After the recent changes to UK insolvency law, the latter part
of 2003 and early 2004 have seen a number of material developments
at the EU level that will have an impact on structured finance
transactions documented under English law. There have also been
some relevant changes to UK tax law.
EU Prospectus Directive
The Prospectus Directive came into force on 31 December 2003 and
EU member states have until 1 July 2005 to implement it. Its stated
purpose is to allow companies to access the European capital
markets in a more efficient manner, while endeavouring to protect
investors across Europe by providing for uniform levels of
disclosure. The overhaul of the current regime has important
implications for issuers of debt and equity securities, including
issuers of securities in structured finance transactions. In some
important respects, the Prospectus Directive already affects
issuers of securities.
Key provisions
The key requirement of the Directive
is that (subject to certain exemptions) an issuer of securities
will be required to publish a prospectus prepared in compliance
with the Prospectus Directive and approved by the competent
authority of its home member state if it offers securities
to the public in the EU or its securities are admitted to trading
on a regulated market in the EU (this would cover listing on an EU
stock exchange).
In addition (subject, again, to certain exemptions) issuers
whose securities are admitted to trading on a regulated market in
the EU will be obliged to provide the competent authority of their
home member state with a document containing or referring to all
information that the issuer has published or made available to the
public over the preceding 12 months in member states and in non-EU
countries in compliance with its obligations under EU or other
securities laws.
Offers to the public
The definition contained in the
Prospectus Directive of what constitutes an offer of securities to
the public is wide (defined as consisting of a "communication ...
presenting sufficient information on the terms of the offer and the
securities to be offered so as to enable an investor to decide to
purchase or subscribe for securities") but most offerings of
securities in structured finance transactions should be able to be
structured so as to fall within one of the exemptions. The
principal exemptions that are relevant in the context of structured
finance transactions are for offers of securities to qualified
investors or to less than 100 people per member state (other than
qualified investors) and offers of securities with a minimum total
consideration per investor or per specified denomination of
€50,000. Qualified investors are broadly defined under the
Prospectus Directive as regulated entities, national and regional
governments, central banks, international organizations, large
corporates, collective investment schemes and pension funds.
Admission to trading
The second case in which the
production of a prospectus is required is where securities are to
be admitted to trading on a regulated market. It is likely that it
is principally this second case that will catch offerings of
securities in structured finance transactions.
Home member state
Under the Prospectus Directive the
power to approve a prospectus lies with the competent authority of
the home member state. Member states also have a number of
discretions under the Prospectus Directive (and under the
Transparency Directive). Hence the determination or choice of the
home member state has significant implications.
The definition of home member state in the Prospectus Directive
is complex and its interpretation has been subject to some debate.
In some, but not all, circumstances the home member state is a
matter of choice, whether the issuer is incorporated within or
outside the EU.
For public offers or admissions to trading of all
non-equity securities with denominations of at least €1,000 or its
near equivalent in another currency, the offeror or the person
seeking admission will be free to select as its home member state,
on an issue-by-issue basis, the member state where the securities
are offered to the public or to be admitted to trading.
For public offers or admission to trading of equity securities
or of non-equity securities with a denomination of less than
€1,000, essentially the home member state will be (in the case of
an EU issuer) the member state where the issuer has its registered
office or (in the case or a non-EU issuer) the member state where
such securities are first offered to the public or admitted to
trading by the issuer after the date of entry into force of the
Prospectus Directive (December 31 2003). Issuers are then tied to
that member state for all future public offers or admissions to
trading of such securities.
In the context of issues of securities in structured finance
transactions, the minimum €1,000 denomination requirement should be
easy to achieve. However, whether certain types of securities are
treated as non-equity or equity securities is a more difficult
analysis and there may be some structured finance transactions in
which the ability to choose the home member state may be
restricted.
Arrangers of structured finance transactions need to be aware of
the implications of being tied to a particular home member state in
the context of a particular transaction or a particular issuer of
securities.
Factors to take into account are:
- Eligibility requirements and continuing obligations:
although member states will not be permitted to require
disclosure over and above what is provided for in connection
with the Prospectus Directive, the Prospectus Directive permits
the competent authority of a home member state to impose other
requirements in the context of admission to trading of
securities, for example, more stringent eligibility
requirements and more onerous continuing obligations.
- Financial information: under the Transparency
Directive, the home member state will be entitled to impose
more stringent requirements than those prescribed by the
Directive.
- Practical matters: the competent authorities of
particular member states may be easier or more difficult to
deal with at a practical level and operational and practical
issues may have a bearing on the choice of home member state.
