New Beginnings for Structured Debt/Securitisation - Clifford Chance

New BeginningsPractical considerations for legal documentation and marketpractice for post-credit crisis structured debt transactions

Primary public issuance to private investors in the European structured debt markethas been extremely rare since the summer of 2007. However, the lack of new transactionssince the summer of 2007 has not meant a shut-down in activity for structured debtprofessionals. New primary public transactions have been replaced by issuances toprovide collateral for central bank liquidity schemes, amendments to existingtransactions to deal with, among other things, changes to rating criteria and collateralperformance and the constant flood of regulations, legislation and industry initiativesto address perceived lacunae and shortcomings in the structured debt market.

Introduction

The market-leading Structured Debt Group at Clifford Chance has continued to be closely involved in all aspects of the structured debtmarket throughout this period and is uniquely placed to use its experience to consider and advise on the issues that have arisen out ofthe credit crisis and which will need to be addressed in the post-credit crisis structured debt market. Now that there are signs that theprimary markets for private investors in European structured debt are beginning to thaw, we believe that the time is right to provide ourclients and contacts with our collected views in this publication on how aspects of the post-credit crisis structured debt market should bereflected in legal documentation and market practice going forward.

The approach we have taken in each section is to identify key issues and to provide practical guidance – including suggested legaldrafting where appropriate – on how to address those issues. We do not expect all market participants to agree with all of oursuggestions and we accept that some of our more radical solutions may not gain traction. Nevertheless, it is, in our view, important thatproper thought and consideration be given by structured debt professionals to how legal documentation and market practice should beadapted in post-credit crisis primary public issuance of structured debt to reflect the concerns, problems and gaps exposed by the creditcrisis. We do not believe simply muddling along with ad-hoc “fixes” on a transaction-by-transaction basis is tenable.

We hope you find this publication useful and thought-provoking. Should you have any questions, comments or observations pleaseget in touch with your usual Structured Debt contacts at Clifford Chance or one of the Structured Debt partners listed on page 95.

Kevin Ingramon behalf of the Structured Debt GroupLondon, 25th November 2009

1. Rating agency confirmations – how necessary will they be? 1

2. Difficult decisions in the capital markets - the role of the trustee 5

3. Servicing and cash management roles in RMBS: a poisoned chalice? 13

4. SPV directors and corporate governance 17

5. The UK covered bond market during the financial crisis:maintaining ratings 21

6. SIVs – lessons from the crisis 27

7. CMBS – the last slice of the dice? 33

8. Disposal of assets: greater flexibility all round? 39

9. New rules for a new way forward for commercial mortgage lending 45

10. Synthetic securitisations, CDO2 and CLNs – distant memoriesor sleeping beauties? 53

11. OTC derivatives in structured debt transactions 57

12. Investor disclosure 67

13. Lifting the regulatory fog - will the amendments to CRD reveal anew landscape? 71

14. Re-securitisation – holding a costly position 77

15. Bank and building society insolvencies revisited: the impactof the Banking Act 81

16. Government asset schemes and their impact on securitisation 87

17. ECB liquidity transactions - a refresher and an outlook onchanges to come 91

Contents

1. Rating agency confirmations– how necessary will they be?

© Clifford Chance LLP, 2009

Broadly speaking, a rating agencyconfirmation or affirmation (an “RAC”) isa written statement issued by the ratingagency that confirms, post-closing, thata proposed action in respect of therelevant transaction will not result in adowngrade or the withdrawal of currentratings of the notes. Traditionallytransaction documents may require thatcertain waivers in respect of, oramendments to, existing transactiondocuments, changes of counterparties(e.g. servicer, liquidity or swap provider),substitution or addition of assets orchanges in certain ratios set out in thetransaction documents are contingentupon the receipt of an RAC.

Rating agency attitudespost-credit crunchThere is currently no market standard,nor published criteria, in relation to whenan RAC will be provided upon request,although we note that there was anincreasing reluctance to give RACs evenbefore the credit crunch. During the creditcrunch, Fitch have taken the most firmview and have issued a report1 statingthat they will no longer provide RACs inconnection with structured credittransactions and, in the event that anRAC is requested, Fitch will direct therelevant trustee to the aforementionedreport. The rating agencies have arguedthat they have traditionally taken the roleof an independent observer of the

transaction who will rate the credit risk ofthe issued liabilities based on thetransaction documents at the time ofclosing. Rating agencies are not partiesto the documentation and will not havebeen involved post-closing. Ratingagencies, in particular Fitch, havetherefore stated that it is inappropriate forthem to be asked to sanction, confirm oradvise upon any post-closingamendments to the transaction. It seemsthat Fitch is applying this policy toexisting transactions even when there areprovisions specifying the circumstancesunder which an RAC is required.

In contrast, it appears that Moody’s, whohave not issued any formal guidance, arestill minded to give RACs for existingtransactions where the documents requireRACs to be provided. In new transactionshowever, we note that Moody’s haveresisted the inclusion of RAC language inmost cases, with the exception of certainprincipal matters (determined on a case bycase basis) where Moody’s may stillrequire an RAC to be given.

S&P does not appear to have changedits policy and seems generally receptiveto giving an RAC when required underthe relevant transaction documents.

Whilst there has been some push back onthe provision of RACs by rating agencies,RACs can be distinguished from merenotifications to rating agencies. Fitch, inparticular, has stated that it will require

notification of changes to transactions.Fitch may determine whether suchchanges are material and may issue itsopinion in a public statement if suchchange is deemed material or results in achange of Fitch’s rating opinion.

In practice it is simply unrealistic toexpect changes to be made to existingtransactions without properconsideration of the impact on the thencurrent ratings and this will imply, inmost cases, a level of engagement withthe rating agencies prior toimplementation of such changesregardless of their policies on RACs.

How has the change inapproach affected existingand future transactions?Existing Transactions

There is currently much uncertainty as towhat the response from the ratingagencies would be upon a request for

In this section we explore the differing attitudes of the rating agencies towards theconcept of rating agency confirmations (RACs) in the current market, how theseimpact on both existing and future transactions; the reactions of trustees towards theRAC (or the lack of it), its impact on the trustees’ discretion as to material prejudiceand ways to address these in existing and future transactions. In our view,requirements to obtain an RAC in existing documentation should not be interpretedby trustees as an imperative prerequisite before exercising its own discretion. In newtransactions, replacing an RAC with a determination as to the likely rating effect byother transaction parties responsible for the ongoing management of the transactioncould be an appropriate alternative.

“Fitch has stated that it isinappropriate for them tobe asked to sanction,confirm or advise uponany post-closingamendments to thetransaction”

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1 “Structured Credit Criteria for Reviewing Post-Closing Actions” published by Fitch Ratings 2009

an RAC, which is specified underexisting documentation to a transaction.One typical scenario is in the context ofamendments to transaction documentsor waiver in respect of a breach underthe transaction documents. Very often,documents will have provisions to theeffect that the trustee may grant consentto a proposed waiver or amendmentwithout noteholders’ consent if suchmatter is not materially prejudicial to theinterest of the noteholders or if an RACis given.

The reference to the latter has created, inour view, a three-fold miscomprehensionin the market in the past. First, on thepart of the originator, that as long as anRAC is provided, the trustee will giveconsent as a matter of course; second,on the part of the rating agencies, thatthey have an “obligation” to provide anRAC and that the matter is contingent onthe provision of an RAC; third, on the partof the trustee, that it will not exercise itsdiscretion unless an RAC has beenobtained (preferably from all ratingagencies that have rated the transaction).During the credit crunch, where this typeof language has been tested on a largescale, it has become clear that when anRAC is used in conjunction with trusteediscretion, the trustee will always berequired to exercise its discretion andshould not rely upon the opinion of ratingagencies to affirm the course of action tobe taken in a particular matter. In ourexperience, trustees have now clarified,on many occasions, that an RAC ishelpful to their analysis, but is notessential in enabling them to reach a viewas to material prejudice. In ourexperience, trustees have also beenwilling to exercise their discretion wherean RAC was not forthcoming from allrating agencies. We believe both of thesepositions are correct and are an inherentpart of the trustee’s role. For a more

detailed analysis of trustee discretion, seethe section entitled “Difficult decisions inthe capital markets - the role of thetrustee.”

Future Transactions

It has been our experience that thoughthe rating agencies have moved awayfrom RACs in certain circumstances, todiffering extents, Moody’s and S&Pcontinue to be willing to issue an RAC inrelation to post-closing matters that arefundamental to the rating analysis of thetransaction. Drafting counsel should alsobe aware of the circumstances in whichan RAC would be required due to thenature of the relevant matter. It istherefore important that the ratingagencies are involved early on inreviewing documentation languagefor future transactions as the views ofthe rating agencies differ materially inthis area.

Where traditionally an RAC would havebeen required but, due to the changeof internal policy, the relevant ratingagencies refuse to include RACs in thetransaction documents, we considerthe following two alternativeapproaches should be acceptable toboth the rating agencies andtransaction parties, with the firstapproach being the preferred one.These approaches have been includedby Clifford Chance in a number ofcompleted transactions:

(a) Replace an RAC with adetermination by anothertransaction party

In some transactions a party who isclose to and involved in the day-to-daymanagement of the transaction, forexample a servicer or cash manager, isbest placed to provide a confirmationthat the relevant amendment will not, inits opinion formed on the basis of due

consideration, result in the downgrade orwithdrawal by the rating agencies of therating. To form such an opinion, it isexpected that the relevant transactionparty will liaise and consult with therating agencies or will be able to rely onpublished rating criteria. This is, in ourview, nothing more than an accuratereflection of the actual process takingplace. It has been our experience thatthis language is, in most cases,acceptable to the transaction parties andto the rating agencies.

(b) Definition of “Rating AgencyConfirmation”

In some transactions, the definition ofRAC has been amended to include theconcept that if the relevant ratingagency has been approached inrelation to the requirement to obtain anRAC and has not provided an RACwithin a specified period of time (norhas it given any negative feedbackwithin such timeframe) the relevantrating agency shall be deemed to haveprovided such RAC.

Though this wording has been acceptedby the rating agencies in certain deals, inour view the concept of a deemed RACshould ideally be avoided due to the factthat it leads to inherent uncertainty for thetransaction parties.


“In practice it is simplyunrealistic to expectchanges to be made toexisting transactionswithout properconsideration of theimpact on the thencurrent ratings”

3 New Beginnings


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2. Difficult decisions in the capitalmarkets - the role of the trustee


• How to assist a trustee to use itsdiscretionary powers to agree tomodifications or waivers or giveits consent under the documentsgiven the difficulties with it gettinginstructions from noteholders.

• Improving the existing mechanicsfor communicating withnoteholders and/or getting theirinput outside of formalnoteholder meetings.

• Ensuring the trustee can amendmanifest errors or maketechnical/minor amendmentswithout noteholder consent evenif the amendments are in respectof a Basic TermsModification/Reserved Matter.

• Dealing with ratings downgradesin respect of third partyservice providers.

What we are seeing inthe market?The need to anticipate (anddocument accordingly) the likelyareas in a transaction where theoriginator/issuer/lead managerwill require ongoingamendments/consents to increasethe likelihood of the trustee beingable to exercise its discretion inthe absence of noteholderconsent. If noteholder input isinevitable, the need to achievesimpler and more accessiblechannels of communication.

This section examines the difficulties which arise for issuers who need tocommunicate quickly or informally with noteholders and for trustees asked to givetheir consent under existing transactions in the context of modifications, waivers,consents and appointment of replacement third party service providers. Thedownturn in the market and the increased need to revisit existing documentation inthe context of, in particular, rating downgrades and restructurings has brought theseissues to the top of the agenda for originators, issuers, trustees and investors alikeacross the market.

This section sets out a number ofspecific issues that have arisen in ourrecent experience with trustees onstructured finance transactions andwhich, until the “credit crunch”, hadrarely been at the forefront of interestedparties’ minds. These issues havecritically exposed constraints on parties’ability to react in good time and measureto some of the problems caused by therecent turmoil in the financial marketsand have had an adverse effect, orcaused considerable frustration for allconcerned. They need to be resolved ormitigated as a matter of priority.

The approach we set out below is not apanacea and will vary between differenttypes of structures, product types,regulatory and jurisdictional issues,transaction as well as the role assignedto the trustee and the commercialexpectations of the parties. However, iftrustees will be required to take a moreactive role in future transactions whilstcommunications with noteholders remaindifficult, then the documentary provisionswill need to give the trustee moreassistance and guidance than previouslyprovided to enable them to do so.

Recent rating downgradesA familiar problem faced by trustees inthe market in recent months arose inthe context of a number of entitiesperforming the role of swapcounterparty, liquidity facility providerand/or account bank suffering ratingdowngrades taking their rating belowthe requisite level required by the terms

of existing transactions (but not,however, below the level required bymore recent revised rating agencycriteria published after the closing dateof existing transactions).

These downgrades triggered provisionsin existing transactions which wouldimpose onerous obligations on therelevant entities to post collateral or, inthe case of liquidity facility providers, tomake a stand-by liquidity drawingavailable to the issuer and, in manycases, require the relevant issuer to finda replacement entity with the requisiterating to perform the relevant role (whichis often a difficult task in the currentmarkets). These provisions weretriggered notwithstanding the fact thatthe relevant entity continued to meet therequisite ratings required by more recentpublished rating agency criteria fortransactions of the type in question andthis led to issuers and/or counterpartiesseeking trustee consent to amend orwaive the required rating definitions inexisting transactions on the basis of therevised published rating agency criteriaand rating agency confirmations of theratings of the notes.

Trustees have, however, been faced withinflexible language used in the requiredratings definitions in existing transactionsand in many transactions, the relevanttrustee has been unwilling to exercise itsdiscretion under the No MaterialPrejudice Limb (see “Trustee discretion –modifications, waivers and consents”below) and instead took the decision tocall noteholder meetings in order to

New Beginnings 6

approve the amendment and/or waiver.Due to the relatively innocuous nature ofsuch proposals and inability toenfranchise noteholders, the trusteeshave in many cases struggled to obtainquorum at the relevant noteholdermeetings and the process for agreeingsuch waivers or amendments has beencumbersome. To avoid these problems infuture transactions, our recommendationis that flexibility should be built into allrequired rating definitions with suggesteddrafting along the following lines:

“The Issuer Account Bank shall at alltimes be a financial institution having ashort-term senior unsecured debt ratingof at least “A-1” by S&P (or, where noshort term unsecured debt rating by S&Pis available and a long term rating of theaccount bank is available, at least “A” byS&P) and at least “F1” by Fitch (or “A”(long-term) by Fitch if the relevant entitydoes not have a short-term rating) and atleast “P-1” by Moody’s (or, where noshort term unsecured debt rating byMoody’s is available and a long termrating of the account bank is available, atleast “A2” by Moody’s) or such otherratings that are consistent with the thenpublished criteria of the relevant RatingAgency as being the minimum ratingsthat are required to support the thenrating of the Most Senior Class of Notes(the “Issuer Account Bank RequiredRating”). In the event that the IssuerAccount Bank no longer satisfies theIssuer Account Bank Required Rating, itshall notify the Issuer, the CashAdministrator and the Note Trustee assoon as practicable and the Issuer, withthe consent of the Note Trustee, shall usereasonable endeavours to procure that areplacement Account Bank, satisfying theIssuer Account Bank Required Rating isappointed in accordance with theprovisions of the Account BankAgreement within 30 calendar days.”

Trustee discretion –modifications, waivers andconsentsThe modification and waiver provisions insecuritisation transactions traditionallygive the trustee a discretion to agree tomodifications and/or waivers without theneed for noteholder consent under twolimbs, namely (1) amendments/waiverswhich would have no material prejudice(the “No Material Prejudice Limb”); and (2)formal, minor or technical amendments oramendments required to correct amanifest error (the “Manifest Error Limb”).These provisions are designed tocircumvent the lengthy process and costsinvolved in calling noteholder meetings insituations where the modification orwaiver in question should, by virtue of thenature of the modification or waiver inquestion, be non-controversial (or, in thecase of a manifest error, be required tocorrect a clear mistake).

In addition, it is common forsecuritisation transactions to require atrustee to give its consent to a variety ofchanges during the lifetime of a dealranging from, for example, approving theappointment of a new service provider toagreeing material commercial changes inrespect of the underlying asset pool (a“Consent Provision”). However, as thecomplexity of securitisation transactionshas grown, it has become increasinglydifficult for a trustee to determinewhether or not it should give its consent,particularly as little or no realdocumentary guidance has beenprovided for the trustee in these morecomplex circumstances.

No Material Prejudice Limb

In the current climate,issuers/originators have been and arelikely to continue to face challengeswhen seeking to utilise these provisionsor restructure existing transactions

based upon the No Material PrejudiceLimb/Consent Provision in light of thelack of guidance/parameters traditionallygiven to trustees to enable them tomake such a determination.

In a number of highly structuredtransactions - in particular, wholebusiness securitisations - clear, disclosedguidelines have been hard-wired into thedocumentation in connection with the NoMaterial Prejudice Limb/ConsentProvisions to assist the trustee in makingits decision as to whether a matter will orwill not cause material prejudice to theMost Senior Class of noteholders (or, aswill be the case in whole businesssecuritisations, the wider universe ofcreditors (including the noteholders)) or toset out the basis on which it should giveits consent.

Such guidelines might take the form ofcertain key statements enshrined in thedocumentation as to what will and willnot constitute material prejudice (i.e. “theamendment or waiver will not adverselyimpact the obligor’s ability to makepayments due in respect of the[Notes]/[debt]”) or, with the ConsentProvision, set out clearly how theTrustee will decide whether to give itsconsent eg “without the consent of thetrustee (the Trustee relying on the adviceof [specify relevant expert]”) or “theTrustee shall give its consent if providedwith a certificate signed by XYZconfirming ABC)”.

Another example is that, if thetransaction documentation grantspermission to the Issuer (or a serviceron its behalf) to amend the economicterms of an underlying loan subject totrustee consent, the trustee’s consentto such amendment could be pre-wiredinto the documents providing that as aresult of such amendment, certainparameters set by reference to a pre-closing agreed financial model (one


7 New Beginnings

which has been agreed by the originatorand the lead manager) are notbreached. The relevant parametersshould be coupled with a certificationobligation in favour of the trustee fromeither the originator or other third partyservice provider having relevantknowledge in relation to the underlyingfinancial model and the trustee shouldbe enabled to grant its consent solelyby relying on that certificate.

The aim of these examples is to enablethe trustee to give its consent after ithas been provided with the relevantcertification/provision of expertadvice/other without noteholderapproval. Whilst it may not, without thebenefit of foresight, be possible to tailorthis concept to the No Material PrejudiceLimb/Consent Provisions on a generalbasis, if the transaction parties areaware at the outset of aspects of atransaction where they know they wantthe flexibility to change them during thelifetime of the deal, the use of such amechanic could bring greater certaintyand efficiency to trustee decision makinggoing forward.

Provided that these indicators of materialprejudice/consent are disclosed toinvestors in the prospectus, we believethat the trustees, originators andinvestors can all benefit from clearparameters upon which to build atrustee’s decision making process as towhether an amendment/waiver causesmaterial prejudice or whether its consentshould be given (noting that inconjunction with these guidelines thetrustee is also likely to seek a ratingagency confirmation to support itsdecision – although readers should noteour discussion on the future of ratingagency confirmations in “Rating agencyconfirmations - how necessary willthey be?”).

This model has not previously beenadopted for more vanilla paradigm truesale securitisations and we wouldsuggest, in light of the challenges beingfaced by trustees on many of thesetransactions, that serious considerationshould be given to a similar model beingfollowed for all transactions goingforward to increase clarity for trusteesand to also raise the likelihood ofissuers/originators being able to utilisethe No Material Prejudice Limb/ConsentProvisions to full effect in appropriatecircumstances whilst still protectinginvestors’ interests.

