On December 15, 2016, the Board of Governors of the Federal Reserve System (the "Federal Reserve") issued its final rules regarding long-term debt and total loss absorbing capacity ("TLAC") requirements for global systemically important banks ("G-SIBs") in the United States. In this article, we discuss the effect of these rules on the U.S. structured products market. For our firm's client alert on the final TLAC rules, please see the following link: https://media2.mofo.com/documents/161215-federal-reserve-final-tlac-rule.pdf. Generally speaking, the final rules are consistent with the 2015 proposed rules, with some important modifications for the intermediate holding companies ("IHCs") of foreign banking organizations ("FBOs") that are G-SIBs and are subject to an IHC requirement. Structured Notes Will Not Be Included in TLAC. As most observers expected, eligible external long-term debt instruments do not include most structured notes, as they are not "plain vanilla" debt securities. The Federal Reserve continues to believe that the complexity of these instruments would diminish the prospects for an orderly resolution of a bank holding company. What Is a Structured Note? Under the final rules, the definition of "structured note" remains largely consistent with the 2015 proposals. A "structured note" is a debt instrument that:
- has a principal amount, redemption amount, or stated maturity that is subject to reduction based on the performance of any asset, entity, index, or embedded derivative or similar embedded feature;
- has an embedded derivative or similar embedded feature that is linked to one or more equity securities, commodities, assets, or entities;
- does not specify a minimum principal amount that becomes due upon acceleration or early termination; or
- is not classified as debt under GAAP.
(The first two bullets above encompass most of the relevant types of instruments in the U.S. market.)
In response to comments on the 2015 proposed rules submitted by the Structured Products Association, the definition of a structured note does not include a non-dollar-denominated instrument or an instrument whose interest payments are based on an interest rate index (for example, a floating-rate note linked to the federal funds rate or to LIBOR) that otherwise satisfies the requirements. Accordingly, a variety of common "lightly structured notes," such as "fixed-to-floating rate notes," that are issued both in and outside of the United States would be eligible long-term debt. However, as discussed below under "--Early Acceleration Clauses" and "--Governing Law," many issuers will not be able to continue their historical issuances in the same manner as they have done in the past.
What Is an Interest Rate Index? For purposes of determining whether a debt security is a "structured note," the rules do not define the term "interest rate index," as used in the preceding paragraph. The Federal Reserve cited as examples in its materials each of the federal funds rate and LIBOR. We believe that widely followed, or "benchmark," interest rates, such as CMS, that are calculated and reported by independent third parties should fit this description; in particular, a note linked to such a rate does not have the characteristics of a reference asset of the type contemplated by the second bullet above.
We would point out that a note that is linked to the federal funds rate or LIBOR that is not principal protected would be considered a "structured note" under the first bullet in the definition set forth above, and would not be eligible. Such a note would have a payment at maturity that is subject to reduction based on an embedded derivative.
No Relief for Principal Protected Structured Notes. Notwithstanding the concerns and comments of market participants, the exclusion from the eligibility requirements for notes linked to equities, commodities and other assets applies both to "principal protected" and to "non-principal protected structured notes." According to the Federal Reserve:
"Structured notes with principal protection often combine a zero-coupon bond, which pays no interest until the bond matures, with an option or other derivative product, whose payoff is linked to an underlying asset, index, or benchmark. [footnote omitted] The derivative feature violates the intent of the clean holding company requirements..., which prohibits derivatives entered into by the covered bank holding company with third parties. Moreover, investors in structured notes tend to pay less attention to issuer credit risk than investors in other longterm debt, because structured note investors use structured notes to gain exposure unrelated to the covered BHC. As a result, these investors are less likely to contribute to the market discipline objective of the minimum LTD requirements."
No Grandfathering for Most Structured Notes. Due to the Federal Reserve's concerns about structured notes, outstanding instruments of this kind will not be "grandfathered" as external TLAC. The Federal Reserve states that it does not expect this limitation to have a significant impact on banks, particularly in light of the grandfathering of other long-term debt, such as notes with early acceleration features, or that are governed by non-U.S. law.
Early Acceleration Clauses. Eligible long-term debt may not have an acceleration clause that provides a contractual right for the holder to accelerate payment, except for a failure to make payments or an insolvency event. As we have previously noted, the indentures for most outstanding U.S. and other medium-term note programs contain acceleration clauses for a variety of additional circumstances, such as the sale of a material bank subsidiary or a failure to maintain a corporate office. Accordingly, in order to enable issuers to more readily comply with the new rules, existing long-term debt of this kind is grandfathered under the new rules if issued before December 31, 2016. However, after that date, without an amendment to the relevant indentures governing debt issuances, newly issued debt securities with other acceleration features would need to be issued out of a finance or other subsidiary.
It remains to be seen whether investors in holding company debt would be prepared to invest in "plain vanilla" or other debt that does not have an acceleration clause for the failure to observe the non-payment covenants in an indenture. Accordingly, even though, as discussed above, lightly structured notes would be eligible long-term debt, it remains to be seen whether issuers will continue to issue them from the holding company.
Governing Law. To qualify as eligible long-term debt, the relevant instruments must be governed by U.S. law. Due to the amount of outstanding issuances that are governed by laws of jurisdictions, such as the U.K., Japan and Australia, outstanding issuances that otherwise qualify will be grandfathered, if issued prior to December 31, 2016.
Survivor's Options. Under the final rule, debt with a survivor's option would be treated as having matured on the first day that it is subject to the investor's option. This would be the date of issuance for most of these instruments. Accordingly, securities with a survivor's option will not qualify as eligible long-term debt, which must have a term to maturity of at least one year. This type of debt, if already outstanding, will not be subject to the grandfathering provisions. Structured Notes (and CDs) Issued by Subsidiaries. Since the rules apply at the bank holding company level only, these rules will generally not affect structured bank notes or "structured CDs" issued by a bank subsidiary. And to avoid any misunderstanding, the adopting release notes specifically that "[t]he cap [on liabilities of bank holding companies] does not limit a covered BHC's ability to issue structured notes out of subsidiaries." Of course, a significant number of G-SIBs have established financing subsidiaries that issue structured products, and we anticipate that these entities will continue to operate in the manner initially envisioned.