Factors to consider include the relevant competent authority's
language, its familiarity with structured products generally
and its review and approval process.
Content of prospectuses
In relation to the content
of prospectuses, the Prospectus Directive provides for a so-called
building-block approach, under which the detailed contents
requirements for prospectuses are set out in a matrix of schedules
and additional building blocks contained in an EU Regulation
implementing the Prospectus Directive. This Regulation will be
directly applicable in the member states from July 1 2005 without
the need for domestic implementing legislation. Hence, the contents
requirements for prospectuses laid down by the Regulation will not
be subject to the imposition of addtional requirements by
particular member states and so will be the same throughout the EU.
It remains to be seen, however, whether the Regulation will be
subject to different interpretations at a practical level by
different competent authorities.
The idea behind the building-block approach is that an issuer
must combine several building blocks to draft its prospectus. The
combination will depend principally on the type of securities. In a
number of cases the required combination will be obvious. However,
there are conceivably a number of different types of asset-backed
securities for which the combination is not necessarily clear-cut.
Where the securities have features completely different from the
securities catered for in the Regulation, the relevant competent
authority will be free to decide what information is required in
the prospectus after consultation with the issuer. Generally,
however, reduced disclosure requirements will apply in the case of
prospectuses for debt securities with a minimum denomination of at
least €50,000 or equivalent in other currencies (wholesale debt
securities). In particular, issuers of such securities will not be
required to produce a summary of the prospectus. Nor will they be
required to fill the annual disclosure statements mentioned
above.
Financial disclosure
The financial disclosure
requirements of the Prospectus Directive and the Regulation have
been the subject of a considerable amount of comment and debate.
The Regulation requires the prospectus for a structured finance
transaction to contain historical financial information covering
the latest two financial years where, since the date of
incorporation or establishment of the issuer, the issuer has
commenced operations and financial statements have been made up. If
the issuer has been operating for less than a year (which will be
the case for newly incorporated vehicle companies) the historical
financial information will be required to cover that period. It is
not clear what the implications are for certain issuers that may
not be required to prepare accounts at all (for example Cayman
Islands special purpose vehicles (SPVs)) and will not have made up
financial statements.
In the case of an EU issuer, the general principal is that
historical financial information included in the prospectus must be
prepared in accordance with International Accounting Standards
(IAS) or, if not applicable (as IAS is only compulsory for
consolidated accounts of listed companies), in accordance with the
national accounting standards of the member state in which the
issuer is incorporated.
In the case of a non-EU issuer, the historical financial
information will need to be prepared in accordance with IAS or in
accordance with the equivalent national accounting standards of the
country where the issuer is incorporated. The Commission has not
addressed the question of what constitutes equivalence for these
purposes. If the relevant national accounting standards are not
equivalent to IAS, the financial information included in the
prospectus will be required to be restated in accordance with IAS,
unless the prospectus relates only to securities with a minimum
denomination of at least €50,000 or equivalent in other currencies,
in which case the prospectus will be required to include a
prominent statement that the financial information has not been
prepared in accordance with IAS and a narrative describing the
differences between IAS and the accounting principles adopted by
the issuer.
The applicability of the financial disclosure requirements to
issuers of securities in structured finance transactions that
constitute equity securities (for example, preference shares) has
not yet been determined but the more onerous requirements
applicable to equity securities may apply.
EU Transparency Directive
On March 30 2004, the European Parliament approved a draft of
the Transparency Directive, which is intended to be implemented at
the member state level in 2005 or 2006.
The proposed Transparency Directive sets out ongoing disclosure
requirements for issuers of debt securities (including securities
issued in structured finance transactions) after these securities
have been admitted to trading on an EU regulated market. The
provisions do not distinguish between EU and non-EU issuers, and an
issuer that has already listed debt securities before the
Transparency Directive is implemented will be subject to its
provisions unless it qualifies for an exemption.
Issuers of EU listed debt securities will be required to produce
annual and half-yearly reports including consolidated financial
statements prepared in accordance with IAS. The competent authority
of a non-EU issuer's home member state may exempt that issuer from
these provisions if the law of the third country where the issuer
is incorporated imposes equivalent requirements. (Although it not
yet clear what equivalence means for these purposes, the concept of
equivalence is apparently intended to be applied consistently under
the Prospectus Directive and the Transparency Directive.) The
requirement to file periodic financial reports will not apply to
issuers who have only issued debt securities with a minimum
denomination of at least €50,000 or equivalent in other currencies
that are admitted to trading on an EU regulated market.