Notwithstanding the above, in all caseswe would (in our view rightly) expect tosee Basic Terms Modifications/ReservedMatters carved out of the No MaterialPrejudice Limb thereby entrenching themost fundamental provisions for thebenefit of all classes of noteholders (seethe example drafting and our discussionon the same below in relation to theManifest Error Limb).

Manifest Error Limb

We are aware of a number oftransactions in the market where the

manifest error discretion given to thetrustee has carved out any amendmentswhich constitute “Basic TermsModifications” or “Reserved Matters”.The Basic Terms Modification/ReservedMatter concepts were established toprotect noteholders against changes toprovisions fundamental to thenoteholders, such as the interest ratepayable on the notes or the due date forpayment of interest or principal. Theyare an important part of the bargainbetween the investors and the issuer.However, in order to facilitate efficientand pragmatic decision making, incircumstances where an amendment toa provision is necessary to correct amanifest error or is of a formal, minor ortechnical nature, the trustee should notbe constrained by the Basic TermsModification or Reserved Matterrestriction and should, in thesecircumstances, have the ability to agreeto such amendment without noteholderconsent even if the proposedamendment is one that would otherwisefall within the Basic TermsModification/Reserved Matter definition.

“Due to the relativelyinnocuous nature of suchproposals and inability toenfranchise noteholders,the trustees have in manycases struggled to obtainquorum at the relevantnoteholder meetings andthe process for agreeingsuch waivers oramendments has beencumbersome”

“as the complexity ofsecuritisation transactionshas grown, it has becomeincreasingly difficult for atrustee to determinewhether or not it shouldgive its consent,particularly as little or noreal documentaryguidance has beenprovided for the trustee inthese more complexcircumstances”


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If there is a manifest error in a provision,for example, the interest rate/maturitydate, it is important that the Trustee hasthe ability to correct this.

If the Manifest Error Limb is madesubject to the Basic Terms Modificationor Reserved Matter restriction, this willresult in time, cost and inconvenience(or at worst, an impasse) for a non-controversial amendment or (in the caseof manifest error) a necessaryamendment to the documents to reflectthe original commercial intentions of theparties. Subject to the trustee beinggiven satisfactory evidence that theamendments fall within the ManifestError Limb, the use of its discretion inthese circumstances should not beconsidered detrimental to noteholders(and, in the case of manifest error)beneficial. It is therefore important toensure that in new transactions, themodification and waiver condition (andthe corresponding clause in theunderlying trust deed) is drafted in theway proposed, with the Basic TermsModification/Reserved Matter conceptapplying only to the No MaterialPrejudice Limb of the discretion and notto the Manifest Error Limb. An exampleof such a clause is set out below.

Sample drafting

The Trustee may, at any time and fromtime to time, without the consent or

sanction of the Noteholders or any otherSecured Creditors, concur with the Issuerand any other relevant parties in making:

(a) any modification to these Conditions,the Trust Documents (other than inrespect of a Reserved Matter or anyprovision of the Trust Documentsreferred to in the definition of aReserved Matter)2, the Notes or theother Transaction Documents inrelation to which its consent isrequired which, in the opinion of theTrustee, will not be materiallyprejudicial to the interests of theholders of the Most Senior Class ofNotes then outstanding; or

(b) any modification to these Conditions,the Trust Documents or the otherTransaction Documents, in relation towhich its consent is required, if, in theopinion of the Trustee, suchmodification is of a formal, minor ortechnical nature, or is made to correcta manifest error.

Most Senior ClassThere will inevitably be situations wherea trustee is asked to consent tomodifications or waivers incircumstances where it feels unable toexercise its discretion on behalf ofnoteholders under either the ManifestError Limb or the No Material PrejudiceLimb and will instead seek the directionof noteholders in respect of the relevantmodification or waiver. In suchcircumstances, we have found thatdocumentation is often unclear (orindeed silent) as to which class ofnoteholders the trustee should turn tofor direction where the particularamendment or waiver affects or maycause material prejudice to more thanone class of noteholders. This hasresulted in trustees taking the cautious

approach of calling meetings of eachclass of noteholders before agreeing toconsent to the relevant matter, whichleads to delays and often to statementbetween different classes ofnoteholders.

We are of the view that for thepurposes of modifications, waivers andconsents where the trustee has notchosen to exercise its discretion underthe Manifest Error Limb or the NoMaterial Prejudice Limb (excludingBasic Terms Modifications/ReservedMatters), the transaction documentationshould give clear and consistentauthority to the trustee to seekdirections from the noteholders inrespect of the Most Senior Class ofnotes only (without regard to the effectof such direction on the junior rankingclasses of notes). This approach willserve to make a typical structure moredynamic and will enable trustees to bemore responsive to requests foramendments, waivers and consents.Whilst we accept that there may be adebate on this point in some existingtransactions where junior noteholdersare seeking to exert pressure ontrustees in respect of restructurings andare looking for a seat at the table,particularly where their views differ fromthose of the Most Senior Class ofnotes, for transactions going forward,we are of the view that this is thecleanest approach to take and aligns

“we believe that the trusteecan benefit from clearparameters upon which tobuild its decision makingprocess as to whether anamendment/waiver causesmaterial prejudice”

“if there is a manifest errorin a provision, for example,the interest rate/maturitydate, it is important thatthe trustee has the abilityto correct this”


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2 Note: as discussed, the Reserved Matter carve-out is not included in limb (b).

with the risk that junior noteholderstake when buying notes ranking furtherdown the capital structure (bearing inmind that all noteholders will continueto benefit from the Basic TermsModification/Reserved Mattermechanics). From a documentationperspective it will be important toensure that this risk is clearly disclosedto investors and that all aspects of thedocumentation (from the terms andconditions of the notes to theunderlying trust deed) align withthis position.

Sub-Classes of NotesWhere a trustee is seeking direction froma particular class of noteholders (whetheras a result of a Basis TermsModification/Reserved Matter or wherethe relevant class is the Most SeniorClass of noteholders) and that classcomprises several “Sub-Classes”,documentation should give clearauthority to the trustee to call acombined meeting of all Sub-Classesunless it considers that would bematerially prejudicial to the interests ofthe holders of one or more Sub-Classeswithin a class (rather than the more usual“conflict” language). This is to decreasethe occurrence of multiple meetings ofsub-classes of noteholders who rankequally in all material respects in thewaterfall (and whose commercialinterests should therefore be aligned).Failure to hold combined meetings ofsub-classes in these circumstances canunnecessarily exacerbate the chances ofnot passing an extraordinary resolution.

Channels of communicationwith noteholdersIf a trustee is unable to exercise itsdiscretion as described above, the formal

decision making process in capitalmarket transactions is generallycumbersome and inflexible, requiring thetrustee to obtain consent from a class orclasses of noteholders using thenoteholder meeting provisions in the trustdeed. These provisions require a physicalmeeting of noteholders and are moresuited to binary decision making wherenoteholders can vote for or against adefined proposal. Likewise, currentcommunication methods forissuers/service providers to contact theirinvestors are neither swift nor designedfor continuous and/or informal dialoguewith them, be it in a restructuringsituation or otherwise. Issuers andtrustees alike are also materiallyconstrained in their ability tocommunicate freely with investors dueto, for example, stock exchange rules,the market abuse directive and theirobligation to communicate any materialinformation to all investors at the sametime (rather than to just those whoseidentity is known to the issuer/trustee).

All these issues have caused problems inexisting transactions throughout the creditcrisis (particularly with restructuringproposals naturally evolving during anyconsent process and/or when investorswere desperate to receive informationabout their potentially (or actually)defaulting securities).

Frequent delays in investors receivingnotices/other communications fromissuers/trustees was a specific concernhighlighted by investor representativesat this year’s ESF/IMN ABS conferencein London. Delay arise in particulargiven that such notices generally haveto be sent through the clearing systemsand so pass through a chain of sub-custodians, often using non-standardcommunication format. The

consequence of this is two-fold:(i) information contained in notices toinvestors may change and may reachthe final recipient in summary form –hardly ideal if the matter requires timelyconsideration and response regardingpotentially complex, commerciallyimportant issues; and (ii) due to delaysin transmission, investors are unableto attend the relevant noteholdermeetings causing unwelcome delaysand costs for all.

Many investors would welcome moreflexibility in the way that information iscommunicated to them. Most investorsprefer to receive notices via Bloombergor Reuters (for example). Provided theinformation is published in accordancewith the rules of the relevant stockexchange and clearing systems andmaking such information public doesnot breach any applicable market abuselegislation, it makes sense to expresslyinclude references to these alternativecommunication methods going forwardin standard notice provisions of theterms and conditions.

At the very least, within the currentnoteholder meeting regime, in order tomitigate the problems arising from sucha binary decision making process,mechanics need to be developed (with

“current communicationmethods forissuers/service providersto contact their investorsare neither swift nordesigned for continuousand/or informal dialoguewith them”


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appropriate controls to protectinvestors’ interests) to allow resolutionsput to noteholders at meetings to beamended at the meeting itself or uponthe vote of a noteholder representativecommittee in order to avoid the need tocall a further noteholder meeting (andwait for the required notice periods toexpire) to deal with a revised resolution.Another idea could be to give issuers ortrustees the ability to cancel meetingsonce they’ve been called (again, withappropriate controls) rather than torequire the Issuer to go through thecost and time of holding, for example,original and adjourned inquoratemeetings when it’s clear that theresolution will not be passed.

However, we also support thedevelopment of new mechanics tofacilitate decision making outside of theexisting communication methods andnoteholder meeting regime. Such newmechanics could take the form of“creditor representatives”, being aninvestor or group of investors acting onbehalf of the noteholders as a group,and the establishment of steeringcommittees akin to those used in thebank lending market. Another option isthe appointment of a “commercialexpert”, being a third party serviceprovider acting to collate the views ofthe noteholders and advise the trusteeaccordingly. Clauses can be included inthe noteholder meeting provisions of thetrust deed to contemplate noteholdersvoting on the appointment of suchrepresentatives or experts. Where formal

mechanics for representative/creditorcommittee/expert decision-making areput in place, in our view, the trusteeshould be removed from the decisionmaking process altogether (other than inrespect of Basic TermsModifications/Reserved Matters) (and inturn, this would also serve to remove therequirement of any suchrepresentative/creditor committee actingon behalf of the noteholders toindemnify the trustee in thesecircumstances).

Inevitably, mechanics of this nature willbring their own challenges, for example:(a) where the costs of third party“commercial experts” will be met in thewaterfall of payments – the“commercial expert” will expect theseto rank super-senior but rating agenciesmay have concerns over potentiallyopen-ended costs being met in priorityto payments on the notes; (b) whethersuch expenses (and liabilities of anyinvestor representative) can berecovered through the super-seniorprovision at the top of the waterfall; (c)whether the market will see creditabilityin such mechanisms at the outset – itwill inevitably take time for participantsto gain confidence in any suchcommunication channels; (d) whetherthere is merit in noteholders having theability to switch on/switch off suchmechanics in certain scenarios. Whilstthis is a developing area, our view isthat noteholder meeting provisions inthe trust deed should allow for suchappointments, such appointmentparties should be remunerated for theirfees through the issuer waterfall at thesame level as the trustee’s fees andexpenses (however any indemnityrequired by the representatives wouldbe provided by the noteholdersthemselves and would not be met by

the Issuer through the waterfall) andthat noteholders can vote todiscontinue such decision makingarrangements at any point, reverting tothe traditional noteholdermeeting mechanics.

Appointment of replacementthird party service providers– trustee discretion to selecta replacementMost termination provisions in cashmanagement and servicing agreementsgive the trustee discretion to agree withthe issuer to appoint a replacement thirdparty service provider following thetermination of an existing appointment.The challenge for the issuer and thetrustee is in coming to an agreement on asuitable replacement in the absence of anyexplicit guidelines written into thetermination provisions.

Our view is that this issue can bedifferentiated by reference to two scenarios:

• if the originator of a transaction issolvent and not in default: thereplacement third party service

“Many investors wouldwelcome more flexibility inthe way that information iscommunicated to them”

Such new mechanicscould take the form of“creditor representatives”,being an investor orgroup of investors actingon behalf of thenoteholders as a group,and the establishment ofsteering committees akinto those used in the banklending market


11 New Beginnings

provider provisions should expresslycontemplate the originator/servicerperforming the primary role in termsof identifying a suitable replacemententity with the issuer being the entityformally appointing such replacementand the trustee consent to suchappointment being pre-wiredprovided that the replacement entitysatisfies the relevant rating criteriaand any other specified criteria (e.g.,in an RMBS transaction, anyreplacement administrator must have“experience servicing residentialmortgage loans in the UnitedKingdom”); and

• if the originator/servicer isinsolvent or otherwise in default:the replacement third party serviceprovider provisions should require theissuer and the trustee to agree a

replacement entity. To facilitate trusteeconsent, this scenario is ideally suitedto the proposals discussed above inrelation to noteholder representatives/commercial experts.

ConclusionWhat we hope this section highlights, is the range of problems being encountered inrelation to trustee decision making on existing transactions and the types of solutionswhich in our view need to be considered going forward. These solutions range fromsimple drafting fixes which should hopefully iron out uncertainty and reduce thelikelihood of impasse between classes of noteholders if incorporated into futuretransactions to more complex proposals which will require thought from originators,issuers, trustees and investors alike across the market. Needless to say, thesesolutions will not necessarily serve to remove the problems being faced by parties onexisting transactions and it remains to be seen whether further lessons will be learntfrom the current restructurings taking their course over the coming months.


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3. Servicing and cash managementroles in RMBS: a poisonedchalice?

Mortgage AdministrationWe expect there to be more focus on theservicing and cash managementarrangements being documented througharms-length, fully inclusive agreements,rather than “broad-brush” SPV documentswhere some aspects of day-to-dayoperation may be left to be figured out afterthe transaction has closed. A number ofspecific aspects are considered below:

Fees, Costs and Expenses

The amount of fees payable to servicers istypically expressed as a percentage of theaggregate amount outstanding in relation tothe underlying portfolio of mortgage loans.This arrangement may be less than idealfor servicers (particularly third partyservicers who are not the originator/seller)in circumstances where the performance ofthe portfolio has deteriorated, or anoriginator/seller has suffered an event (suchas insolvency or administration) amountingto a perfection event. In suchcircumstances, the servicer may berequired to do substantially more work thanoriginally anticipated, particularly if it isnecessary to perfect the issuer’s legal titleto the loans (by notifying borrowers) andrelated mortgages (by executing therelevant transfer documents and lodgingthose with HM Land Registry). Unlike inCMBS transactions, where an increasedlevel of fees payable to “special servicers”reflects the increased level of work requiredwhere borrowers are in default, the typicalRMBS transaction documents do notprovide for such an increased level of fees.

It would be advisable to specificallyconsider the different scenarios, andinclude provisions that specifically addresseach of these scenarios; an example mightbe providing for a higher level of feeswhere larger than expected numbers ofborrowers are in default (for example,during a recession).

Whilst a servicer will typically be able torecover the resulting increase in its “out-of-pocket” costs and expenses from theissuer, it is often not contemplated thatthe servicer be remunerated for the extratime it has spent in doing the work. Inaddition, the term “out-of-pocket” costsand expenses itself may not be broadenough to encapsulate expenses of aservicer which may be incurred inextraordinary circumstances.

Whilst we do not expect a radical change,such as the introduction of a CMBS-stylespecial servicer role in future RMBStransactions, we expect that servicers mayconsider the increased amount andcomplexity of the work that may berequired at different stages in the life of adeal; particularly given that it will have to beperformed at a time when the transactioncash flows may be under pressure due tothe performance of the portfolio, or whenthe portfolio may be in jeopardy due to anoriginator’s failure. This may be reflected inmore sophisticated contractual provisionsrelating to fee arrangements and therecovery of costs and expenses.

This was perhaps less of an issue whenthe RMBS market was largely

performing, but now there is much morefor the servicer to do and, potentially,without additional compensation.

Previous practice is perhaps a result ofthe parties underestimating the rolebefore agreeing fees, or assuming thatthe mortgages will continue to perform inline with historic averages. Goingforward, it will be of far greaterimportance where the roles oforiginator/servicer are split at the outset,although it would be wise to contemplatea potential split of roles during the life ofthe transaction (for example due to thesale of parts of an originator’s business).

Potential solutions or features which arelikely to be included in future agreementsare provisions which provide for thereview of servicer fees in certaincircumstances (though this may beresisted by the issuer who may preferfees to be renegotiated subject toagreement with the issuer or subject to apre-determined cap) and morecomprehensive provisions detailing whichexpenses can be reimbursed.

Borrower Administration Fees

A number of transactions containprovisions carving out certain fees

The failures during the credit crunch of several originators of residential mortgageshave brought into sharp relief the practical difficulties that may be faced by servicersand cash managers in the day-to-day operation of RMBS deals. These issues havebeen particularly acute where the originator or seller does not have an ongoinginvolvement as servicer or cash manager. Further, the failures or downgrades of othertransaction parties (such as swap providers, liquidity facility providers or accountbanks) have brought about new challenges in administering mortgage pools anddetermining cash flows.

“the servicer may berequired to dosubstantially more workthan originally anticipated”


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payable by borrowers for particularservices performed by the servicer (forexample, at the request of the borrowerproviding a lender’s reference or aredemption statement) from the generalpool of receipts, and paying this to theservicer outside the general revenuewaterfalls. However, over time and asthe aggregate balance of the portfoliodiminishes and redemptions, transfers ofmortgages, and other changes inborrowers’ circumstances become morefrequent, such fees may become anincreasingly important part of theeconomics of a deal for servicers. Inaddition, where the maximum amountsof such fees are specified in theservicing agreement and there is nospecific mechanism for increasing theamounts, the amount of the feechargeable for a particular service may,over time, become inappropriately small.In this context it may also be worthconsidering whether or not theunderlying loans (i.e. the agreementswith borrowers) provide for an increasein the amounts or types of fees thatmight be charged. We anticipate that, atthe time of entering into a transactionthat contains this structural feature,servicers may want to do some duediligence on the terms and conditions ofthe underlying loan agreements (orrequire assurances fromoriginators/sellers in this regard).

Cash ManagementIn a typical RMBS transaction, the cashmanagers have little, if any, discretion tomake determinations about how toapply cash in a deal. This wouldgenerally have been the commercialintention where the cash managerswould not want to be responsible formaking “judgment calls” in relation toamounts payable to noteholders andother parties.

However, this has caused some difficultyin practice where an unexpectedsituation arises which is not provided forin the documents or, for example, whereassumptions are made in relation to thecalculation of amounts and theseassumptions subsequently transpire tobe false. In such circumstances, cashmanagers have at times been leftwithout clear instructions in theseunanticipated situations; either wherethere seems no clear direction on how acertain amount should be calculated orwhere there are clear instructions, butfollowing these to the letter would leadto an economically “odd” result which isunlikely to be what was originallyintended by the transaction parties.

Problems include potential liability forthe cash manager where it has anabsolute obligation to calculate anamount to be paid but to do so isimpossible without the cash managerhaving to interpret or deviate from, thedocuments or calculations andpayments are required to be madewhere results appear contrary to whatthe parties commercially agreed. Thismight even result in cash becoming“stuck” inside the deal.

In many of these situations the cashmanager has no ability to make its owndecisions, nor is there provision forrecourse to another transaction party orto the decisions which would be made bya prudent cash manager acting inaccordance with market standards. Inpractice, seeking to obtain direction fromthe issuer and/or trustee in suchsituations has been unproductive.

Potential solutions might, forexample, include:

(i) adding more detail and trying toanticipate these unexpectedcircumstances, resulting inevitably insignificantly longer and more

We expect that, wheretransactions provide for such afee payable to the servicers, it islikely that servicers would want toincorporate such a mechanism inthe servicing agreement. Thismay, for example, be draftedas follows:

(1) by incorporating a provision inthe Mortgage AdministrationAgreement that provides that:

“A current list of servicingactivities in respect of whichBorrower Administration Feeswill be payable, and the currentlevel of fees associated witheach such activity (whichactivities and/or fees are subjectto being changed from time totime in accordance with theterms of the Loans by theMortgage Administrator acting asa Prudent MortgageAdministrator) is set out in theSchedule to the MortgageAdministration Agreement.”

