com +188.8.131.52.20.47 Paris
Sanjev D. Warna-kula-suriya firstname.lastname@example.org +44.20.7710.3034 London
Suzana Sava-Montanari email@example.com +184.108.40.206.20.00 Paris
Roberto L. Reyes Gaskin firstname.lastname@example.org +220.127.116.11.21.29 Paris
You Might Also Be Interested In
Financial Statement Requirements in US Securities Offerings: What Non-US Issuers Need to Know,
Council of the European Union Approves Its Position on NPL Directive
CFTC Seeks to Amend Commodity Pool Regulations
New EU Securitisation Regulations to Alter Securitisation Markets
Client Alert is published by Latham & Watkins as a news reporting service to clients and other friends.
The information contained in this publication should not be construed as legal advice. Should further
analysis or explanation of the subject matter be required, please contact the lawyer with whom you
normally consult. The invitation to contact is not a solicitation for legal work under the laws of any
jurisdiction in which Latham lawyers are not authorized to practice. A complete list of Lathamâ€™s Client
Alerts can be found at www.lw.com. If you wish to update your contact details or customize the
information you receive from Latham & Watkins, visit https://www.sites.lwcommunicate.com/5/178/forms-
english/subscribe.asp to subscribe to the firmâ€™s global client mailings program.
Latham & Watkins April 22, 2019 | Number 2488 | Page 8
1 Covered bonds were exempted â€” up to the value of the collateral in the cover pool â€” from the reach of â€œbail-inâ€ power which
permits regulators to cancel, write-down or convert into equity all or part of the liabilities owed by the failing financial institutions
to creditors established by Directive 2014/59/EU of May 15, 2014.
2 See Proposal for a Regulation of the European Parliament and of the Council on amending Regulation (EU) No. 575/2013 as
regards exposures in the form of covered bonds (COD/2018/0042) OJ C [â€¦] [â€¦], p. [â€¦] and Proposal for a Directive of the
European Parliament and of the Council on the issue of covered bonds and covered public supervision and amending Directive
2009/65/EC and Directive 2014/59/EU (COD/2018/0043) OJ C 367, 10.10.2018, p. 56-60. The proposals were agreed between
the European Council and the member states on February 26, 2019 and approved by the European Parliament on April 18,
3 See Article 4(1)(1) of Regulation (EU) No. 575/2013 which sets forth a definition of a credit institution â€œas an undertaking the
business of which is to take deposits or other repayable funds from the public and to grant credits for its own account.â€
4 Bankruptcy remoteness is defined as the covered bond not being subject to automatic acceleration upon the insolvency or
resolution of the credit institution issuer. Similarly, derivatives in the cover pool used for hedging purposes cannot be terminated
upon an insolvency or resolution of the credit institution issuer.
5 It should be noted that for certain national frameworks, notably France, where the issuer is often a specialized mortgage
institution with no other activity or assets other than making or acquiring mortgage loans, extending financing to public sector
entities by making public sector loans or acquiring public sector obligations and acquiring debt securities backed by such assets,
the actual utility that dual recourse can provide may be limited, but the European Covered Bond Directive indicates that this is
sufficient for compliance with the dual recourse requirement.
6 Eligible assets would include EU assets (or, subject to member state discretion, certain non-EU assets of analogous quality),
including: (a) liabilities of member state central governments, central banks, public sector entities, regional or local governments
(direct or guaranteed); (b) non-member state liabilities substantially equivalent to clause (a) above, except that they are limited
to 20% of the outstanding covered bonds issued and are subject to certain risk weight depending on credit quality; (c) liabilities
of credit institutions and investment firms that meet certain credit quality requirements (subject to a value limit of 15% of the
outstanding covered bonds issued); (d) loans secured by residential property (with the loan amount capped at 80% of the value
of the pledged property); (e) residential loans guaranteed by credit protection providers such as central, regional or local
governments and authorities, public sector entities, financial institutions and corporate entities with high credit quality (with the
loan amount capped at 80% of the value of the pledged property and where a loan-to-income ratio is capped at 33%); (f) loans
secured by commercial property (with the loan amount capped at 60% of the value of the pledged property); (g) loans secured
by maritime liens on ships (with a loan-to-value ratio of at least 60%); and (h) loans to public undertakings of similar high credit
quality providing essential public services and with sufficient revenue generating powers. Member states can set rules on
homogeneity of cover pools at their discretion.
7 The European Covered Bond Directive contemplates various means of segregation, including on-balance sheet and using a
8 See Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements
for credit institutions and investment firms.
9 European Covered Bond Council. European Covered Bond Fact Book 2018.
10 European Central Bank (ECB). â€œECB 2018 stress test analysis shows improved capital basis of significant euro area banks.â€