Issuers of listed securities in structured finance transactions
that constitute equity securities may be subject to the full
financial reporting requirements that will apply to listed shares
under the Transparency Directive.
Implications for existing transactions
There are no grandfathering provisions in the Prospectus
Directive or the Transparency Directive. An issuer of securities
that are already listed on an EU exchange will be subject to the
ongoing reporting requirements of the two Directives, unless an
exemption is applicable.
In relation to issuers with existing note issuance programmes
that are listed on an EU exchange, any new issue of securities
under the programme that are intended to be listed on the exchange
will require the revision of the prospectus for the programme to
the extent that the existing prospectus does not comply with the
requirements of the Prospectus Directive and the Regulation.
Matters for arrangers and issuers to consider now
Now that the Prospectus Directive and the implementing
Regulations are in force, and in the run up to the implementation
of the Prospectus Directive at the member state level and the
finalization of the Transparency Directive, arrangers of structured
finance transactions should be aware of the following matters and
plan accordingly:
- Arrangers should consider the requirements of particular
member states as they develop in relation to the Prospectus
Directive in terms of choosing a home member state for the
issuing vehicles in particular transactions. We expect that the
UK, Ireland and Luxembourg will continue to be the
jurisdictions of choice for listing asset-backed securities in
the EU.
- Arrangers should consider setting the minimum denomination
of any asset-backed securities in excess of the €50,000
threshold for wholesale debt securities to be able to choose
the home member state for issues of listed securities on a
deal-by-deal-basis, to ensure that the reduced disclosure
requirements for wholesale debt securities will be applicable
to any prospectus that has to be prepared, to avoid the
necessity to restate financial information in accordance with
IAS (for non-EU issuers) and to avoid the necessity for the
issuer to file an annual disclosure statement under the
Prospectus Directive and periodic reports under the
Transparency Directive.
- Arrangers may also wish to consider, in the case of non-EU
issuing vehicles, listing the securities on a non-EU exchange
(for example, the Cayman Islands, Bermuda or Jersey stock
exchanges) in order to avoid the ongoing financial reporting
requirements of the Transparency Directive.
- Arrangers of note issuance programmes should consider
whether existing programmes will have to be updated before
issuing a further series of notes once the Prospectus Directive
has been implemented at the member state level. Arrangers may
wish to consider changing the terms of programmes to ensure
that the minimum denomination of notes that may be issued under
them is greater than €50,000, for the reasons outlined above,
or moving the listing of programmes to another member state or
outside the EU altogether, depending on the requirements of the
relevant home member state.
Financial Collateral Arrangements (No 2) Regulations
2003
On 26 December 2003, the Financial Collateral Arrangements (No
2) Regulations 2003 came into force, implementing the EU Financial
Collateral Arrangements Directive of 2002.
The Financial Collateral Regulations affect the validity and
enforcement of certain charges that are over cash or financial
instruments in collateral arrangements and are intended to
facilitate the use of such arrangements. In this context,
collateral arrangements are agreements or arrangements the purpose
of which is to secure or otherwise cover the relevant financial
obligations owed to the collateral-taker and would therefore cover,
for example, standard collateral arrangements such as the ISDA
English law Credit Support Deed and Credit Support Annex. Clearly,
structured finance transactions containing credit support
arrangements under English law (such as collateralized debt
obligations (CDOs) or certain repackaging structures) are covered
by the Financial Collateral Regulations.
The main implications are as follows:
- It will no longer be necessary to register charges over
cash (for example in blocked deposit accounts) or over
financial instruments such as bonds and other similar items
under the UK Companies Act.
- Certain UK insolvency law, provisions that would otherwise
apply to collateral arrangements (for example, the power to
disclaim onerous property) have been disapplied.
- Closeout netting provisions in collateral arrangements are
to take effect in accordance with their terms, notwithstanding
that a collateral provider or collateral taker under the
relevant arrangement is subject to winding-up proceedings or
reorganization measures.
- A collateral-provider may create a security interest under
which it is provided for the collateral-taker to use and
dispose of any collateral advanced under the collateral
arrangement.
- Where a legal or equitable mortgage is the security
interest created or arising under the relevant collateral
arrangement, there is no requirement to apply to a court to
appropriate collateral.
- Where collateral provided is in the form of book-entry
securities held through one or more intermediaries, the
domestic law of the jurisdiction in which the relevant account
is maintained determines issues such as the requirements for
perfecting the collateral arrangement, the transfer or passing
of control or possession of book-entry securities under such
arrangement and whether a person's title to or interest in
book-entry securities is overridden by, or subordinate to, a
competing title or interest.