(2) by including a defined termstating that:

“Borrower AdministrationFees” means all amounts relatingto fees payable by Borrowers inrespect of specific servicingactivities undertaken by theMortgage Administrator in respectof Loans following their originationin respect of which the relevantBorrower is, under the terms ofthe Loan, obliged to pay a fee.

Whilst such, or similar, clauseshave been included in certaindeals, we expect to see moreemphasis on ensuring thisflexibility going forward.


15 New Beginnings

comprehensive documents. However,since it is not possible to anticipate alleventualities, this may amount to“moving the goal posts” withoutchanging the game. We do, however,think more time will be taken to dealwith, at least, the situations whichhave arisen most commonly in thecredit crunch.

(ii) providing for the cash manager touse its discretion, act in accordancewith market practices or to haveopportunity to consult with or seekdirection from other parties, e.g.trustees, where the documents areinconclusive or appear to lead toeconomically bizarre results (andexpressly obliging such third partiesto give such a direction within aspecified time). However, weanticipate that giving such discretionto the cash manager may beunpopular with arrangers and cashmanagers alike.

(iii) limiting the liability of cashmanagers in relation to suchdecisions and requiring the issueritself to make decisions where thedocuments are unclear (but issuersmay not want this responsibility; we

discuss the possibly of an increasedand more active role for issuers andtheir directors elsewhere in thispublication – see “SPV directorsand corporate governance” onpages 17-20).

ConclusionIt is our experience that, over time, practices in relation to administering mortgageloans may change, which can lead to some differences between what thetransaction documents anticipate and how the assets are administered in practice.In addition, as events that were previously considered to have a very remotelikelihood of occurring have in fact occurred over the past couple of years, manyparties have suffered losses or have in practice been unable to perform theirfunctions as expected without, for example, going to noteholders for directions.

We anticipate that transaction parties may in future spend more time consideringexactly how each part of the process will operate in practice, to ensure that alldocuments actually reflect working practices and processes, and on the otherhand, making some provision for changes to working practices. This will likelyresult in longer, more comprehensive (and more robustly negotiated!) servicingand cash management agreements.


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4. SPV directors andcorporate governance

In this section we consider the decisions,which are ultimately commercial, thatunderpin the role and responsibility offinding and appointing replacements andask who is best placed to take thesedecisions; the duties of SPV directors;and the need for professional advice andimproved documentation to help thedecision-making process.

To whom should the role offinding a replacementcounterparty be allocated?Generally, the trustee (in its capacity assecurity trustee holding security over theIssuer SPV’s rights under the transactiondocuments) has no duty under thetransaction documents to exercise any ofits rights or powers prior to an event ofdefault of the Issuer SPV and/or thesecurity becoming enforceable (and this, ofnecessity, will not occur simply because atransaction counterparty has defaulted).However, as any amendment ormodification to the transaction documents(including the appointment of a successoragent by the Issuer SPV) will inevitablyrequire trustee consent, trusteeinvolvement in replacing a transactioncounterparty is a pre-requisite. To theextent the trustee can exercise itsdiscretion to consent to any amendmentsor modifications, this is typically where thechange is not (in its determination)materially prejudicial to the noteholders.The commercial ramifications of exercisingthe Issuer SPV’s rights of termination under

a contract and the decision to appoint areplacement (at market rates which maydiffer from the deal struck with the originalcounterparty), make the material prejudicetest difficult to determine, especially wherea conflict between classes of noteholderscould be construed.

Therefore, rather than exercise itsdiscretion, the trustee will in all likelihoodapproach the noteholders for consentand, possibly, the rating agencies forrating affirmations. In order to obtainconsent from the noteholders,noteholders’ meetings must beconvened which can be timeconsuming, with requirements formaterial notice periods andadjournments for want of quorum. Thestructure will come to a grinding haltwhile the different classes seek commonground. Where the transactiondocuments expressly provide for thetrustee to follow the views of one classof noteholder, this is less of an issue –see “Difficult decisions in the capitalmarkets - the role of the trustee” above.

Additionally the trustee will lack therequired expertise to make an informeddecision as to the suitability of areplacement agent and whether thecommercial terms of the replacementagent are acceptable. While thetransaction documents purport to grantthe trustee much room for discretion, inpractice the trustee will be hesitant touse discretion in circumstances whichwere never contemplated when the

transaction was concluded.

Further, even where noteholders exerciseany rights of direction to the trustee, thetrustee will not necessarily have a right ofdirection to the Issuer SPV (as opposedto a right of approval) in conjunction withreplacement counterparties.

As between the Issuer SPV and thetrustee, it is therefore inevitable that thedirectors of the SPV are likely to retaindiscretions in dealing with circumstancesaffecting the Issuer SPV which had notbeen contemplated at the time thetransaction was documented. Indetermining the exercise of suchdiscretions, they should have regard totheir fiduciary duties as directors.

The sudden collapse of Lehman Brothers in September 2008 and the unprecedentedeconomic conditions since have thrown up a range of dilemmas for parties tosecuritisations. The transaction documents typically did not envisage thepossibility of a counterparty becoming insolvent overnight - for example, ratingdowngrade triggers and related covenants envisaged a more gradualreplacement mechanism.

The purpose of this section is to provide a summary of the governance issues facingSPV directors and trustees in light of the current economic circumstances and tosuggest a number of practical solutions to these issues going forward.

“No amounts of planningcan avoid circumstancesoccurring in the futurewhich were nevercontemplated in thedocuments. By giving SPVdirectors more protectionand availability of support,more flexibility is afforded tothe Issuer to act decisivelyand quickly”


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The duties of an SPV directorThe directors of an SPV owe fiduciaryduties to the SPV and the shareholderslike other directors of a company(although SPVs are typically structured asorphan vehicles with the shares held oncharitable trust).

These duties include the duty pursuantto the Companies Act 2006 “to act in away that would be most likely to promotethe success of the company for thebenefit of its members as a whole” ormore simply to act in the best interestsof the company.

This fiduciary duty to the SPV meansthat every commercial decision thedirectors make must be aligned withthis overriding duty. They cannot hoistthis fiduciary burden on another party,and must ensure that all decisionsmade in relation to the SPV are in theSPV’s best interests.

Ideally, while the directors should wantto protect the investments of allstakeholders (be it the shareholders orthe creditors including the seniornoteholders or the junior noteholders,for example), they owe an overridingduty to act in the best interests of theSPV (although priority considerationmust be given to the interests ofcreditors when facing insolvency). Indetermining the best interests of theSPV, there ought to be no reason whythe directors cannot exercise suchjudgment, albeit on behalf of a specialpurpose vehicle with a limited profit-making ability.

Although little attention is typically paidto the management expertise of thedirectors of the SPV in a securitisation,as investors would focus on the qualityand management of the servicer whichmanages the underlying assets ratherthan management of the Issuer SPV(which is intended to be for the mostpart a passive company), directors ofthe SPV are typically professionalsspecialising in the provision ofdirectorship services.

The need for professionaladvice and improveddocumentationWhere directors of the SPV areexercising discretions in circumstanceswhich were never envisaged at theoutset of the securitisation however, it isunlikely that there will necessarily be aself-evident conclusion on what is in thebest interests of the company. SPVdirectors may also lack the requiredexpertise or even access to the relevantinformation to make an informeddecision on replacing an agent. Despitetheir overriding duty towards the SPV,the directors will feel reticent inexercising discretions if they feel thattheir decisions will expose them topotential liability in respect of thesecured creditors, for a judgmentinvestors were not relying on the SPVdirectors to make.

Express contractual provisions arerequired to ensure the directors are ableto seek professional advice to help themin their decision making process. When

the documentation does not alreadyprovide a clear process (e.g. a creditorcommittee process - see “Difficultdecisions in the capital markets - the roleof the trustee.” The transactiondocumentation should be updated toprotect the SPV directors who act onindependent professional advice fromliability to secured creditors who might beprejudiced as a result of the SPVdirectors’ actions. Also, the priorities ofpayment provisions ought to expresslycontemplate the possibility of funds beingto be made available to the directors topay for such professional advice.

With these changes there should hopefullybe a better framework for SPV directors toexercise discretions which the SPV hasbeen left with and although this may notnegate the need for trustee involvement,such changes should provide morecomfort for SPV directors taking a moreproactive role in breaking the decisiondeadlock which may otherwise result. Inother words we believe it would bedesirable for transaction documentation tomake it clear that residual decision makingpower resides with the SPV directors andthat the SPV directors have the tools, andlegal protection, to exercise it proactively.

“Directors will be reticentin exercising discretions ifthey feel that theirdecisions will expose themto potential liability”


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New Beginnings 20

5.The UK covered bond marketduring the financial crisis:maintaining ratings

Since the public market for UK coveredbonds effectively closed towards the endof 2007, banks and building societies haveissued covered bonds for the purpose ofaccessing liquidity through the governmentschemes which have emerged and accepthighly rated covered bonds and assetbacked securities. The issuers haveincluded both banks and building societiesthat have continued to issue coveredbonds out of their existing covered bondprogrammes, and banks and buildingsocieties which have established newcovered bond programmes.

The Government support for covered bondissuance has contributed to continuedactivity in the covered bond marketthroughout the financial crisis. However,given recent signs of revival in the publicmarket for covered bonds, with BarclaysBank PLC and Abbey National successfullyissuing covered bonds into the publicmarket in October 2009, it appears thatinvestor confidence in this area is returningand there is likely to be an increase in thevolume of covered bond issuance placedwith third party investors going forward.

Structuring challengesand responsesThe credit crisis, and in particular thedifficulties faced by several UK banks and

building societies since the autumn of2007, prompted the credit rating agenciesto re-evaluate the link between the ratingsof covered bond programmes and therelevant issuer’s corporate ratings.

Traditionally UK covered bonds have had“bullet” repayments similar to Germanpfandbriefen and other European coveredbonds; this meant that there was amismatch between the maturity of thebonds and the maturity of the underlyingassets (such as residential mortgage loanswhich amortise over a period of a numberof years).

The effects of the maturity mismatch priorto issuer insolvency were alleviated by thefact that, while the issuer remainedsolvent, investors would rely on theissuer’s ability to service its debt (ratherthan the actual performance of the coverpool). However, following an issuer eventof default (such as insolvency or otherunremedied failure to pay by the issuer),the mismatch in cash flows becomesmore hazardous, as investors will then relyonly on the cover pool to service theprincipal and interest elements of theirdebt. Should an issuer fail shortly before aseries of covered bonds matures, it wouldbe necessary for the manager of the coverpool quickly to sell or re-finance theassets in order to make payments on thematuring covered bonds. Such a sale or

refinancing may be difficult in a marketwhere there is a lack of liquidity for theunderlying assets; if the cover poolmanager cannot raise sufficient funds, thematuring covered bonds wouldconsequently not be repaid in full on thematurity date.

Overview of rating agencyapproaches to maturitymismatchesAs a result, rating agencies have adoptedthe view that the rating of UK coveredbond programmes cannot be de-linkedfrom the corporate rating of the issuer.Issuers (and investment banks advising onthe structuring of covered bondprogrammes) have therefore proposed anumber of solutions to deal with thisstructural challenge.

The rating agencies are also assuming that inthe current market it will take longer to sell orrefinance a portfolio of mortgage loans, andthat the proceeds of a sale or refinancingwould be below the nominal value of theportfolio. An overview of the approach ofeach rating agency is set out below.

Fitch Ratings Limited

Fitch assesses the likelihood that failure ofan issuer may affect the receipt of timelypayments under the covered bonds

Like other issuers of structured debt securities, UK issuers of covered bonds havefaced difficult market conditions since the autumn of 2007. While Governmentschemes have supported the market by providing an essential source of funding, thefailures of some banks and building societies, lack of market liquidity and thepublication of new criteria by rating agencies, have resulted in new challenges forstructuring covered bond programmes. Market conditions have driven the ratingagencies to scrutinise structures and challenge the delinkage between an issuer’scorporate rating and the rating of its covered bonds.

Solutions include the introduction of pass-through covered bonds, and variousadjustments to mechanisms aimed at maintaining asset pools (for example refinementsto the Amortisation Test) or ensuring that cash flows are not interrupted even if anissuer should fail (for example requiring the appointment of back-up servicers).


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through assigning a “discontinuity factor”,or D-Factor, to the covered bonds. D-Factor scores range from 0% to 100%,with a lower score signifying a lower linkbetween the issuer’s corporate rating andthe covered bond rating.

An increase in the weighting Fitch gives tothe “liquidity gaps” component of the D-Factor score has increased the importanceof the structural mechanisms issuers mightuse to manage the liquidity gap.

Moody’s Investors Service, Inc.

Moody’s refers to its assessment of thelikelihood of timely payment being madeto covered bond investors followingdefault of the issuer as the “TimelyPayment Indicator”, or TPI. There are sixlevels of TPI, ranging from “VeryImprobable” to “Very High”; the higher theTPI, the better the chance of timelypayment following issuer default.

Standard and Poor’s FinancialServices LLC

S&P is expected shortly to amend itscriteria, with the effect that it will groupcovered bond programmes into one ofthree distinct liquidity risk categories(Categories 1 - “match-funded”, 2 –“minimal liquidity risk”, or 3 – “heightenedliquidity risk”). Covered bond programmesthat have greater maturity mismatcheswould rely more heavily on asset sales orother refinancing techniques. S&P regardsthis as an increased risk and is expectedto reflect this, for each category, in theextent to which its rating of theprogramme can exceed the issuer’scorporate rating for each category.

Structuring solutions tomaturity mis-matchesThere are a number of possible structuringsolutions that can reduce the effects ofmaturity mismatches and the resultinglinking between issuer ratings and covered

bond programme ratings by the ratingagencies. The following are some of themore common structural features used incovered bond programmes, which havebeen given credit – to a greater or lesserextent – by rating agencies.

Pass-through covered bonds

The fact that covered bonds issued by UKissuers have traditionally had bulletmaturities, whilst the cover pool assetsamortised over a period, is the main reasonfor the liquidity mismatch, and ratingagencies’ linking of covered bondprogramme ratings to the issuer’scorporate ratings, as described above. Anumber of programmes have recently beenamended to include a pass-through feature– specifically to address these concerns.

Where covered bonds are specified to bepass-through or “long-dated” coveredbonds, following certain events (usuallydelivery of notice to pay on the LLP,linked to failure by the issuer to pay thefinal redemption amount by the specifiedfinal maturity date) the covered bonds willbe redeemed on an amortising basis. Oneach interest payment date, after makingmore senior payments under theguarantee priority of payments, the LLPwill use available funds to partially redeemthe covered bonds. In this way principalredemption of the bonds operates in away more akin to residential mortgagebacked securities than traditional, bulletcovered bonds.

The pass-through maturity date will fallafter maturity of all assets in the cover pool,so that it should not at any time benecessary to sell selected loans to makeredemption payments. There may, howeverbe specific instructions to the cover poolmanager about selling assets when anappropriate price may be achieved.

When introducing a pass-through feature, itmay be necessary to amend the paymentwaterfalls, certain elements of calculations

(e.g. of the Amortisation Test) or to switchoff certain tests or triggers. For example:

• the “Guarantee Priority of Payments”is usually amended to make specificprovision for the payment of principalon pass-through covered bonds(after payments in respect of bulletcovered bonds);

• the calculation of the amount ofnegative carry for purposes of theAsset Coverage Test and theAmortisation Test should be amendedto take into account the fact thatthere should not be any negativecarry beyond the next interestpayment date (as any principalreceipts would be used to reduce theprincipal amount outstanding on thepass-through covered bonds ratherthan trapped within the structure);

• in a number of programmes theAmortisation Test is completely“switched off” where the onlyoutstanding covered bonds are pass-through covered bonds.

As the pass-through feature potentiallyaffects cash flows to investors, it is alsoimportant to ensure that the mechanism isadequately disclosed in the prospectus(including appropriate risk factors). Anexample of a specific risk factor would be:

“In the six months prior to, as applicable,the Final Maturity Date (in the case of aSeries of Hard Bullet Covered Bonds) orthe Extended Due for Payment Date (in thecase of a Series of Extendable MaturityCovered Bonds which are not Pass-

“There are a number ofpossible structuringsolutions that can reducethe effects of maturitymismatches”


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Through Covered Bonds), the LLP isobliged to sell the Selected MortgageLoans for the best price reasonablyavailable notwithstanding that such pricemay be less than the Adjusted RequiredRedemption Amount. If any Series of Pass-Through Covered Bonds is outstanding,the LLP will not at any time be permitted tooffer to sell the Selected Mortgage Loansfor a price which is less than the AdjustedRequired Redemption Amount for theoutstanding Series of Pass-ThroughCovered Bonds. This may delay thepayment of principal to investors.”

On some transactions a concern has beenraised that, if bullet covered bonds andpass-through covered bonds were to beoutstanding at the same time, the pass-through covered bonds might effectively betime-subordinated to the bullet coveredbonds. We do not consider such concernto be justified because, for example, theissuance of bonds or notes with a diverserange of maturities is a common feature ofbank debt, and by their very nature, manystructured programmes (for example,RMBS or CMBS master trust structures, orcredit card master trust structures) whereinvestors are willing to consider, and take aview on, the resulting risks of subsequentissuances being shorter-dated and hencerepaid in time priority notwithstanding adeteriorating but not defaulting securitisedportfolio. However, should the perceivedconcern need to be covered off indocumentation it might be addressed bystipulating that at any time there can onlybe either pass-through covered bonds orbullet covered bonds outstanding, but notboth. Although the appetite of investors formore complex structures should beconsidered, there may be other solutions. Itmay also, for example, be possible tocreate a structure that allows both pass-through and bullet covered bonds to beoutstanding at the same time, althoughnone have yet been implemented owing toa lack of necessity where bonds are used

for the discount window facility with theBank of England. Our view is that, as themarket for public placement thaws, theneed for a covered bond programme toissue both pass-through and bullet coveredbonds will likely become unavoidable. Toachieve a solution further analytical andstructural refinements will be necessary.

A question that has arisen recently iswhen the pass-through feature should beactivated. In the case of pass-throughcovered bonds issued in more than oneseries where the pass-through feature istriggered on a different date for eachseries, there is a risk that if more than oneseries of covered bonds are outstandingthen the earlier maturing series of coveredbonds will start receiving repayments ofprincipal on a pass-through basis inadvance of later maturing series ofcovered bonds. This means that if theresidential property market deterioratessignificantly, the later maturing series ofcovered bonds might be disadvantaged.This risk was not initially consideredsignificant: first because most issuers hadonly one series of covered bonds issuedfor the purposes of liquidity schemes, andsecondly because most covered bondmortgage pools were adequatelyover collateralised.

Some issuers of pass-through coveredbonds are now choosing to address thisrisk by adopting a test similar to theAmortisation Test, upon the breach ofwhich all outstanding series of coveredbonds would immediately start repayingprincipal on a pass-through, pro rata andpari passu basis. A similar test might alsobe used to test whether different series ofpass-through covered bonds shouldaccelerate simultaneously or in a phasedmanner on their original final maturitydates. The purpose of these tests is toensure that later maturing series ofcovered bonds are not unduly prejudiced.We believe such tests may become a

common feature of the market for UKcovered bonds going forward.

Investor appetite for pass-through coveredbonds in their current form remains limited;however, indications are that such coveredbonds will for the time being continue to beaccepted into the various central bankliquidity programmes. This underlines ourview above that covered bond programmeswill need to be able to issue both pass-through and bullet covered bonds.

Extendable maturity periods

Covered bonds may also be issued as“soft bullet” covered bonds – that is,they have a specified final maturity dateand an extension period, with finalrepayment due only by such extendedmaturity date. Extension of the coveredbonds will usually only follow if the issuerfails to pay the final redemption amounton the original final maturity date, and ifthe LLP does not then have sufficientfunds to make such payment under thecovered bond guarantee.

The purpose of extension is to ensure thatthe cover pool manager will have enoughtime to raise funds by, for example, sellingselected loans. The extension periodshould in theory also mean that assets canbe sold at better prices than might havebeen the case in a “fire sale” scenario.

A number of UK covered bondprogrammes already have the abilityto issue “soft bullet” extendablecovered bonds. We see this as a likelyfeature of UK covered bond programmesgoing forward.

Deferral of due date at theissuer’s option

Some programmes allow for deferral of thecovered bonds for a specified time. Thisdiffers from the more common extensionprovisions in that the latter only becomerelevant following service of a notice to payon the LLP and failure by the issuer to


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make payments when due. Thismechanism potentially gives the issuerextra time to refinance the cover pool.

It has the advantage over typicalextension provisions in that, as deferraldoes not require an issuer event ofdefault, it would not trigger cross-defaultprovisions in other financing transactionsthat the issuer may then have outstanding(such as EMTN programmes).

During the deferral period the issuermight start making partial redemptionpayments in broadly the same way asunder a pass-through covered bond,whilst the LLP might simultaneouslyattempt to raise funds by way of a sale ofselected assets. If, at the end of thedeferral period, the issuer remains unableto make the scheduled redemptionpayment, and the LLP has been unableto raise sufficient funds, the coveredbonds may be extended for a furtherspecified period (where they will betreated the same way as “normal”extendable covered bonds).

Pre-maturity Test

The purpose of the pre-maturity test(which usually only applies if ratingtriggers are breached) is to test, sometime before a scheduled principalrepayment on a “hard bullet” coveredbond becomes due, whether the LLPhas sufficient cash or other liquid assetsto make such repayments should theissuer fail to make such principalrepayment when due.

If the test is not met, the LLP must raisethe necessary cash, either from a capitalcontribution by the issuer or by sellingassets. The timing of the pre-maturitytest is aimed at allowing the cover poolmanager enough time to raise fundswithout having to sell assets in a “firesale” scenario.

Whilst the relevance of the pre-maturity

test may be diminished in programmeswhere recent issuance comprisespredominantly pass-through orextendable covered bonds, a similar test(or an adapted form thereof) may also beuseful in covered bond “treasuryoperations” (which we deal with in moredetail below). We further believe that, aslong as investor appetite for bulletcovered bonds remains, the pre-maturitytest will remain a feature of UK coveredbond programmes.

Other Areas of ConcernThere have been some other areas ofconcern that have been considered inrelation to UK covered bond programmes.A number of these are set out below:

Alternative management of thecover pool

As the issuer often fulfils multiple roles in acovered bond programme – including thatof manager of the cover pool on behalf ofthe LLP and cash manager – an issuerevent of default may also mean that theLLP will have to appoint an alternativemanager, as the LLP itself will not be ableto carry out this function. This may resultin a default on the covered bonds shouldan issuer event of default occur shortlybefore a payment is due.

To address this risk, rating agencieshave started to require the programmetransaction documents to expresslyprovide for either the appointment of aback-up manager at the inception ofthe programme (but with theappointment only being “activated” ifcertain rating triggers are breached), oralternatively to provide that a back-upor standby manager will be appointedfollowing the occurrence of a ratingtrigger event. We believe this trendwill continue.

In appointing alternative managers, it willalso be necessary to consider issues

such as confidentiality and dataprotection, the protection of proprietarysystems and information, as well as thepracticalities of transferring servicingfunctions to a third party.

Dedicated reserve funds

Some programmes require dedicatedreserve funds (in addition to theusual reserve funds) to allow forpayment of, for example, interest onthe covered bonds for one interestperiod. This improves short-termliquidity and reduces the risk thatinterest may not be paid in a timelyfashion. However, this would notaddress concerns related to thepayment of principal amounts due.

The requirement to fund such reservesmay be triggered by a rating downgradeof, for example, the cash manager or aswap counterparty.

We expect that, for the foreseeablefuture at least, this type of reserve fundwill continue to be a feature of coveredbond programmes.

Covered bond treasurymanagementThe changes in the rating agencies’approaches to rating covered bondprogrammes mentioned above have to alarge extent been driven by the ratingagencies’ views on mismatches betweenthe maturity of cover pools and coveredbonds issued by the banks. We havealready mentioned above that this hasintroduced structural complexity into thetraditional UK model of a covered bondand has raised the issue of how tocombine issuance of hard-bullet bonds andbonds with repayment profiles more closelytied to the performance of the cover pool.

In our view, this issue can be addressed, atleast in part, through active managementof issuance through the covered bond


25 New Beginnings

programme and, potentially, issuance testsas to the proportions of different types ofcovered bonds. Consequently, we believethat, in addition to the structural changeswe have highlighted, the time may be ripefor issuers to consider a dedicated“treasury” function in respect of a coveredbond programme. This might, for example,be achieved by the issuer and/or the LLPappointing a liquidity manager, who wouldbe tasked with actively monitoring thefunding mix of the covered bondprogramme – i.e. monitoring the maturityprofiles of the cover pool and coveredbonds in issue and to be issued on astand-alone basis, rather than merely aspart of the issuer’s overall funding strategy.The liquidity manager would play an activerole in managing any liquidity mismatches –for example, by recommending, andarranging for, the issue of further series ofcovered bonds with particular features and

the addition of further assets to the coverpool – to ensure that expected cash flowsof the covered bond programme are

sufficient to meet its payment obligationsby reference to the mix of coveredbonds outstanding.

ConclusionWhilst indications are that the covered bond markets will remain an important sourceof funding for UK banks and building societies, recent changes, particularly in theapproach taken by rating agencies to rating covered bonds, have created somechallenges for issuers and their advisors. In current market conditions, which remainlargely driven by central bank schemes, it is often necessary to maintain a AAA ratingon the bonds, and therefore to minimise the link between the ratings of a coveredbond programme and the corporate ratings of the issuer. These considerations,among other things, indicate in our view a focus on asset cashflow and hence closerconvergence between the covered bond markets and the market for RMBS. Asinvestor appetite for UK covered bonds continues to sharpen, as mentioned, wewould nevertheless expect to see a move back to more traditional hard and soft bulletmaturities, as market investors are not generally supportive of the uncertain maturityprofile created by the pass-through mechanism. In our view, this will lead to morestructured innovation and treasury management in order to permit issuance of bothhard and soft-bullet maturities.


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6. SIVs – lessons from the crisis

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Structured investment vehicles (SIVs)have been one of principal casualties ofthe financial crisis and their demise hasbeen well publicised. From a peak in2007, with some 30 vehicles and $400billion under management, todayalmost all SIVs have either been takenon balance sheet by their sponsorbanks or have entered into receivershipor been restructured.

In this section, we look at the lessons tobe learned for structured finance fromSIV design flaws, the implications ofcase law that the SIV sector continuesto generate, and some restructuringtechniques that may have a role forother asset-backed issuers. To set thediscussion in context, we briefly recapon the structure of SIVs.

SIVS are limited purpose investmentcompanies which buy highly ratedmedium and long-term debt (primarilyasset-backed securities) and fundthemselves by issuing cheaper, highlyrated commercial paper and medium-term notes and ‘equity-like’ capitalnotes, subordinated to the senior debt.The SIVs’ short-term funding thereforeneeds to be continually refinanced.

The chronic lack of liquidity in thefinancial markets meant that SIVs wereunable to issue or re-issue commercialpaper, forcing them to draw on availablebank liquidity and in many cases toliquidate assets.

Is there any future for SIVs?Given the level of negative publicitywhich SIVs have attracted, it is widelyassumed that this type of vehicle hasdisappeared, never to return. Certainly,it is unlikely that any product called a‘SIV’ will ever be marketed in future. But

the basic concept behind SIVs –arbitraging the spread between long-dated assets and cheaper, mostly short-term liabilities – is as old as bankingand fundamental to it. And as investorconfidence and risk appetite return, weare likely to see demand for productswhich arbitrage the spread betweenlonger and short-term debt. The historyof finance shows that financialinnovations rarely disappear completely,but more often mutate into otherproducts with similar features. If there isto be any future for vehicles with SIV-like features, it is clear that many of thedesign flaws of SIVs will need tochange, including the following.

Liquidity SupportUnlike a traditional asset-backedcommercial paper conduit, SIVs did nothave committed liquidity facilitiescovering the face amount of short-termliabilities. Instead SIVs sought toaddress the need for liquidity through anet cumulative outflow (NCO) test whichmonitored the maximum projected cashoutflows over defined time periods andrequired liquidity to be held in anamount equal to multiples of theapplicable NCO. Liquidity coveragecould take the form of bank liquiditylines, asset purchase or repo facilities orassets classed as ‘liquid assets’. It isclear that SIVs’ liquidity structure didnot work in a sustained liquidity crisisand that a different liquidity structure willbe needed if similar vehicles are to beassigned high ratings in future. Futurevehicles will need to have liquiditystructures designed to survive a liquiditycrisis of 2007 proportions.

One obvious alternative would be torequire bank liquidity or asset purchase

facilities to cover the face amount ofoutstanding short term-debt. Howeverthe diminishing pool of banks withsuitable short-term ratings is muchmore reluctant to provide these type ofliquidity facilities, given their increasedregulatory capital cost and perceivedincreased riskiness as a result of the SIVcrisis. The cost might in any event beprohibitive. Another alternative would beto require a higher proportion ofliabilities to consist of medium ratherthan short-term debt.

Other possibilities include: (i) closermanagement of asset-liability maturities

This section examines:• Whether there is any future for

SIVs or similar vehicles

• What the impact is of the latestcase law on the drafting ofsecurity documents andwaterfall provisions

• What can be learned from SIVrestructuring techniques

How will issues be addressed indocumentation?• Achieving effective time

subordination of pari passuliabilities may require explicitexclusion of the principle of paripassu distribution on insolvency

• ‘Non-standard’ waterfall or otherprovisions should be supportedby other documentary evidenceof the parties’ intentions, such asrisk factors

• Contractual security enforcementprovisions should include creditoropt-out from mandatoryliquidation provisions

Structured investment vehicles have largely disappeared from the market, but leaveas a legacy valuable lessons for structured finance and a growing body ofimportant caselaw.

through the use of extendible CP andcall and put options on the CP so toachieve a degree of maturity matching,coupled with SIV-like NCO tests (ii)establishing the vehicle as a regulatedfinancial institution – a special purposebank – with access to interbank fundingand central bank liquidity and (ii) use ofsynthetic structures to reduce the needfor continuous funding.

During the SIVs’ death throes, manySIVs resorted to using repos of portfolioassets to provide liquidity whencommercial paper could not be issuedor rolled over. However, since repocounterparties own the repo collateral,the effect of this form of liquidity is, ineffect, to confer on repo counterpartiesa ‘super priority’ and it is probable thatrating agencies will in future imposestricter limitations on the use of reposas liquidity.

Unwind TriggersSIV documentation typically includedstop-loss triggers designed to protectsenior creditors. The two main triggerswere the NCO tests (described above)and the capital adequacy test. Thecapital adequacy test assumed that theSIV was unable to rollover its fundingand was required to liquidate assets attheir market value. If the tests werebreached, the SIV moved from itsnormal operating mode to ‘restrictedoperations’ and eventually intoenforcement or wind-down.

The capital adequacy test, which wasintended to mitigate losses, in factmade matters worse and probablyincreased losses by forcing SIVs intodeleveraging or enforcement, resultingin many cases in the liquidation ofassets in a highly depressed market. Itis notable that, despite significant falls inthe mark-to-market value of their

assets, there was no drasticdeterioration in the actual credit risk ofSIV portfolios – only a small proportionof their portfolios were downgraded.

One of the restructuring measuresadopted by surviving SIVs or successorentities was to remove or modify ‘hard-wired’ market value tests that wouldotherwise trigger a liquidation of theunderlying portfolio.

Although it may be difficult to convinceinvestors to abandon completely unwindtriggers based on portfolio valuation, itseems that more flexibility is needed inhow these triggers operate. Thechallenge is to distinguish betweenmarket value declines which arewarnings of credit problems of aparticular vehicle and those whichreflect wider systemic dislocations.Possibilities include ensuring certainhard-to value structured finance assetsfrom the triggers, or amending themechanics of triggers so that they arenot automatic.

TransparencyFor competitive reasons, most SIVs didnot include asset-specific disclosure intheir investor reporting. Monthly investorreports would typically provide high-level portfolio information only. One ofthe root causes of the SIV crisis wasthat investors were fearful of the extentof SIVs’ exposure to US sub-primemortgages. Although most SIVs in facthad little exposure to US sub-prime (asopposed to some ‘SIV Lites’, whichdid), and many rushed to issue pressreleases confirming this, in the feveredatmosphere of summer 2007, investorswere not in the mood to differentiatebetween ‘aggressively’ and‘conservatively’ managed SIVs. Inretrospect, more granular reporting mayhave avoided this panic. If similar

vehicles return, it is clear that reportingwill be more detailed and will have toprovide asset-specific disclosure. Underthe new Article 122b of the CapitalRequirements Directive (CRD) “highlycomplex resecuritisations” will in anycase be a straight deduction fromcapital unless the investing bankdemonstrates to the competentauthority that it has complied with thedue diligence and ongoing monitoringrequirements contained in theamended CRD.

Market Value StructuresThe collapse of the SIV market calls intoquestion whether it will be possible infuture to assign a AAA rating to marketvalue structures for certain assetclasses such as ABS, given theirpotential vulnerability to price volatility.We would expect market valuestructures to disappear for theforeseeable future.

SIV LitigationThe SIV crisis has been a fertile sourceof litigation and has produced someimportant case law.

Most of the litigation has turned on theinterpretation of enforcement provisionsand waterfall priorities. In some SIVs,the occurrence of an enforcement eventwas intended to trigger acceleration ofthe SIV’s senior liabilities; in other casesenforcement was intended to produce acontrolled wind-down, but noacceleration. This has been a criticalissue, because the acceleration of theSIV’s liabilities (or not) determinedwhether senior creditors continued tobe paid sequentially in order of maturity(the ‘pay as you go’ model) or paripassu with other senior liabilities,regardless of maturity.

The most recent and authoritative


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decision is Sigma Finance Corporation(in administrative receivership) [2009]UKSC2, the first judgment to bedelivered by the new Supreme Court.The case turned on the interpretation ofa security trust deed and how it was tobe enforced on the occurrence of anenforcement event. An enforcementevent did not trigger acceleration ofSigma’s liabilities, but required thesecurity trustee to form pools of assetswhich were maturity-matched toliabilities. The various classes of seniorcreditors were to be confined torecovery out of a particular pool duringa realisation period. In relation to theshort-term pool, the security trust deedprovided that “the Security Trustee shallso far as possible discharge on the duedates therefor any Short Term Liabilitiesfalling due for repayment during suchperiod, using cash or other realisable ormaturing assets of [Sigma]”.

The Supreme Court considered that itstask was to interpret the security trustdeed as a ‘reasonable man’ wouldapproach its meaning andunderstanding. This required the Courtto interpret the security trust deed as awhole “in light of the commercialintention that may be inferred from theface of the instrument and from thenature of the debtor’s business”. By afour to one majority, the Supreme Courtfavoured a pari passu distribution andconcluded that it was never intended toleave to chance (in terms of the timingof maturity) the priority of payments. Ina dissenting judgment. Lord Walkerendorsed the views of the majority ofthe Court of Appeal that the Courtshould not rewrite the contact on behalfof skilled and sophisticated investors.

The Sigma decision illustrates therecent tendency for appellate courts tofavour a purposive interpretation of theparties’ supposed commercial

intentions over objective interpretationof contractual terms.

Although the decision is specific to thecontext of the Sigma security trustdeed, it has potentially wide-rangingimplications for the drafting of securityand intercreditor documents. Thenarrow point is that to displace whatLord Walker calls the “strong instinctivefeeling” of judges and insolvencypractitioners for pari passu distributionon insolvency, it will be advisable incases where time subordination of paripassu liabilities is actually intendedwhether or not the issuer is insolvent toinclude in the drafting an explicitexclusion of the principle of paripassu distribution.

More generally, the implications forthose drafting security agreements is asfollows. The Court will look at theagreement as a whole in order toconstrue the meaning of certain clauseswhich lead to results which areperceived to be outside commercialnorms. Accordingly, if parties havenegotiated provisions which are notmarket-standard, then special careneeds to be taken to ensure that theyare not only clear and unambiguous,but also that they are not expressly orimpliedly contradicted by otherprovisions in the document. Inappropriate cases, we would suggestthat a risk factor in disclosuredocuments may be an effective methodof providing contextual evidence ofparties’ intentions.

Cashflow Insolvency - In theMatter of Cheyne FinancePLC (in receivership)The receivers of the Cheyne FinanceSIV sought clarification from the Courtas to how proceeds of underlyingassets should be distributed to creditors

in the period between appointment ofthe receivers and the occurrence of an“Insolvency Event”. The Court instructedthe receivers to apply the monies on a‘pay as you go’ basis, meaning thatmonies were to be paid to seniorcreditors in order of maturity of therelevant liabilities.

However, the receivers quicklydetermined that meeting senior debtsas they fell due would require theimmediate sale of Cheyne’s assets, astep which would prevent the companyfrom paying future debts of later-maturing creditors. The receivers thenapplied to the Court to determinewhether the company was, or wasabout to become, “unable to pay itsdebts as they fall due as contemplatedin Section 123(1) of the [Insolvency]Act [1986]”.

The Court held that the receivers coulddetermine that there had been an“Insolvency Event” with respect toCheyne as soon as it appeared on thebalance of probabilities, or that it wasmore likely than not, that Cheyne couldno longer expect to pay all of its seniorliabilities in full as and when theyfell due.

The result in the Cheyne case dependedupon the fact that the issuer had a fixedcashflow profile and determinable returnsand that there was virtually no prospectof a refinancing.

Accordingly, although the result may bedifferent in the case of a tradingcompany with variable andindeterminate cashflow streams andliabilities, the case has importantimplications for SPVs and theirdirectors. If language equivalent to thatin Section 123(1)(e) of the InsolvencyAct 1986 is used in definitions of eventsof default or enforcement events,directors will need to monitor carefully

the effect of portfolio losses or defaultsto assess whether the issuer is cashflowinsolvent. They should also exercisecaution in signing solvency certificateswithout consideration of projectedcashflows and liabilities.

Parties will also need to considercarefully whether they wish to includethis form of cashflow insolvency test inevents of default, enforcement events orother unwind triggers. The ability to takeinto account future debts whendetermining whether a default hasoccurred may be used by creditors toargue that a default has occurred muchearlier than would be possible prior tothe Cheyne decision, and as a lever inworkout or restructuring negotiations.

Limited Recourse provisionsAs a footnote, the Cheyne case castssome light on the effect of limitedrecourse provisions limiting thecreditors’ recourse to the value ofspecified assets of the issuer. Thedocumentation of the Cheyne SIVcontained limited recourse provisions.The necessary consequence of theCourt’s determination that the SIV wascashflow insolvent was that the limitedrecourse provisions, as drafted, did notlimit the SIV’s debts by reference toavailable assets but only restricted the

creditors’ ability to make a claim inexcess of the value of the SIV’s assets.Accordingly, in drafting limited recourseprovisions, consideration needs to begiven to whether these provisions areintended to apply both pre- and post-enforcement and whether they areintended to affect contractual provisionstriggered by inability to pay debts.

Lessons from SIVRestructuringsThe restructuring of the Cheyne FinanceSIV (renamed SIV Portfolio PLC) was atemplate for several other restructuringsof distressed SIVs. The restructuring waseffected by Goldman Sachs, on behalf ofthe receivers, auctioning part of the SIV’sassets. The remainder of the assets weretransferred to a new SPV. Senior creditorsin SIV Portfolio PLC had the option toreceive cash based on the auction prices,an investment in the new SPV, or directownership of a ‘vertical slice’ of theunderlying portfolio. This allowedcreditors to avoid the effect of forcedasset liquidation in an illiquid market.