UK tax legislation changes
One of the policy objectives underlying the UK government's 2004
Budget is to clamp down on abusive mass-marketed tax avoidance
schemes. New rules are being introduced, increasing the level of
disclosure of financial products set up for UK tax avoidance
purposes and requiring promoters of such schemes to disclose them
to the Inland Revenue in advance of their implementation.
Similarly, a number of technical loopholes have been closed in the
increasingly complex rules governing taxation of derivatives and
debt relationships.
Not so much desired policy but forced reaction are behind the
recent changes to the UK's transfer pricing rules. Various recent
European judgments prohibit tax discrimination between EU member
states. The UK tax rules requiring connected party transactions
(such as intra-group loans and guarantees) to be at arms' length
rates/prices now apply to UK transactions as well as cross-border
transactions.
Lastly, even where tax rules are static, moving market practice
can still collide with them. With an ever-increasing range of
complex structured products being issued with increasing
regularity, the existing minefield of UK tax legislation is
becoming progressively more difficult to navigate safely. Most
structured products are issued out of non-UK vehicles, which helps
steer clear of many of the issues. However, the past year has
witnessed a growing minority trend of issuing structured products
out of the UK, giving rise to potential stamp duty costs on their
issue or transfer and restrictions on the tax-deductibility of
their interest.
Market developments
In this section, we examine some of the recent market
developments relevant to structured finance transactions.
Synthetic CDOs
One of the most remarkable trends in the international capital
markets in recent years has been the explosive growth in structured
credit products that combine the features of capital markets
instruments with derivatives.
The asset class that has come to dominate this segment of the
market is the synthetic CDO. A synthetic CDO is an issue of debt
obligations structured so that the investor is exposed to the
credit risk of a portfolio of underlying assets by virtue of a
credit derivative (usually one or a number of credit default swaps
(CDSs)) entered into by the issuer of the obligations. In a
synthetic CDO, the credit portfolio is typically made up of
corporate and/or sovereign bonds, but it may also consist in whole
or in part of loans (a synthetic CLO) or asset-backed securities,
which may be other CDOs (known as a CDO squared or
synthetic resecuritization). Increasingly, synthetic CDOs
have been structured so as to separate out the various tranches or
layers of credit risk otherwise comprised in a multiple tranche CDO
into packages that can be sold separately to investors.
Single-tranche synthetic CDOs (known as correlation trades)
now account for most synthetic CDO issuance. For the investor the
advantage of a single-tranche deal is control and flexibility and
for the arranger it is the ability to sell a particular piece of a
capital structure to a particular customer without having to find
purchasers for the rest of the structure. Single-tranche deals are
particularly well suited to issuance under note issuance programmes
and the speed, economy and flexibility of programme issuance are a
powerful incentive to arrangers in structuring these deals.
Initially, when synthetic CDOs first started to be brought to
the market in Europe, these transactions were used as risk transfer
mechanisms to reduce balance sheet capital requirements for
financial institutions. Over time the predominant goal has evolved
from balance sheet risk transfer to arbitrage. In arbitrage
transactions, the underlying credits are specifically selected for
the transaction and do not necessarily reside on the balance sheet
of the originator. They are chosen for the spread at which they are
trading versus their rating.
Over the past year credit spreads have tightened considerably
with the result that arbitrage opportunities have lessened. The
result of this trend has been that arrangers of synthetic CDO
transactions have been considering other types of transactions that
have the potential of delivering greater yield to investors than
would otherwise be the case in the current market environment. In
particular, arrangers have been exploring new asset classes and
structural innovations.
- Asset classes: There has been a considerable growth
in interest in synthetic CDOs referenced to portfolios of
asset-backed securities and high-yield debt securities.
-
Structural innovations: Among the structural
features that have become more common in the current market
environment are the following:
- The use of cash diversion features (borrowed from
cashflow deals) in synthetic deals. For example,
performance triggers that divert cash to a reserve
account that provides extra subordination for the
mezzanine tranches.
- Contingent coupons or step-up coupons.
- The use of equity default swaps (where a payout is
triggered by the fall in an entity's share price below
a certain level) and constant maturity technology
(where the premiums payable under the relevant swap
reset based on the mark-to-market value of the
swap).
Fund-linked notes
The last quarter of 2003 and the first few months of 2004 have
seen an increasing interest in fund-linked notes. Fund-linked notes
are typically issued pursuant to structured medium-term note
programmes by financial institutions, which may or may not hedge
the fund-linked notes by actually purchasing the shares/units in
the relevant fund, or pursuant repackaging programmes by SPVs,
which will purchase the shares/units in the relevant fund.