The technique of ‘vertical slicing’ mayprove to be an important restructuringoption in the future. This involvescreditors being allocated a proportionateshare of each asset in the portfolio,calculated according to their

proportionate share of the issuer’sliabilities. This technique allows creditorsto manage the assets on their ownbalance sheet and issuers to reduce theirliabilities. Since participating creditorsretain exposure to each asset in theportfolio, vertical slicing also helps tomitigate litigation risk, since it eliminatesthe argument that certain creditors havecherry-picked better performing assets.One practical problem with verticalslicing is the inability to slice certainassets because of minimumdenomination or transfer restrictions. Thisproblem can be addressed byestablishing custody arrangementpursuant to which non-transferable ‘stub’assets are held for the benefit ofparticipating creditors.

Although the restructurings effected byreceivers appointed under SIVsecurity documents havedemonstrated the effectiveness andflexibility of receivership as acontractual insolvency procedure, it hasalso highlighted deficiencies in contractualliquidation procedures, in particular theinability in many cases of any formalmechanism for creditors to direct or voteon the timing of liquidation of assets. Infuture, documentation should includeprovision for creditors to opt out ofmandatory liquidation proceduresprescribed by security documents.


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7. CMBS – the last slice of the dice?

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Market overviewRising commercial property valuesfostered by easy access to credit in thedebt markets and strong demand frominvestors from the mid-2000s until August2007 drove the rapid expansion of thecommercial mortgaged-backed securities(CMBS) market in the UK and ContinentalEurope. Banks were able to originateloans confident that the risk could bequickly sold down through packaging upthe loans and selling them into the bankand capital markets. Banks weretherefore able to earn good fees withoutincurring onerous capital requirementsand borrowers/sponsors were able toobtain increasing leverage in the mediumterm at a low all-in capital cost.Increasingly complex capital structuresproviding for multi-layering of debt (socalled “slicing and dicing”) enabledinvestors to access paper that matchedthe risk and yield they were looking for,including mezzanine and junior tranchesheld within or outside the CMBStransaction. Over time the spectrum ofreal estate assets broadened fromtraditional investment properties to morespecialised assets such as leisure parksand private hospitals.

The liquidity crisis and rapid decline incommercial property values has resultedin many CMBS transactions being subjectto rating downgrades1, breaches of loan-to-value and other covenants and, insome cases, tenant or borrower defaults.

Historically low interest rates (even takinginto account the impact of interest rateswaps struck in a higher interest rateenvironment) have meant that to date,despite the large market value decline,interest cover ratios have generallyremained strong and borrowers have beenable to support interest payments on theloans that support the notes.

Most CMBS transactions were structuredwith little or no amortisation, exposinginvestors to significant refinancing risk.The legal final maturity of the CMBSNotes is therefore typically structured tobe (depending on the number, size andtype of real assets and jurisdiction) atleast two to three years after theexpected legal maturity, being the finalrepayment date under the related loan(s).Although the size of the CMBS marketrelative to the aggregate amount ofsecured real estate lending over theboom period is small, the proximity of thetransactions means that many of thetransactions will come up for refinancingwithin the next 24 to 36 months. It is nowwidely expected that borrowers will beunable to refinance the loans supportingthe current crop of CMBS transactionsleaving investors with the prospect of aloss or at the very least extension risk ontheir investments.

However, despite a rising number ofdefaults in CMBS transactions and theexpectation that there may be muchworse to follow, there has not been the

flood of distressed loans, notes or assetsales that might otherwise be expected ina downturn. This is not for want ofdemand on the buy-side, rather the lackof liquidity results from the absence offorced sellers. There are a number ofpossible reasons for the lack ofsecondary market activity:

• The reluctance of “hold to maturity”investors to crystallise a loss ontheir investment.

• The expectation (or hope) that theworst is over and that values willimprove sufficiently over time andahead of expected legal maturity.

• The comparatively small number ofdefaulted transactions, meaning thatdemands on management time arenot unduly burdensome.

• The subjectivity of property appraisalsand uncertainty as to where valuereally breaks in a particular transaction.

• In the case of junior investors,perceived “hold-up value” in anyfuture restructuring.

ObservationsWhilst the legal structures for CMBStransactions (both single asset andmulti-loan conduits) follow a welltrodden path, the same cannot be saidfor some of the keycommercial/intercreditor terms. Theterms are often a product of the

Noteholders, lenders, trustees and other market participants are now having causeto revisit the complex and highly-leveraged CMBS transactions completed prior tothe credit crisis and the commercial property market decline. In this sectionwe consider trends and developments in the CMBS market prior to the credit crisisand issues that have become and are likely to become relevant to market participantsas many CMBS transactions approach their expected final maturity. Additionally, weset out our thoughts on the implications for the future development of theCMBS market.

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preferences and/or motivations of thearranging bank at the time thetransaction was entered into, the natureof the property asset and the jurisdictionin which it is located. As such, a one-size fits all analysis of the existingCMBS transactions is not possible, butwe have attempted to summarise themain issues that have arisen uponrecent CMBS restructurings, are likely toarise in the future and that we considerrelevant to market participants.

Real estate work-outs in the past havetended to be bank-led through asteering committee of the lead banks onthe transaction. Banks’ interests haveon their face been aligned as an investorclass given they hold a senior securedpari passu investment. In addition,decision making has been relativelystraightforward in line with majority orinstructing bank approvals customarilyfound (and easily understood) in loandocumentation. The only complexity hasbeen the demise of the “Londonapproach” and the emergence ofsecondary trading of loans and the entryinto the market of distressed investorswho share different aspirations andwhose “break-even” points are differentto original lenders of record. However,these senior lenders have now beenreplaced by a passive special purposevehicle (incapable of managing its loaninvestment) whose senior debt has beentranched into various classes oftradeable securities creating classes ofinvestors with different terms and oftenconflicting interests. Thus, each CMBStransaction will have appointed servicersand special servicers to manage theissuer’s investment in its loan(s) typically,for so long as the notes are not indefault, without recourse to thenoteholders. The servicer and specialservicer may similarly be servicing theloan for any junior or so called “B

lenders” who have participated in thesame “whole loan” as the issuer but sitbelow the rated CMBS securities in thecapital structure under an intercreditorarrangement. In each case, the servicerand special servicer have a relativelybroad discretion to service and work outthe loan subject to a servicing standard.This follows precedent in the US CMBSmarket but largely remains uncharteredterritory in the UK/European CMBSmarket. The experience to datesuggests that the special servicingmodel is not necessarily working out ascontemplated on the face of the legaldocumentation. Here are a few of thereasons why we believe this to bethe case:

• In some instances, servicers haveother interests in the capital structure(whether as an “in the money” hedgecounterparty or “out of the money” Blender) leading to concerns regardingconflicts of interest (real or otherwise).

• The absence of a sponsor/borrower.Non-recourse structures haveallowed sponsors/borrowers whotook out their dividend on originationof the loan and who have noincentive to inject new equity into thedeal to walk away from theirinvestment. Without an engagedborrower, servicers and specialservicers have no counterparty towork with. This circumstance is notexplicitly contemplated or addressedin the existing CMBS documentation.

• Transaction documents may specifythat a particular action may not betaken without a rating affirmationor rating agency confirmation,which may either not be forthcomingfrom the rating agencies or no longerof relevance in light of existingdowngrades.

• Noteholder activity and an expectation ofenfranchisement even in spite of theabsence of a note event of default. Thishas led to Special Servicers consultinginformally and formally with noteholdersin the exercise of the servicing standardin the hope of obtaining a consensus inspite of the competing interests acrossinvestor classes.

• The complexities and ambiguities of theservicing standard (and relatedintercreditor arrangements) leavingservicers and special servicers nervousof the risk of legal challenge from adisaffected investor class and potentialresultant liability. This is oftencompounded by other ambiguities inthe legal documentation (not always bydesign). Additionally what is the properexercise of the servicing standard willalso depend on the size of the assetand any future re-letting risk.

• Uncertainty as to who is the“controlling class” and whether or nota “Control Valuation Event” hasoccurred. The controlling class ofinvestor is typically the most juniorclass of investor provided that aControl Valuation Event has notoccurred. The controlling classtypically has the right to replace theincumbent special servicer and toappoint an operating adviser to lookafter their interests. The classpotentially fluctuates depending onthe most recent valuation and thus itmay not be clear at any given pointin time as to whether a particularclass of creditor is subject to acontrol valuation event. Further, givenits subjectivity, any valuation used todetermine the occurrence of acontrol valuation event may bechallenged by junior creditors(who may request or seek afurther valuation).

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• The need for a detailed jurisdictionalinsolvency/enforcement analysistriggered not just by the location of thereal estate but also the jurisdiction ofthe real estate owner and any generalpartner (in the case of limitedpartnership structures).

• Enforcement strategies may beimpaired by the “super-senior” markto market value of any fixed/floatinginterest rate swaps entered intobetween the borrower and the swapcounterparty and which would becrystallised on any acceleration ofthe loan or insolvency of theborrower. Projected investorrecoveries are being reduced bypotential sizeable termination claimsof interest rate swap counterpartiesin light of current very low rates ofinterest and which would be paidahead of investor principal.

What is clear is that noteholders havetended to gain an entry point in thetransaction earlier than originallycontemplated. However, to a large extentand with the exception of the controllingclass provisions, the note terms andconditions are traditional ABS note termsand do not provide a proper basis forcommunicating with or instructing thespecial servicer. In particular, there is nodocumented means for more informalmethods of communication or theestablishment of creditor committees (thatmay be more appropriate within the contextof CMBS restructuring where the specialservicer is likely to be seeking instruction ona number of specific matters on an ongoingbasis). Rather the existing arrangements forcommunications with noteholders typicallyrequire any decision of noteholders to bemade at a physical meeting convened on atleast 21 clear days’ notice, which is slowand impractical. Further, the most seniorclass will typically have control rights over all

matters other than entrenched matterswhich relate specifically to the notes (asopposed to the underlying loans) which maynot be what junior investors actually expectto be the case.

In any event, it may be difficult to reach aconsensus between noteholders/creditorswhose preference in relation to aparticular issue may, for example, bedetermined by their respective rankings(senior creditors will typically be motivatedto see the return of capital in the shortterm which can be reinvested at currentmarket rates whereas junior creditors willtypically seek maximisation of recoveriesover a longer term).

Conclusions/thoughts forthe futureIt is unlikely that the highly leveraged,complex and tiered structures thatcharacterised the peak of the CMBSmarket will be repeated in the short tomedium term. In particular, the multi-loanconduit transactions are less likely toreturn. However, even with lower gearedtransactions with less complexity andtiering, there are lessons that can belearned from today’s (and very likelytomorrow’s) CMBS experience.

Transparency and clarity is key. Loansare more likely to be tranched upfrontrather than bifurcated as between thelenders “behind the scenes”. In terms ofwho controls decision making andenforcement, we might see a return toconventional lending and securityprinciples, namely that the most seniorclass controls in all circumstancesexcept where it would cut acrossentrenched rights of the junior classes.Subordination is of course the risk thatthe junior investors are beingcompensated for. Cure and purchaserights might survive albeit on more

limited terms. Servicing Agreements arelikely to be more specific in terms of theduties and standards of specialservicers. We would expect more clarityto be given to the servicing standard(especially where there are competingand conflicting interests). For instance, aspecial servicer might be expresslyallowed to disregard the interests of anyinvestor who ceases to have anymeaningful economic interest in theunderlying assets. Conceivably thiscould be extended to enabling principalof junior classes to be written off tofacilitate a restructuring and to eliminatehold-up value where investors have noskin left in the game.

As for loan arrangers, we doubt verymuch that there would be appetiteamongst the investor community forarrangers to take a “skim” on the marginthrough a AAA rated Class X Note.Rather, we will see a return to traditionaldeferred purchase price arrangements atthe bottom of the waterfall allowingarrangers to take out excess spread onlyto the extent that the bonds are fullyperforming.

As we note elsewhere in this publication,we would expect the drafting of the noteterms and conditions to catch-up withthe realities of modern day technologiesand the experience of current and theimminent CMBS restructurings. Thusone might expect provision to be madefor a more informal means ofnoteholders communicating with thenote trustee, servicers and othercreditors, including the ability to appointnoteholder representatives and establishnoteholder steering committees, with thewaterfalls providing the representativeswith a super-senior claim to recoveramounts paid to the note trusteepursuant to any indemnity required to begiven to the note trustee at the time of

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the representatives’ appointment.Additionally, the basis for providing anindemnity might be open to challenge ifan instruction mechanism can be found

which obviates the need for theintermediate step of instructing thetrustee to instruct the noteissuer/servicer. It is reasonable also to

expect originators/issuers to maintainsecure investor websites for the purposeof disseminating information.

An example of successful restructuring - REC 6 AlburnA recent success story in the market is the successful restructuring of a multi-property UK sterling CMBS which was in breachdue to LTV covenant defaults. The success of the restructuring was largely due to the involvement of the borrower, AlburnProperties and the sponsor, NM Rothschild, who engaged with noteholder steering committees at an early stage and werecommitted to find a solution. The borrower was willing to commit significant time and resources to the transaction in the belief thatthe value of the properties will recover to an extent that there will be realisable equity in the structure when the loan matures in2013. The key terms of the restructuring were as follows:

1. Disapply the loan to value ratio covenants and amend the interest cover ratio covenants.

2. Deliver the loan by requiring the borrower to dispose of at least £50,000,000 of properties on a best efforts basis beforematurity of the loans and to use the proceeds of such disposals to prepay the notes on a sequential basis.

3. Provide for all surplus cash flow accumulating in the rental income account following payment of certain prior ranking amountsto be swept into a new account and to use amounts standing to the credit of such account to amortise the senior loan: (i) oneach interest payment date on which swap breakage costs are less than or equal to zero; (ii) on the final repayment date; and(iii) on any interest payment date on which senior noteholders have directed the issuer by an extraordinary resolution to requirethe borrower to prepay the senior loan up to the amount standing to the credit of such account.

4. Require all amortisation payments due to the junior lender to be paid to the issuer (in its capacity as senior lender) and to beapplied to prepay the notes on a sequential basis.

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8. Disposal of assets: greaterflexibility all round?

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Prior to the outset of the financial crisis,portfolio sales were fairly common,particularly as market players were tryingto rid themselves of unwanted assets andshore up some liquidity in the process. Asthe credit crunch began to bite, however,these asset sales slowed to a trickle and inmany instances stopped altogether asthere was limited or no appetite for furtherburdening balance sheets that werealready being stretched to capacity.However, as we come to the time when asignificant number of transactions beingused for the central bank liquidity schemeswill require refinancing (and as the centralbanks are making concerted efforts towean banks off these schemes), there willundoubtedly be a number of originatorsasking themselves what to do with theirexisting portfolios, as well as a few playersout there willing and able to purchasethem. Against a backdrop of greaterstability (and to some degree, increasedliquidity), we focus on how this will impactthe securitisation market in three ways:first, in terms of the ease of disposal andacquisition of assets; secondly, in terms ofhow easily assets acquired (rather thanoriginated) by a bank can be incorporatedinto their existing securitisationprogrammes; and thirdly, we considerasset disposals from another angle,namely, disposal of a business thatincludes existing securitisations.

Accessing the assets andliquidating existing structuresPrior to the recent market turmoil, it wasrelatively rare for originators to have theability to collapse existing securitisationstructures in order to have access to theunderlying assets, which they could thendispose of. The reasons behind this werevaried, but included concerns for the

integrity of the true sale analysis togetherwith the fact that the exercise of such anoption by an originator would have beenunpalatable to investors. However, this isnot such an issue for retained deals, wherethe originator holding all the notes hasoverall control. It should therefore generallybe a relatively straightforward process fororiginators that hold the notes in retained

transactions to collapse their existingstructures, thereby easily accessing thesecuritised asset.

The situation is more complicated intransactions where some or all of thenotes are publicly-held as transactionscannot easily be unwound without theconsent of the third party investors who

We expect to see increasing flexibility in the market allowing for more frequentdisposal and acquisition of businesses which include securitised assets (“securitisedbusinesses”), as well as greater ability to dispose of assets from transactions and toadd assets originated by another entity to existing securitisation programmes.

Principal issues

• The ability of originators to collapse retained deals and access theunderlying assets.

• Incorporating new assets into existing programmes such as master truststructures and covered bond programmes.

• Acquisition and disposal of securitised businesses.

• Changing of counterparties following any acquisition or disposal.

What are we seeing in the market?

• Push for “investors” in retained deals to access the assets.

• Greater freedom to free up and transfer assets from retained deals leading toavailability of assets which are able to be transferred into other deals.

• Generally, counterparty roles clearly established as being fully separate,allowing an individual role to be replaced relatively easily.

• For more difficult structures such as originator trust or CMBS a move towardsseparate, stand-alone servicing provisions meaning replacing a servicer ismade easier.

How will the documentation be affected?

• Documents may become more flexible for easier access to removing theassets in line with retained deals in order to facilitate any sale process.

• Eligibility criteria, servicing procedures and representations and warranties tobe examined to permit new assets to be added to existing programmes(possibility of confirmation of no adverse rating impact rather thannoteholder consent).

• Mandatory disclosure updates following any material acquisition or disposaland also following the addition of any new assets to existing programmes ifeligibility criteria widened.

• Detailed provisions regarding the appointment of replacement counterparties tofacilitate securitisation disposal or acquisition.

hold the notes. It is therefore very likelythat unless originators start dealingdirectly with investors (through, forexample, liability managementexercises), assets that are currently tiedup in publicly-held securitisedtransactions will remain included in thecollateral pool of those transactions forthe foreseeable future. The otherinteresting area to consider is the abilityto tap into the assets currently beingused for retained deals and how thepractice for unwinding transactions willbe shaped going forward.

Lately, there has been a push by thecurrent “investors” themselves (at thisstage, mainly the central banks but insome circumstances other third partyinvestors) to have the ability to access theassets in “default” situations. Recentcovered bond transactions in particularhave been incorporating the ability of thebondholders to force the guarantor toliquidate the portfolio and sell the assets,rather than activating the guaranteepayments (see “The UK covered bondmarket during the financial crisis :maintaining ratings”). While this is aninteresting counterpoint to rating agencyconcerns in respect of “fire sales” and“market value” stresses, it could be takenas an indication that there is a trendtowards a greater ability to tap into theassets directly in certain circumstancesand that this push is coming both fromthe bottom (investors) as well as the top(originator/issuer) of the structure. If this istrue, we would expect the documents tobe more flexible to allow access to theseassets in specified, typically “default”-type, circumstances, although carefulconsideration would need to be given tothe drafting to ensure there are limitedcircumstances for investors to obtain theassets, that there is no cherry-picking ofthe best assets and that existing ratingsremain unaffected.

Incorporating new assets inexisting structuresAs the securitisation market starts to allowfor greater flexibility to free up and transferthe underlying assets, originators may findthemselves wanting to incorporate newasset portfolios in existing securitisationprogrammes, such as master trust orcovered bond structures.

Assets originated by different entities maytherefore form part of the same collateralpool. The obvious advantage of thisapproach is mainly cost effectiveness (inthat it would cost much less to tap intoan existing structure rather than to set upa new one and the lower ongoing costsof running one programme, as opposedto two) as well as being less time-consuming and resource-intensive.

There are, however, a number ofchallenges with this approach. In additionto the practical considerations (such assystem compatibility), separate originatorsare extremely unlikely to have identicaloriginating and servicing policies, so froma documentary perspective, the eligibilitycriteria, servicing procedures and, mostimportantly, the representations andwarranties will all have to be revisited inlight of the new assets. In certainprogrammes and transactions, the waiverof any representation or warranty ispermitted, provided that rating agencyconsent or confirmation is obtained. Howthis consent or confirmation can beaddressed in the future is discussed in“Rating agency confirmations: hownecessary will they be?” above. Suchflexibility would avoid the need fornoteholder consent to be obtained inorder to add in new assets which fail tomeet any of the specified criteria.

A further thought is that although wewould expect representation andwarranty packages on existing‘AAA/Aaa’ securitisations to be fairly

consistent among themselves and theeligibility criteria and servicingprocedures to be fairly widely drafted, itwill not always be the case that theypermit the inclusion of the proposednew assets. An originator will thereforehave to think about whether anyupdates to its disclosure and whetherany amendments to the transactiondocuments will be required. In light ofcurrent trends towards increaseddisclosure and greater transparency, it islikely that originators will have to providedisclosure about any new underlyingassets which are added to the currentsecuritised portfolio or which may berelevant to the rating analysis goingforward. Furthermore, if anyamendments are required to be made tothe underlying documentation, trusteeconsent will need to be sought and theratings will need to be unaffected. Webelieve that this will remain addressedthrough the consideration as to the roleof the trustee in giving its consent (seefurther “Difficult decisions in the capitalmarkets - the role of the trustee”).

Disposals of businessesthat include existingsecuritisationsIn addition to the disposal of assets thatmay previously have been used byoriginators in securitisation structures,there will also be disposals of entirebusinesses that include securitisations.Recent examples include RBS acquiringABN AMRO, Lloyds TSB acquiringHBOS, Barclays acquiring Standard Lifeand the Nationwide acquiring a numberof smaller building societies.

The acquisition of a business thatincludes existing securitisationprogrammes will involve the considerationof issues such as the definition of“originator” and, a review of thetransaction documents to ensure that


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certain rights of the “old” originator arereadily transferrable to the “new”originator. To take the right to receivedeferred consideration as an example, thismight be more easily achieved if the rightto the deferred consideration is effectedby the issue of a residual certificate intransferrable form. In addition to theserights, however, the “new” originator mayalso have a number of ongoingobligations, not just in relation torepurchasing the assets, but also in termsof certain servicing functions in thecapacity of servicer and/or cash manager.

The following type of wording can beincluded in a transaction to facilitate transferof the business from one originator to asuccessor entity at some point in the future:

“If the [relevant transfer conditions] are satisfied, theparties hereto agree that (a) all parties will use theirbest efforts to take all steps required to novate on atimely basis the rights and obligations of the[originator] under this agreement to the [succeedingentity] and (b) the trustee shall enter into suchdocuments as the [succeeding entity] may reasonablyrequire to effect such novation. Following suchnovation, it is agreed and acknowledged thatreferences in this agreement to the [originator] in anycapacity shall be read and construed as references tothe [succeeding entity] in the relevant capacity. The[succeeding entity] shall represent and warrant to theIssuer and the trustee on the date of such novation inthe form set out in [insert reference to representationsand warranties of the succeeding entity].”

The “transfer conditions” will, broadlyspeaking, consist of certain conditionsprecedent to ensure that the agreementsare properly novated, legal opinions areobtained and confirmation that the ratingsof the notes will not be adversely affectedby the transfer.

The most relevant counterparty change inthe context of the acquisition of abusiness that includes securitisations islikely to be the servicer and this will bethe most significant change for bothrating agencies and investors. In moststructures, this is relatively easyconceptually as the roles of originator,servicer and cash manager are treatedand documented separately and distinctlyfrom each other even if carried out by thesame entity.

The process of replacing a servicer or acash manager may itself be time-consuming if the provisions in thedocumentation for appointing areplacement are inadequate or unclear.For example, for any transactionsincorporating common terms replacing aservicer would almost certainly involve allparties to the transaction re-executing therelevant documents. However easy theappointment may be from a proceduralperspective, rating agencies and investorsare likely to have concerns about theability of any replacement servicer tocarry out the servicing functions to thesame standard as the previous servicer.In addition, the existing servicer may havedelegated certain functions to thirdparties and may therefore be a party toexisting delegation agreements, whichmay create problems when the servicer ischanged. We believe more time will needto be spent prior to execution ofdocuments in considering anddocumenting the eligibility requirementsfor replacement servicers, includingimpact on ratings and the mechanics forchanging a servicer. In many areas, we

believe it will be prudent to “hard-wire”these matters into the underlyingdocumentation (see “Difficult decisions inthe capital markets - the role of thetrustee” above for some furtherconsiderations in this regard).

As noted above, most securitisationstructures distinguish the originator andthe servicer role in cases where the role isperformed by the same entity at theoutset. However, in originator truststructures, for example, this distinction isoften less clear, as usually theadministration of the loans is carried outby the originator and is rarely contained ina separate agreement (as the originator isthe continuing “owner” of the assets,albeit as trustee). Clearly, the addition ofdifferent assets and the possibleaccession of a replacement servicer wouldpresent more complications under thesestructures. We have started to see a movein the market towards having separateand more detailed servicing provisionseven in originator trust structures. This isespecially the case in CMBS transactionswhere the servicing function is crucial tothe transaction, particularly in stressedscenarios where the underlyingcommercial real estate may require pro-active management. This will facilitate anew servicing entity being appointed tocarry out the servicing functions. Forfurther considerations on this matter,please see “CMBS - the last slice of thedice?” above.

A further challenge in the current marketis that finding suitable replacementcounterparties at suitable cost andwithin a suitable time period may not beeasy (any incoming servicer is likely towant to negotiate a new fee package,for example). To such an extent, in fact,that rating agencies and/or trustees havestarted to require the appointment ofstand-by servicers and stand-by cashmanagers at the outset of a number of

“As the securitisationmarket starts to allow forgreater flexibility to free upand transfer the underlyingassets, originators mayfind themselves wanting toincorporate new assets inexisting securitisationprogrammes, such asmaster trust or coveredbond structures”

transactions or at the very least,detailed provisions about the roles andappointment of any replacemententities. This may include the followingtype of provision allowing differentaspects of the servicing and cashmanagement roles to be separated out,thereby allowing the trustee to appoint

more than one entity if finding a suitablereplacement to carry out the entire roleproves difficult:

“The Trustee shall concur with the Issuer in (a)appointing more than one successor servicer to actsimultaneously and allocating between suchsuccessor servicers the rights, duties and obligationsof the Servicer set out in this agreement; and (b)making such amendments to the TransactionDocuments as may be necessary in order to facilitate

the appointment of more than one successor servicerand the allocation of the rights, duties and obligationsof the Servicer to such successor servicers.”

We believe this trend will continue andwill result in more complete servicingcontracts and greater documentary focuson the role of servicers and theirreplacements in stressed scenarios.

ConclusionWe are seeing a degree of liquidity returning to the bank market and a growing focus by financial institutions on meetingcompetition considerations, liquidity requirements and capital adequacy concerns. Added to this are increasingly frequentdisposals of easily-accessible assets from existing securitisations alongside disposals of businesses which include securitisedassets. In view of all of this, the frequency of the acquisition of assets into existing transactions and the sale and purchase ofexisting securitised business is only set to increase. We have seen both how transaction documentation can assist suchactivity but also how it can hinder it. With disposals and acquisitions on the increase, flexibility will be key and transactiondocumentation will need to adapt accordingly, not least by including more pre-planned steps and procedures.


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9. New rules for a new way forwardfor commercial mortgage lending

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ValuationLenders do not trust all of their borrowersto pay the right price so they ask for avaluer (or appraiser) to appraise the valueof a property before advancing a loan tofund a purchase or refinancing, whetherfor commercial or residential property. Avaluation speaks as of the date on whichit is given and is determined inconsiderable part by reference tocomparable evidence in the market andthe availability of finance for the purchaseof the property concerned. As a generalrule, a buyer will pay more for a property ifhe can raise debt finance to buy it than ifhe had only to use equity. The morefinance that is available, the more buyersthere are in the market, the higher thevalue of the property, or at least that is thelikelihood. One can see the potential forthe creation of an inflationary bubble,particularly if one adds in the ability ofborrowers to refinance unrealised equitywith debt (a practice which was commonplace leading up to the credit crunch) andthe impact of a series of purchasers overpaying for assets resulting in overlyoptimistic comparable evidence on thevaluation of other properties. One nowsees the position in reverse: propertyvalues are down in considerable partbecause there is very little debt available inthe market. The more values fall, the less

new debt finance is available and so on.There needs to be a review of the wayproperties are valued.

The tax systemInvestors can off-set their interest costsagainst their income and so reduce theirtax charges. In short, the more debt that aborrower can raise at the time ofpurchase, the less tax he should paythrough the life of the loan. The name ofthe game for the investor is to ensure thathis investment “washes its face” (or paysfor itself) but leaving him with as muchequity as possible with which to do thenext deal and hope for yet more capitalgain. This is not to suggest that theborrower’s ability to deduct interest costsfrom rental income for tax purposes shouldbe abolished which would not be popularnor necessarily desirable but, perhaps,there should be a review to establishwhether or not the balance is currentlyright. For example, for propertytransactions there could be a rule that taxis only deductible on borrowings up to75% of day one loan to value. There mightbe a potential trade-off in the form of areduction in the amount of stamp dutyland tax (SDLT) payable in return for anytightening of the deductibility rules. Asthings stand the 4% SDLT charge inhibitstransactions so loss of tax revenue caused

by a reduction might not be as much asthe Government might fear. Although taxchanges are usually not popular,inflationary bubbles are not ultimately in theinterests of most investors.

Availability of easy financeWe all know that the availability of financeincreased through the early and mid2000s up until the onset of the creditcrunch in mid 2007. The commercialproperty finance market had its part toplay in the creation of the credit crunch.Traditionally, an investor buying a goodcommercial property was able to raise65% or 70% of a property’s value by wayof senior bank debt. The investor wouldhave financed the balance out of equity or,possibly, some equity and somemezzanine (or junior) debt finance. In the1990s mezzanine finance went from beingexotic to somewhere near normal. In the2000s traditional mezzanine finance wasincreasingly replaced by “stretched senior”debt so that senior loans sometimesaccounted for more than 90% of thepurchase price or value of a property. Inextreme cases, a mezzanine financierwould provide further debt and part of theequity to the borrower. This happened inparallel with the development of thesecuritisation market where banks wereable to sell on their loans to third party

The commercial mortgage market remains subdued and many banks have largeamounts of credit impaired or, increasingly, defaulting commercial property backeddebt on their books. This is, therefore, a good time to look to the future in terms ofwhat is required to re-start the market and whether any changes are required toreduce the risk of a repeat of the credit crunch or something similar. This is importantif investors are to be attracted back to the property market and would, indirectly, helpthe banks clean up their balance sheets.

Before looking at what is required for the future it is worth looking at some high levelissues which might have contributed to the credit crunch. These issues include theway properties are valued, the tax system, the availability of easy finance, lack oftransparency and the front ended remuneration structure for bankers.

investors and re-lend the proceeds.Banks were not always able to securitiseall of their mortgage debt so a marketdeveloped for “B notes”. B notes werecreated out of the piece of debt which abank could not securitise. It would besold (or retained by the originating bank)junior to the securitised part of themortgage debt but carrying a higher rateof interest, often involving complicatedinter creditor arrangements and,sometimes, further securitisation stylestructures. The increase in availability of(cheap) finance fuelled increased values.

The role of bankers,investors and regulatorsThe system encouraged bankers to do asmany deals as they could. Those bankersdid not want to lose money. On thecontrary, a loss would potentially deterinvestors in mortgage products and, atbest, interrupt the bankers’ ability to writenew business and earn money. However,the system which developed arguablyencouraged bankers to take risks whichthey did not appreciate fully. The bankerswere remunerated through originationfees, through the arbitrage afforded tothem through securitisation and the saleof B notes. They did their due diligenceand sought their valuations but, overall,they made one fundamental mistake.They forgot or did not fully appreciatethat the whole market could go down atonce. They were not the only ones asmost investors and Governments madethe same mistake.

The need for changeWe know where we are now. We do notneed to rehearse the story of bank bail-outs and restricted levels of credit but it isworth looking at what could be done tohelp prevent this type of economicdisruption happening again. Although

lenders and borrowers are now chastenedand unlikely soon to make the samemistakes again, memories fade, goodtimes return and sooner or later the sameold temptations will befall anothergeneration of bankers and investors. It isworth looking at some possible new rulesfor lenders. These would help bringconfidence back, not just to lendersthemselves but also for their investors,particularly the people who buy their sharesand bonds. At the same time the new ruleswould operate to build in good practice forthe future. It is worth noting that noteverything in the world of commercialproperty finance pre-2008 was bad sothere is still, potentially, a place forsecuritisation, covered bonds and otherdebt products. They just need to bebolstered by some new rules in order tohelp remove some unnecessary risk.

Covered bonds orsecuritisation?The UK already has a covered bondmarket but it is mainly utilised forresidential mortgage finance and notused as a means of raising finance forthe commercial property sector in theUK. There are a number of reasons forthis including restrictions on includingcommercial mortgages in UCITScompliant schemes and the nature of acovered bond means the related assetsand liabilities remain on the bank’sbalance sheet. This means that the bankmust continue to hold capital against theassets. In contrast, a securitisationshould normally constitute a sale of theassets for regulatory purposes with theassets and liabilities moving off thebank’s regulatory balance sheet so thatthe bank’s ability to lend is notconstrained by the size of its balancesheet. Whilst there are arguments thatkeeping all assets and liabilities on abank’s balance sheet helps to keep the

bank “honest” with incentives aligned toinvestors, the consequential constraintson the banks’ ability to lend may meanthat there is insufficient capital availablein the market place to fund themortgage market.

A new set of rulesA new set of rules, conservatively drafted,would encourage investors to provideliquidity to the commercial propertymarket safe in the knowledge that theirmoney must be used only in accordancewith strict criteria, thus restoring marketconfidence. The rules would alsointroduce a much greater degree oftransparency so that borrowers,originating lenders, investors andregulators would all be able to see whoowes what to whom and on what terms.With strict criteria and greatertransparency it would also be possible formortgage origination to be linked to theissue of bonds, thereby creating a newdebt based asset class for bothprofessional and retail investors offeringan alternative to bank deposits andGovernment bonds. Attracting newfinance to the property sector should, intime, help banks clean their balancesheets of so-called toxic debt by re-starting a property market into which theycan sell distressed assets. As well asproviding market infrastructure for newinvestors, tight rules would encouragegood practice and therefore help dampenthe possibility of the market over-heatingin the future, although the widerregulatory framework is also important inthis regard. Any new regime should notoutlaw traditional bank lending or fundingoutside the regime, but should act as anadditional form of finance available to thewider market. In other words, the newrules should provide a framework for aquality kite mark rather than a restrictionon how mortgage business is carried out.


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How would such a new lending regimework? A new set of criteria could beapplied across the market forsecuritisation, covered bond anddebenture stock issues, perhaps even formortgage loans intended only forsyndication. New criteria could prescribe:

(a) valuers to be instructed in a standardway to reduce risk of borrower orlender influence;

(b) minimum financial covenant tests;

(c) (possibly) amortisation requirementsat least for higher loan to value deals;

(d) categories of property suitable assecurity;

(e) minimum levels of due diligencewhich must be undertaken prior toorigination;

(f) transparency as to inter creditorarrangements;

(g) origination fees capped or payable instages to discourage too much front-ended remuneration and risk taking;

(h) restrictions on the ability of borrowersto refinance equity and so realiseprofit prior to a sale; and

(i) the ways in which mortgage loansmust be managed and what willhappen on default.

The key is that criteria would be simpleand objective but allow enough flexibilityto allow deals actually to be concluded.

Financial covenantsValuation is not an exact science butvaluations would be carried out on aconsistent and conservative basis,perhaps always assuming that a borrowermust invest a minimum amount of equityon purchase (say 30%) and that a loan ofmore than 50% loan to value will beamortised to 50% or less or by a certainpercentage amount. Ongoing loan tovalue tests are unpopular for borrowersbut a solid valuation at the outset isessential in order to help ensure that theloan is of the right sort of proportion at thetime of origination. In a rising marketvaluers tend to be primarily instructed byborrowers whereas in a falling marketvaluers tend to be instructed by lenders.This is, perhaps, an over simplification butthere is a potential moral hazard in thatthe former could conceivably help driveup values and the latter could conceivablydrive down values thus arguably bringinginto question the full worth at any time ofvaluations. The key is good all round duediligence at the time of origination, ofwhich valuation should be a part but notthe be all and end all.

It is worth looking at financial covenanttests in a little more detail. The easiesttest for all parties is a day one loan tovalue test at the time of the origination ofthe loan. The more conservative the initialloan to value test, the less one shouldneed financial covenants in the loandocumentation, a continuing loan to valuecovenant in particular. If the maximumloan to value were 60% then, assuming arobust valuation process, there shouldnot be a need for ongoing loan to valuecovenants. Above 60% life starts tobecome more complicated. Ongoing loanto value tests are not popular withborrowers as they are driven by mattersoutside the borrower’s control. If the initialvaluation is carried out on a prudentbasis, other origination criteria are met

and the loan is properly managed, thenone can argue that an ongoing loan tovalue test should not be required. Onecan also argue that with differences ofopinions as to value at any time, the meritof an ongoing test is questionable if thereis an interest cover test and/or a debtservice cover test.

Ongoing interest cover and debt servicetests tend to be more acceptable toborrowers than ongoing loan to valuetests but their exact terms can vary a lotfrom deal to deal. Depending on thevagaries of a particular property orportfolio, it should be possible to settleupon a suitable test which would workacross the market as part of a new set ofrules. In any event, it is always open tothe borrower to cure a financial covenantbreach by reducing the amount of theloan and putting up more collateral,finding a new tenant or otherwiseprocuring an increase in rent.

To amortise or not?Linked to financial covenants is thesubject of amortisation. Old fashionedlending terms demand that a borrowerreduces a loan over a period of time. Inrecent years, interest only mortgages (ormortgages with very limited amortisationrequirements) have been popular withborrowers as large borrowings mop uppotential tax liabilities and leave moremoney for other deals, with theassociated potential for capital gains. Asa general rule, the higher the initial loan tovalue, the greater the pressure thereshould be on the borrower to reduce theloan over time. An amortisationrequirement could be included as part ofthe new rules but would not be popularwith borrowers. The new rules wouldneed to protect lenders but also besufficiently workable for borrowers. Thatsaid, amortisation does focus the mind.

“Any new regime shouldnot outlaw traditional banklending or funding outsidethe regime, but should actas an additional form offinance available to thewider market”

Special purpose vehicles –a good thing?Another aspect of financing in recentyears worthy of review is the trend forspecial purpose entity (or vehicle)(SPE/SPV) financing. This is where asponsor of a deal forms an entity solelyto acquire an asset or a group of assets.This has been attractive to lenders andborrowers alike. Secured lenders like thisarrangement because it should givethem exclusive access to the underlyingassets of the borrower, should there be adefault, without the need to competewith other creditors. Investors like itbecause it allows them to ring fenceeach investment. The difficulty with SPEfinancing is that it could perhaps causeboth investors and lenders alike to seethe property as the borrower rather thanas the security for the borrower’sobligations. It also denies the lenderaccess to other assets of the borrowershould the loan default. SPE financing isnot bad in itself and is probably here tostay but, arguably, it encouragesirresponsibility and perhaps there shouldbe tighter requirements for SPE financingthan for where a sponsor is prepared toput its assets generally on the line. Anyrule along these lines would probably betoo arbitrary but the subject is at leastworthy of debate.

Compliance with new rulesA new set of rules would be uselesswithout a system for certifyingcompliance. Self-certification by thoseinvolved at the time of origination couldbe an option, but it would need to besubject to independent audit orverification by an independent person.The auditor (or other independent person)would examine not just the work of theoriginator but also the work of theoriginator’s advisers to ensure that formsand procedures had been followed in the

prescribed way. Those opting into therules would be able to use a kite mark (orbrand) which sends a message toinvestors in the market that the mortgageloans which they are buying directly orthe secure bonds have been originatedhave done so in the prescribed manner.