Typically, fund-linked notes issued by financial institutions
will provide that, on redemption, investors will receive an amount
calculated by reference to the increase in the net asset value
(NAV) of the relevant fund over the term of the fund-linked notes.
In many cases, there is also a principal protection element to the
redemption payment, although this can also be achieved by a
so-called knock-out feature, whereby the notes will be redeemed if
the NAV of the fund drops below a certain value.
Issues of fund-linked notes by SPVs are generally pass-through
structures, pursuant to which the investor receives amounts that
the SPVs receives from the underlying fund. Again, there may be a
principal protection feature, for example, provided either through
a swap or alternatively through the purchase by the SPV of highly
rated Eurobonds (often zero coupon).
Issues associated with fund-linked notes are:
- Place of incorporation: Consideration should be
given to establishing the SPV in a jurisdiction that is tax
efficient, but it is also important that the SPV be able to
issue fund-linked notes without being treated as a fund itself
or as the promoter of a fund under the laws of that
jurisdiction. In addition, certain jurisdictions may not allow
offers to the public to be made in relation to notes linked to
certain types of fund.
- Listing: The rules applying to the listing of
fund-linked notes on various stock exchanges in the EU differ
and so care must be taken to ensure that it is possible to
obtain a listing. This is particularly the case where the
underlying fund is not listed (which may prevent a listing of
the fund-linked notes in the UK and Ireland). For the
Luxembourg Stock Exchange, generally the criterion for listing
a fund-linked note is that the regulator of the underlying fund
has been recognized by the Commission de Surveillance du
Secteur Financier (CSSF). Whilst the CSSF has recognized
regulatory authorities in the EU member states, Switzerland,
the US and Canada (among others), the regulatory authorities in
some other jurisdictions, such as the Cayman Islands, have not
been recognized. These issues are critical if a listing of the
notes is required, either as a result of regulatory or other
restrictions on investors that limit their ability to buy
unlisted notes or so that the issuing SPV can pay interest free
of withholding tax (for example, Irish SPVs usually take
advantage of the Irish quoted Eurobond exemption to the
requirement to withhold tax under Irish law).
- Prospective investors: Fund-linked notes may be
targeted at retail investors, which raises certain issues (some
of which are examined below) that arrangers and their advisers
should be aware of.
New classes of investors
There has been a considerable increase in interest by arrangers
in offering structured products to retail investors and high net
worth individuals. The desire of arrangers to market an
ever-increasing range of sophisticated financial products to an
increasingly wide universe of potential investors has been
accompanied by an increasing awareness of the attendant risks of a
legal, regulatory and reputational nature. While many of these
risks can be effectively managed, careful consideration should be
given to them when marketing products which until recently have
been the exclusive domain of institutional investors.
Among the structures adopted by arrangers in marketing
structured credit products to investors other than institutional
investors is the use of a distributor intermediary. Typically, the
distributor intermediary will be a financial institution with
particular knowledge or coverage of the jurisdictions in which the
relevant securities are being offered. It will purchase the
securities from the arranger and then sell the securities to the
targeted investors in the relevant jurisdiction. In such a
structure, there is no direct contractual relationship between the
arranger and the ultimate investors.
Issues for arrangers to consider when adopting a distributor
intermediary approach are as follows:
- the relevant foreign law issues (including prospectus
content and registration requirements).
- the appropriate disclosure levels in the prospectus,
including risk disclosure and disclaimers.
- the status and financial viability of the distributor
intermediary.
- the contractual arrangements between the arranger and the
distributor intermediary. In particular the arranger should
consider appropriate representations and warranties from the
distributor intermediary as well as indemnification of the
arranger against any liability arising from the activities of
the distributor intermediary in connection with the
offering.
Author
biography
Michael Dodson
Simmons
&Simmons
Michael Dodson is an assistant in the capital markets group of
the financial markets department of Simmons & Simmons. He has
acted on a wide range of equity and debt capital markets and
structured finance transactions and in particular has focused on
CDOs and repackaging. Michael's recent experience includes advising
Barclays in relation to the Lambda synthetic CLO (the first CLO of
UK small and medium enterprise loans) and CSFB on the recent Cheyne
Correlation CDO.
Michael was educated at Queens' College, Cambridge. He qualified
as a solicitor in England in 1996, and in Hong Kong in 1997, where
he spent three years working in the capital markets group of the
Hong Kong office of Simmons & Simmons.
Simmons & Simmons
Citypoint, 1 Ropemaker
Street
London
EC2Y 9SS
Tel: +44 20 7628 2020
Fax: +44 20 7628 2070