Amount of loanOne of the most difficult areas is the levelof debt which can be raised against anyparticular property whilst keeping riskslow. A property which is well located, welllet and well managed is likely to be a saferbet than a property which is badlylocated, vacant and owned by an investorwith a poor track record. There are anumber of safety nets which can be builtin, including a conservative valuationprocess, a possible restriction onrefinancing except by reference to theoriginal purchase price of the property(and not by a re-valuation) but, ultimately,new rules would need to set out howmuch debt in loan to value terms couldsupport the branded bonds. Theconservative nature of the rules mightcause a lender to make a loan to aborrower outside the scope of the ruleswhere the security looks very good. Whilstthis conservative approach will not alwaysallow sufficient flexibility for goodborrowers and thus potentially removeprime property from the branded assetpool, on balance, the need for investorconfidence is arguably greater. Greaterconfidence should translate to lowerpricing and therefore is a bigger reasonfor lenders and borrowers to opt into theregime, including for very good properties.

Inter creditorconsiderationsIt should be quite possible to introduce anew set of branded low risk bondssecured by mortgages over commercialproperty for the first 50% to 60% of a

purchase price. This would be the end ofthe issue if a borrower were to financethe balance out of its own funds. In thereal world, however, there is likely to be ademand for higher loan to valuecommercial mortgage debt. Even intimes when markets have been relativelyconservative, for good qualitycommercial property, borrowers wouldexpect to be able to raise senior debtfinance up to approximately 65% or 70%of value. There are, therefore, questionsas to where the loan to value line shouldbe drawn and whether or not the kitemark should go further and restrict thetype of debt which ranks junior to thesenior mortgage debt. On balance, forthe best quality of the branded bonds, itwould be preferable to restrict theamount of junior debt but this is unlikelyto be entirely practicable. In any event,the rights of junior debt holders shouldbe subordinated to the senior mortgagedebt. Further, control of the enforcementand loan management processes shouldinvariably rest with the more senior levelof debt, which has tended not to be thecase for securitised debt. This will likelymean that, in percentage terms,investors in commercial property willneed to put up more equity than was thecase prior to the on-set of the creditcrunch. Most will consider this a positivestep towards the long-term stability ofthe commercial property market, even ifshort-term possibilities are less excitingthan previously might have beenthe case.

The danger of refinancingsIn an inflationary environment thetemptation for lenders to agree torefinance borrower equity without a newsale or purchase can be great.Refinancing of equity (and subordinateddebt) should be prohibited in any newkite mark system. This would improve


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the quality of day one loan to value/ loanto purchase price analysis as referenceto value would be by reference to a realmarket value transaction. High transfertax costs mitigate against real propertylevel transactions and encouragerefinancings. This is another potentialargument for a change to the tax systemin so far as it applies to property.

FlexibilityIn order to meet the market demand forloan to value of up to 70% withoutcompromising the principle of a clear,conservative framework, the mortgageloans could allow investors to buy in atdifferent levels or to take on different levelsof risk. For example, there could be a lowrisk “green” level of mortgage debt at under55% of loan to value, a riskier “blue” level of55% to 65% and a more risky “orange”level of 65% to 70%. Bond issues could bestructured with mortgages only at one level,for example, a “green” level of debt under55% loan to value. Alternatively, bondissues could include more than one level ofmortgage debt to create more investmentpossibilities, such as an issue whichincludes mortgage debt of up to 65% loanto value, which would consist of “green”and “blue” debt. This would be in additionto any credit rating applied to the bonds.Unlike the A/B structures developed for thepre-credit crunch securitisation market,there should, in any event, be transparencyas to the levels of interest and the amountspayable to the investors at each level sothat all lenders and bond holders can seethe total liabilities of the borrower securedagainst shared security and who, exactly,controls what.

Who owns what debtinterest?A potential problem in allowing lenders tooriginate differing levels of debt is that itcan become tempting for them to keep

the junior, more risky pieces of debt,thereby storing up potential problems ontheir balance sheets. This was an issue inthe pre-credit crunch mortgagesecuritisation market. There has beenrecent discussion amongst regulatorsthat lenders should retain a proportion ofthe risk in order to keep them honest andalign incentives with investors (see“Lifting the regulatory fog - will theamendments to CRD reveal a newlandscape?” on page 71 below) but thiswas already as a matter of fact often thecase for many securitised transactionswhere first loss was retained and did notprevent disastrous results all round.Lenders who opt into a kite markedregime should, ideally, not be required(and perhaps not even able) to retain theriskiest parts of the loans on theirbalance sheets. Prudent lending andcompliance with a set of clear rulesshould be the protection afforded to themarket. Conservative lending criteriamight have another less obvious benefitbut lenders might be encouraged (orrequired under regulatory proposals) toretain a small piece of the loan on a side-by-side “pari passu” basis with the muchlarger part of the loan to be sold. It mightbe possible to operate the rules in a waythat allows mortgage loans to be fungiblein terms of providing security for brandedbonds. In other words, originatinglenders could establish a specific pool orspecific pools of mortgages to supportbond issues but be able to removemortgage loans and replace them withnew ones as security for the bonds and,for large pools, spread risk for investors.Well spread risk should ultimately feedthrough to lower pricing for borrowers.

The role of rating agenciesWhether or not the bonds are rated by oneor more rating agencies would be up to theissuer or the person arranging the issue. A

rating should not be a pre-requisite of thenew rules. Compliance with the rules wouldbe intended as the protection afforded toinvestors (although the arranger or issuermight apply for a rating in order to assistdistribution and liquidity in the light of thefact that some investors are restricted frominvesting in products which do not have arating). If a rating becomes a pre-requisiteto a transaction it is at least arguable thatthere is a risk that the credit committee ofthe arranger or issuer might be influencedby what the rating agency wants whendeciding whether or not to advance a loanrather than forming its own view of atransaction. The need for compliance witha set of clear-cut rules as to thedeterminant and protection for investorstakes away the uncertainty as to whatrating a particular transaction might ormight not achieve.

Government support(or not)?A Government guarantee should not benecessary to support a branded bondscheme. Although, in the absence of aguarantee, initial take-up of a newscheme might be slow, it would bepreferable for the market for kite markedlending to develop on its own. In anyevent, a guarantee would not comewithout a cost to the lender both in puremonetary and regulatory capital terms,which would be passed onto borrowersnegating some of the benefits of off-balance sheet lending, at least forsecuritised products. There may,however, be a role for a Governmentguarantee for mortgage loans to fund UKGovernment or social projects.

Government or bankingindustry led?How would such a new regime beintroduced? One option would be

industry self-regulation, but withconfidence in the banking industry at alow ebb, legislation or regulation maybe preferable. Legislation or regulationwould give added comfort to domesticand international investors. It could alsohave the advantage of providing anappropriate regulatory framework forthe audit process and for decidingwhich financial institutions should,within a kite mark framework, belicensed to originate mortgage loansand issue (or arrange the issue of)branded low risk bonds. The new rulesshould not be restricted to mortgagelending in the UK but should enablemortgage lenders to originate orarrange mortgage debt secured onproperty throughout the EU so long asthe specified criteria are satisfied.

However, if the commercial mortgageindustry were able to demonstrate asufficient level of appetite forintroducing and policing their ownrules, Government intervention mightbe unnecessary.

Introduction of new rulesA new set of rules for mortgage lending isnot the only solution to current problems inthe wider markets but will establish abenchmark for best practice across theproperty and mortgage industries, providea transparent minimum level of comfort forinvestors and encourage new lending,enabling banks to begin cleaning up theirbalance sheets. The commercial mortgageindustry (or, if not them, the Government)should turn its attention to enabling rules

or, if necessary, legislation or regulation.We encourage those engaged in themortgage and property industries todebate the topics raised in this section.

“A new set of rules formortgage lending willestablish a benchmark forbest practice across theproperty and mortgageindustries, provide atransparent minimum levelof comfort for investors andencourage new lending”


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10. Synthetic securitisations, CDO2

and CLNs – distant memoriesor sleeping beauties?

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Synthetic securitisation structures were aregular feature of the landscape until thefinancial crisis began. They provided andcan continue to provide a very efficient toolfor banks seeking to transfer risk withouthaving to go to the cost of actuallytransferring assets and disruptingcommercial relationships. Side by side withsynthetic securitisation structures was aprosperous structured credit marketproducing all kinds of complex (andsometimes opaque) structured financeproducts, such as CDO2 and CDOs of ABS.

Probably because they sound particularlycomplicated, and because manyjournalists and politicians have only alimited understanding of how they work,credit default swaps, and thereforesynthetic securitisations based aroundcredit default swaps, have been one ofthe favourite whipping boys throughoutthe financial crisis, regularly beingaccorded a large slice of the blame foreverything that is wrong with the world ofstructured finance. This situation was nothelped by the fact that Lehman Brotherswas one of the major arrangers andsponsors of synthetic securitisations andcredit linked notes. With the recenttentative recovery in the markets, can weexpect to see synthetic securitisationsand structured credit products returnfrom the dark days of old? There havebeen some signs of recovery, withappetite returning in particular for firstloss tranches by yield hungry hedgefunds and some investor interest inmezzanine tranches.

Restoring ConfidenceCredit default swaps, both funded (in theform of synthetic securitisation) andunfunded (in the form of portfolio creditdefault swaps) remain a powerful and flexibletool for banks in managing their balancesheet and regulatory capital requirements.Credit linked notes can also continue to

provide an attractive investment forinvestors. In fact, in some ways, syntheticsecuritisations expose investors to less risk,and in particular less unwind risk, thantraditional asset-backed securitisation.

Nevertheless, in our view, syntheticsecuritisations are not likely to return to ameaningful extent unless:

(i) the trust which investors placed inrating agencies can be repaired;

(ii) investor demand returns for risk at thedifferent levels of the capital structureat spreads which make economicsense to originators;

(iii) there is greater clarity for originators asto what constitutes “significant risktransfer”; and

(iv) the impact of the regulatory initiativescovering central counterparty clearing,collateralisation of OTC exposures andamendments to the CapitalRequirements Directive (“CRD”) arefully assimilated.

Providing greater transparency onreference assets is not always as easy asit may sound due to the need to complywith data protection laws and duties ofconfidentiality. Restoring confidence inrating agency methodology will also notbe easy. In addition, the more complexand esoteric structures create reputationaland regulatory concerns for financialinstitutions that can cause participants toshy away from their use.

To help restore confidence, in depthinvestor education and involvement instructuring new transactions from theoutset, particularly in more complicatedstructures, is likely to be required.However, it is likely that many investorswill not have the time or resources todevelop the expertise required to assessproperly the risks and rewards ofinvesting in synthetic structures and may,once again, need to rely to a material

extent on the ratings given to syntheticdeals. This may cause some regulatoryissues which could limit their ability toinvest (see “Lifting the regulatory fog -will the amendments to CRD reveal anew landscape?”).

For originators, a key benefit of syntheticsecuritisation (whether funded orunfunded) is avoiding the need toachieve a true sale of the assets, andtherefore ensuring a much more flexiblereplenishment mechanism to managethe portfolio over the life of thetransaction. For originators operatingunder the internal ratings basedapproach under Basel II, syntheticsecuritisation also offers a morestraightforward way of transferring only aproportion of the risk in respect ofindividual reference obligations, andallows for more dynamic management ofFX exposure in connection withreference obligations denominated indifferent currencies than does traditionalsecuritisation. These features mean thatcredit default swaps and syntheticsecuritisation remains a powerful andflexible tool for originators to managetheir balance sheet and regulatorycapital requirements.

However, if the spreads for syntheticsecuritisations are significantly widerthan the spreads for cashsecuritisations, originators are not likelyto have an incentive to use synthetictechnology unless there are othercompelling business reasons to do so,such as the difficulty of complying withtransfer restrictions or a commercialdesire not to upset bank/customerrelationships which might result fromseeking consent to a transfer.

Regulatory OversightIn market conditions where outright assetsales have been difficult to structure in aneconomic manner, market participants

In this brief overview, we look at what will need to be achieved for syntheticsecuritisations to re-emerge as a popular securitisation technique. In addition, wenote the difficulties faced by managers of synthetic CDOs and the impact that the“Big Bang” and “Small Bang” developments will have in the credit-linked note area.

have sought to structure creditprotection arrangements in other ways.Some of these arrangements may havebeen more cosmetic than real and maynot have transferred significant risk awayfrom the originator of the assets to athird party. Going forward, regulatorscan be expected to be more vigilant tothe substance of transactions or seriesof transactions to ensure that the letterand spirit of their rules are compliedwith. In July 2009, the UK FinancialServices Authority made it clear that itexpected the letter and spirit of its rulesto be complied with and requestedproviders and purchasers of regulatorycapital structures to discuss with theirsupervisory contacts proposedtransactions prior to executing them.Regulatory initiatives amending the CRDare likely to require increased andongoing exposure and it remains unclearhow the proposals to increasecollateralisation requirements for non-central counterparty cleared trades willaffect the market. Overall, in our view,this will mean a greater focus onregulatory compliance anddocumentation being prepared with thepossibility of regulatory review in mind.

Managed CDOsManaged CDOs have had a tough timeover the last two years, with multipletranches of synthetic transactions havingbeen downgraded. In addition, syntheticCDO managers have struggled tocomply with portfolio criteria for manyreasons, including widening spreads,

reduced market liquidity, less originationof the underlying assets and fewerdealers. As a result, many syntheticCDOs that were intended to have thebenefit of CDO management have inpractice become static. The result of thishas been the restructuring of manytransactions (which has not always beenstraightforward) to adjust subordinationlevels and portfolio parameters. Of allthe areas that have used synthetictechnology, managed synthetic CDOsseem the deepest in their slumber.

Credit-linked Note IssuanceThe “Big Bang” and “Small Bang”developments in the credit derivativesworld introduced a 60 day back-stopdate for credit events, an ISDAdeterminations committee to makebinding decisions regarding credit eventsand related matters as well as anindustry standard auction settlementmechanism (unless the parties decideotherwise). The market standardisationcreated by “Big Bang” and “Small Bang”may give an impetus to the issuance ofcredit-linked notes, particularly off ofrepackaging and debt issuanceprogrammes which allow for a very costeffective method of issuing credit-linkednotes. While some credit-linked notescontinue to be issued using dealerquotation methodology for determiningloss payouts, investors will move todemand more frequently that credit-linked notes generally follow auctionsettlement pricing determinations asindustry standard pricing so far has

resulted in lower loss amountdeterminations and, therefore, higherpayouts to noteholders. Whilst the notesthemselves may not always requireauction terms to be embedded in theirconditions, the increased use of theauction process will inevitably flowthrough to dealer quotes and then intocash payments under the notes.

The FutureThe destination and size of the first-losspiece of an issuance will be of increasingimportance to investors, and will interactwith the new “skin in the game”requirement for arrangers to retain anexposure to some or part of thesecuritised assests (see “Lifting theregulatory fog - will the amendments toCRD reveal a new landscape?”). Investorand regulator demands for transparency,simplicity and a greater depth ofexplanation of the details of syntheticproducts are likely to lead in due courseto the emergence of simpler syntheticsecuritisation and structured producttransactions. While it seems like a longtime since we had an active syntheticsecuritisation and structured productsmarket, the use of synthetic technologyis a very efficient tool for transferring risk(as can be seen by its extensive use in anumber of government backed assetsupport schemes) and, subject toconfidence being restored in how riskscan be modeled and rated, we shouldsee synthetic technology make a gradualreturn from its current slumber within thenext twelve months or so.


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11. OTC derivatives in structureddebt transactions

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BackgroundMost structured finance transactionsincorporate OTC derivatives as a tool formanaging or metamorphosing cashflows orhedging exposures within the structure.

However, developments in financial marketssince the onset of the global financial crisishave forced both rating agencies and theparties to these derivative transactions toreconsider how these transactions operatein a stressed financial climate.

In some cases, this has been as a resultof commercial considerations, and, inparticular, the reality that the features ofsuch transactions which were intended tominimise the exposure of noteholders tothe credit risk of swap counterpartieshave not operated as intended. In othercases, the reexamination has resultedfrom legal developments, particularlythose arising from the collapse andinsolvency of Lehman Brothers inSeptember 2008. By examining theprincipal issues and difficulties which haveemerged during the past year, it isintended to offer some guidance andsuggestions for how these difficulties canbe minimised in future transactions.

The role of OTC derivatives inStructured Debt TransactionsThe primary role of OTC derivatives instructured finance transactions is tomanage the cashflows associated with thetransaction. Swaps are essential forconverting the cashflows generated by theunderlying assets or reference obligationsinto the cashflows which the issuerrequires to meet its obligations tonoteholders and other creditors. Inparticular, currency and interest rateswaps are necessary, where theunderlying assets are either denominatedin a different currency from the currency ofthe notes, or generate income on adifferent basis from the interest which ispayable on the notes.

However, whilst at a basic level theseswaps are based around exchangingcurrency or interest rate cashflows, theyare often very different from “plain vanilla”OTC interest rate or currency swaps.Rather, the cashflows generated by theswaps will be, of necessity closely tied tothe cashflows generated by the underlyingassets, investment accounts and collateral

The global financial crisis has resulted in a re-examination of the practical operation ofOTC derivatives in the context of structured finance transactions, particularly in thecontext of the remedial actions to be taken following the downgrade ofswap counterparties.

Main issues:

• The swaps supporting many structured finance transactions are usuallytailored to the underlying assets and require in-depth knowledge of theasset pool and the structural features of the overall transaction, all of whichmakes these swaps difficult to price. This results in a lack of the liquidityessential for the effective calculation of collateral requirements or procuringreplacement swap counterparties where required.

• Recent litigation arising from the collapse of Lehman Brothers has thrown theefficacy of commonly encountered provisions in structured financetransactions into doubt. This is particularly so for swap counterpartiesincorporated in the US. and therefore subject to the US Bankruptcy Code.

What we are seeing in the market?

• Swaps are becoming more difficult to put in place, and pricing is lessfavourable than was the case prior to the onset of the global financial crisis.

• Replacement of swap counterparties once downgrade trigger levels havebeen reached has been problematic and impractical, largely due to problemswith obtaining credible mark-to-market swap valuations.

• Recent bankruptcy driven litigation causing concern for rating agencies as toenforceability of common contractual provisions.

• Pending regulatory initiatives by the G20, the US Congress and the EuropeanCommission to strengthen the financial system will impact on thecollateralisation and clearing of OTC swaps, although it is currently unclearhow the proposals will affect derivative transactions used in structuredfinance transactions.

How will issues be addressed in documentation?

• To the extent that it is possible, there will need to be greater focus on swapsbeing drafted so that cashflows can be calculated independently ofknowledge of the underlying assets and transaction structure.

• There will be refinements to collateral calculation mechanics to minimise risk tonoteholders of an extended delay in obtaining a replacement swap counterparty.

• A move away from US swap counterparties in structured debttransactions towards English incorporated entities, possibly backed by USparental guarantees.

within the deal. As a result, the terms ofthese swap transactions will dependsignificantly on the nature of thoseunderlying cashflows and sources, andare specifically negotiated by thearrangers of the transaction, along withthe rest of the transactiondocumentation. Frequently, the arrangeror one of its affiliates is the counterpartyto the swap with the issuer.

Where the notes issued in a structureddebt transaction are to have a AAArating, the rating agencies require theswap counterparties to the issuing vehicleto have at least an A or AA rating and tocomply with certain criteria prescribed bythe rating agencies. In particular, if theswap counterparty is downgraded, it isrequired to take specified remedial actionto ensure that the downgrade does notexpose noteholders to the risk of a swapcounterparty default.

Rating agency criteria forOTC derivativesHistorically, the three major ratingagencies (S&P, Moody’s and Fitch)required both OTC derivatives whichsupported structured debt transactionsand the counterparties that providedthem to comply with comparable criteria.Broadly speaking, these requirementscan be divided into “terminationprovisions” and “downgrade provisions”.

The termination provisions themselveshave two key features. First, thecircumstances in which a swapcounterparty is permitted to terminate aswap transaction is limited to eventswhich, in practice, would be likely to resultin the structured finance transaction beingunwound or the disapplication of whichwould be so commercially unattractive toa potential counterparty as to make itdifficult to find a willing party (e.g., apayment default or insolvency of the

issuer). The other termination events arethose that are not taken into account inthe rating process (e.g., change of tax lawor illegality). The global financial crisis has,by and large, not resulted in any concernswith these provisions. The second groupof termination provisions relate to the levelat which the swap counterparty receivespayments in the post enforcement priorityof payments applicable to the transaction.Rating agency criteria distinguish betweenwhether or not the swap counterparty isin default on its obligations under theswap. If it is not, then generally it willreceive sums due to it (if any) in priority tothe noteholders; if it is in default, then it isentitled to any payments that may be dueto it after the noteholders have been paidout. This “flip” feature of rated structureddebt transactions has recently been thesubject of significant litigation which isdiscussed below.

The second category of rating agencycriteria, the rating downgrade provisionshave undergone significant reworking andmodification in recent years, particularlysince the onset of the global financial crisis.However, the fundamental principlesremain unchanged. Essentially, if a swapcounterparty is at or is downgraded belowa specified rating level, it is required postcollateral to support its obligations underthe swap. Alternatively, or additionally itmay also elect to obtain a guarantee of itsobligations under the swap from a thirdparty, or transfer its obligations under theswap to a third party where, in either of thelatter two cases, the third party has therequired ratings. If the swap counterparty issubsequently further downgraded below asecond rating level, posting collateral is nolonger a sufficient remedy, and the swapcounterparty is required to find a guarantoror replacement swap counterparty.

The aim of these downgrade provisions isto ensure that the issuer is not faced withan insolvent swap counterparty by ensuring

that, prior to the occurrence of thatinsolvency, the swap counterparty will havetaken appropriate action to ensure that theissuer (and therefore the noteholders) arenot adversely affected by that insolvency.This approach is, however, predicated onthe assumption that the ratings of swapcounterparties do not migrate frominvestment grade status to insolvencywithin the period of time prescribed for theswap counterparty to take the requisiteremedial action. Historically it was assumedthat a swap counterparty experiencingfinancial difficulties would undergo anorderly transition of its rating evidenced bya series rating downgrades over time,thereby providing sufficient time for theremedial action required by the ratingagency criteria for swap counterpartydowngrades to be carried out and avoidingthe disruptive consequences for structureddebt financings of a non performing swapcounterparty. However, the recentexperience of Bear Stearns, AIG andLehman Brothers as well as the rapiddecline in the asset base of US andEuropean banks has challenged thesetraditional assumptions and timelines.

The response to these experiences hasbeen for the rating agencies to raise thetrigger points at which swapcounterparties are obliged to take remedialaction and to reduce the timelines in whichthey have to act. The options available tothe swap counterparties have also beennarrowed particularly at the lower ratinglevels where self-collateralisation by theswap counterparty is not an option,leaving third party guarantee and novationas the only course open to the entity. Inpart, this is to avoid the risk of collateralbeing clawed back upon the occurrenceof the swap counterparty’s insolvency. Italso seeks to reflect the view that ratingmigration may occur more rapidly than theparameters used in older analytical modelshad assumed.


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The problems with swapcounterparty downgradeprovisionsThe two key remedial actions to be takenfollowing the downgrade of the swapcounterparty are to require the swapcounterparty to post collateral or to find areplacement swap counterparty.1

However, because of the way in whichOTC derivatives work, both thesecourses of action are implicitly predicatedon the existence of a liquid market forswap transactions having the sameeconomic effect as the swap transactionsin question. Where the swap counterpartyis to post collateral, the amount ofcollateral to be posted is calculated byreference to the mark-to-market value ofthe transaction (usually with a volatilitybuffer add-on). Similarly, where a swapcounterparty is to be found, thatreplacement swap counterparty will eithercharge or be required to pay an up-frontfee for entering into the replacementtransaction This fee will also be based onthe mark-to-market value of thetransaction. Where there is little effectiveliquidity for equivalent transactions,determining that mark-to-market isdifficult to determine.

The difficulty arises because, in practice,there is not a deep and liquid market forthe type of tailored OTC derivatives whichare used in structured financetransactions. As discussed above, whilethese transactions are often interest rateor currency swaps, in practice the termsof these swaps are closely tailored to theunderlying assets. To price thesetransactions, with all their idiosyncrasies,and therefore to calculate their mark-to-

market value at a given point in time,requires detailed knowledge of theunderlying assets and the other featuresof the structured finance transaction. (Forexample the termination provisionsdiscussed above mean that the ISDAmaster for these types of swaps differmarkedly from those found in the highvolume “flow” markets.). This deal specificinformation cannot be gleaned from asimple review of the swap documentationalone, but requires extensive review of theoverall transaction documentation,accompanied by discussions with theother transaction parties. In additionexamination of the underlying asset pool,any credit enhancement that may beembedded in the structure and anycollateral that may be held by the securitytrustee for the benefit of creditors(including the swap counterparty) will alsobe required. The result of all this is that itis difficult to obtain a realistic mark-to-market value for these swap transactions,making it difficult to calculate the correctamount of collateral to be posted or acommercially realistic transfer value.

Furthermore, even if the correct mark-to-market value can be determined, it isdifficult to find a replacement swapcounterparty to take the transaction on atthat price, because, by definition, themark-to-market value represents theprice at which the transaction would notresult in either party being in or out-of-the-money, and any built-in profit in thetransaction (e.g., arising as a result of amarket or credit spread payable by theissuer) would therefore be retained by theoutgoing swap counterparty. In practice,given the significant work which must beundertaken to price these swap

transactions appropriately, a replacementswap counterparty will only be preparedto take on such a transaction where it willreceive a significant uplift from, or benefitfrom a worthwhile mark down of, themark to market value. Accordingly itfollows that any such benefit accruing tothe transferee swap counterparty willentail a corresponding loss of value forthe outgoing swap counterparty, which itwill naturally be reluctant to bear. (Theonly other outcome would be for theissuer to bear the loss which would beunpalatable to the noteholders andtherefore also the rating agencies.).2 Theconsequence for the swap counterpartyof not agreeing to the transfer (namely,termination of the swap at its true mark-to-market value) may well be preferableto the loss of value associated withtransferring to a replacement swapcounterparty at an unattractive price.

These difficulties are exacerbated by thefact that the swap downgrade criteria dealwith each transaction in isolation of thebroader market. In reality, however, arelatively small number of swapcounterparties are responsible for providing

“One consequence of thecollapse of LehmanBrothers has been agrowing body ofinsolvency-driven litigation,much of it relating to OTCderivatives of the kindprevalent in structuredfinance transactions”

1 The third option, to find a guarantor of the swap counterparty’s obligations, is rarely a viable remedy in practice, as it is very difficult for swap counterparties to findsuch an arms length guarantor where the swap counterparty has already been downgraded. Also the issues of accurate valuation of the swap obligations discussedbelow, apply equally to the pricing of such a guarantee. Consequently, where guarantors are used, it is usually limited to circumstances where the swap counterparty isa subsidiary of the guarantor, and the guarantee is provided at the commencement of the swap transaction,

2 As noted above, in many cases, the original swap counterparty will be a member of the originator or arranger’s corporate group, and therefore the costs associatedwith entering into the swaps are either factored into the original swap pricing, or recovered through the fees earned by the arranger as part of the issuance.

the bulk of the OTC derivatives supportingstructured debt financings, all of which arebased on the same rating criteria.Therefore, the downgrade of a swapcounterparty not only presents a problemfor the note issuers which have to deal witha swap counterparty in a stressedsituation. It also has significant impact forthat downgraded swap counterparty(which suddenly finds itself needing to postsubstantial amounts of collateral and/orfind replacement swap counterparties) Anillustration of this was the situation whichdeveloped with AIG after September 2008,when it ceased to have the required ratingsto act as swap counterparty for most ofthe structured financings in which it wasinvolved. Despite the rating criteria applyingto those financings requiring AIG to bereplaced as swap counterparty in shortorder (no more than 60 days from the dateof the downgrade), such replacement infact took many months, and, at the time ofwriting, is still continuing for sometransactions. This inability to comply withthe downgrade provisions in anythingapproaching the prescribed timeframeserves to illustrate not only the lack of theliquid market for these sorts of swaps butalso the frailty of the assumptionsunderlying the criteria.

It is not possible to eliminate theseconcerns and difficulties entirely.However, below we offer somesuggestions for ways in which they canbe minimised for future transactions.

Current uncertainties:subordination of defaultingcounterparties andsuspension of paymentsOne consequence of the collapse ofLehman Brothers has been a growing

body of insolvency-driven litigation, muchof it relating to OTC derivatives of the kindprevalent in structured financetransactions. Two cases which haveparticular implications for structuredfinance are the decision of the Court ofAppeal in Perpetual Trustee CompanyLimited v BNY Corporate Trustee Services[2009] EWCA Civ 1160 (“Perpetual”) andthe decision of the US Bankruptcy Courton a motion by Lehman Brothers SpecialFinancing Inc. or “LBSF” to compelperformance by Metavante Corporationunder certain derivative contracts withLBSF3 (“Metavante”).

(a) Subordination of insolvent swapcounterparties – the Perpetual case

The Perpetual case concerned a commonfeature of may structured financetransactions, whereby the swapcounterparty ranks in priority to noteholdersupon enforcement of the security over thecollateral unless the swap counterparty itselfis in default (which includes where the swapcounterparty is insolvent), in which case theswap counterparty ranks below thenoteholders in the priority of payments.4

This was referred to by the court as the“flip” provision. The rationale for the flipprovision is readily apparent. Given that it ismarket practice for swap transactions toterminate at their then current mark-to-market value, regardless of which party is indefault, the flip provision is an importantprotection for noteholders. It ensures that itcannot be advantageous for an in-the-money swap counterparty to default on itsobligations under a transaction, therebyforcing the issuer to terminate the swapand unwind the structure and ensuring aprofitable payout for the swap counterpartyand a potential loss for the noteholders.Arguably, it also reflects the proposition that

a defaulting counterparty should in someway bear the burden of its delinquency orat least the noteholders should not suffer forit. By moving the swap counterparty downthe priority of payments when it is in default,the noteholders are better protected andmore likely to receive a greater proportion ofthe termination payments.

However, the issue which arose inPerpetual was whether the flip provisioncontravened the “anti-deprivation”principle. This principle is best summarisedas the rule that “there cannot be a validcontract that a man’s property shall remainhis until his bankruptcy, and on thehappening of that event shall go over tosomeone else, and be taken away from hiscreditors.”5 This rule has a long judicialheritage dating back to the 19th century,although the precise scope and applicationof the rule has been the subject ofconsiderable and increasing uncertainty inrecent years, particularly where, as in thecase of the flip provision, the asset inquestion is an intangible asset such as acontractual right. The issue is to whatextent do contractual provisions, whichchange the nature of an intangible rightupon the insolvency of a party, themselvesconstitute an integral part of the asset (inwhich case there is no dealing with theasset to which the anti-deprivation principlecan apply) or amount to a dealing with theasset (and which will therefore be subjectto the anti-deprivation principle)? In thelandmark House of Lords decision in BritishEagle International Air Lines Ltd vCompagnie Nationale Air France [1975] 1WLR 758 (“British Eagle”), the majority oftheir Lordships held that clearing housearrangements which provided for the multi-party netting of debts and credits owedbetween an insolvent airline and a group of

3 See Transcript issued by Judge Peck of the US Bankruptcy Court on 15 September 2009 pages 3–4 and 99–113.4 Although the relevant swaps in the Perpetual case were credit default swaps, the issues arising in the case apply equally to any other type of OTC derivatives in astructured finance transaction.

5 Ex p Jay; In re Harrison (1880) 14 Ch D 19, 26.


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other airlines constituted a disposal of theinsolvent airline’s assets and, therefore,following the onset of insolvencyproceedings in respect of that airline, was adealing with those assets in contraventionof the anti-deprivation principle.

In Perpetual, the swap counterparty (theinsolvent LBSF) argued that the flipprovision involved a breach of the anti-deprivation principle because it had theeffect of reducing the value of the assetsof LBSF (i.e., its right to have its claimsagainst the issuer satisfied out of theproceeds of collateral held by the securitytrustee in priority to the claims of thenoteholders) as a result of the insolvencyof the swap counterparty. This argument,if successful, would have had significantimplications for the many structuredfinance transactions containing flipprovisions of this kind.

Fortunately for the structured financemarket, the Court of Appeal affirmed thevalidity of the flip provision. It held that theeffect of the flip provision was not to divestLBSF of any asset currently vested to it, butmerely to change the order of priorities.6

The asset held by LBSF was the right toenjoy the proceeds of the enforcement ofthe security. The extent of this right was setout in the terms of the documentation, ofwhich the flip provision was an essentialcomponent. Unlike British Eagle, where themulti-party netting arrangements were heldto be a dealing with the assets of theinsolvent airline, in Perpetual, the flipprovision was an essential feature of theasset vested in LBSF, not a provision whichvaried an otherwise existing asset on theinsolvency of LBSF.

In reaching this conclusion, the courtrecognised the necessity of ensuring that

the law in this area is clear and consistent.Whilst the court recognised that this hasnot always been the case, it stated that“the need for consistency and clarity is allthe greater now that commercial contractsare becoming increasingly complex both intheir underlying nature and in their detailedprovisions, as is well demonstrated by thecontracts in the instant cases”.7 The courtalso recognised the desirability of givingeffect to the contractual terms to whichparties have agreed, particularly in thecontext of complex financial instrumentswhere “the parties are likely to have beencommercially sophisticated and expertlyadvised”. In fact, the court went further,acknowledging that even in those caseswhere the anti-deprivation principle may berelevant, it will often be possible to avoid itsapplication by careful drafting.8 The courtreferred to the “anti-avoidance” provisionsin sections 238 and 239 of the InsolvencyAct, and stated that, in light of the detailedstatutory regime laid down by Parliament, itwould only rarely, if ever, be appropriate forthe courts to invent their own anti-avoidance policies and frustrate the termsof commercial contracts freely entered intoby sophisticated parties. These commentsfrom the court are helpful, giving renewedsupport to the principle of freedom ofcontract and indicating reluctance for thecourt to interfere in arrangements agreedto by sophisticated parties unless suchinterference is absolutely necessary.

However, notwithstanding the foregoing,the reasoning of the Court of Appeal is notentirely satisfactory. One of the reasonsreferred to by the Master of the Rolls forthe court finding that the flip provision didnot contravene the anti-deprivationprinciple was that the collateral over whichthe issuer had granted security in favour of

the swap counterparty and the noteholdershad been almost entirely acquired by theissuer using the proceeds of thesubscription money advanced by thenoteholders.9 In fact, this appeared to bethe key point for the Master of the Rolls,who also suggested that had this not beenthe case, there may have been room toargue that the flip provision would havecontravened the anti-deprivation principle.10

However, it is difficult to understand whythe fact that the collateral was purchasedwith the noteholders’ subscription moneysshould be a relevant consideration. Anoteholder does not retain any proprietaryinterest in its subscription money followingits payment to the issuer. All the noteholderhas is a debt claim against the issuer forrepayment of the redemption proceeds inaccordance with the terms of the notes.Additionally, a noteholder does not haveany interest in the assets belonging to theissuer, except via the security interestwhich it holds (through the security trustee)over the collateral. Given that the legalstatus of the claims of both the swapcounterparty and the noteholders isultimately identical (i.e., debt claimssecured against the collateral held by theissuer), this preference for the interests ofthe noteholders over that of the paripassu interests of the swap counterparty isunsettling and appears contrary tothe general principles of Englishinsolvency law.

It is possible that the decision of the Courtof Appeal may be appealed to theSupreme Court. If this is the case, it is tobe hoped that the Supreme Court upholdsthe decision of the Court of Appeal, butwithout the apparent reliance on the factthat that the collateral had beenpurchased with the proceeds of the

6 Paragraph 62.7 Paragraph 58.8 Paragraph 92.9 Paragraph 61.10 Paragraph 67.

noteholders’ subscription moneys. Whilethis requirement may be unlikely to causea concern in the context of structuredfinance transactions where the collateralhas been bought out of the subscriptionproceeds, the uncertainty of the legal basisfor this requirement does leave an openingthrough which to attack the validity ofarrangements such as the flip provision.

There is also a further potential complicationwith Perpetual. A parallel proceeding isunder way in the US Bankruptcy Courtswhere LBSF is arguing that the flip provisionoffends the anti-deprivation provision inChapter 11 of the US Bankruptcy Codeand, on that basis, cannot be binding onLBSF, notwithstanding that the relevantdocuments are governed by English law.The argument is not surprising given that inmost jurisdictions, the provisions ofinsolvency legislation are of mandatoryapplication, for to allow otherwise wouldenable parties to contract aroundinconvenient legislative provisions. TheCourt of Appeal did not address theimplications of Chapter 11 in its decision inPerpetual, but it was briefly considered atfirst instance in the English High Court inresponse to a request from LBSF for a stayin the English proceedings pending theoutcome of the decision in the USBankruptcy Court. In that case, theChancellor decided that, on the facts, therewere no grounds for him to grant a stay atthe present time and therefore parked the

issue to one side.11 It is expected that theUS hearing will occur in late November2009 and, if that hearing concludes that theflip provisions do contravene the anti-deprivation provisions of the US BankruptcyCode, this will give rise to considerableuncertainty as to how such provisionswould apply in structured financetransactions involving US incorporatedswap counterparties, notwithstanding thatthe provisions are valid under English law.As noted below, should this situation cometo pass, one solution would be for USbased swap counterparties to enter intoswaps in connection with structured financetransactions through English subsidiaries,backed, where necessary, by a parentcompany guarantee from the US entity.

Prior to the Court of Appeal handingdown its decision, Fitch had reacted tothe uncertainty generated by this litigationby announcing that it would require anunqualified legal opinion on theenforceability of flip provisions instructured finance transactions. For thetime being, the Court of Appeal decisionat least means that it should be possibleto give such an opinion as a matter ofEnglish law. However, Fitch has indicatedthat it requires such opinions to cover thelaws of all relevant jurisdictions, whichmay not be possible, particularly in lightof the ongoing litigation in the US relatedto Perpetual. In any case, thisrequirement is a significant departurefrom the previously established positionthat transaction opinions address only theconsequences of insolvency of the issuer,and not of other parties to thetransaction. In fact, one of the primaryreasons for the inclusion of downgradeprovisions in structured financederivatives is to avoid the situation wherethe issuer is facing an insolvent swapcounterparty. If those rating downgradeprovisions apply, there should be no need

for legal opinions to address theenforceability of flip provisions followingthe insolvency of the swap counterparty.

(b) Suspending payments toinsolvent swap counterparties –the Metavante case

Under the ISDA Master Agreement, whichapplies to almost all OTC derivatives usedin structured finance transactions, theobligation of a party to make payments inrespect of a swap transaction isconditional on there being no event ofdefault continuing in respect of the otherparty. As an event of default includes theinsolvency of a party, if a swapcounterparty does become insolvent, andthat insolvency cannot be cured (which willalmost always be the case, particularlywhere a winding up petition has beenpresented and has not been dismissedwithin 30 days), then the issuer can rely onthat insolvency to stop making paymentson the swap without having to terminatethe swap. This applies, even when theswap counterparty is in-the-money.

This is an application of the construct whichis often referred to as a “flawed asset”.Because the issuer’s obligation to performis contingent on the swap counterparty notbeing in default, the asset (i.e. the right ofthe swap counterparty to receive thepayment flows under the swap) is “flawed”by that contingency. When it is not possiblefor the swap counterparty to cure thedefault (i.e. the insolvency), there is no wayfor the liquidator of the insolvent swapcounterparty to cure the flaw and “unlock”the value which would otherwise beavailable to the in-the-money swapcounterparty. The ability of the issuer (or anynon-defaulting party) to rely on a “flawedasset” provision has been upheld underEnglish law. It is an important protection foran issuer where it is apparent that thecounterparty is well on the road to

“The court also recognisedthe desirability of givingeffect to the contractualterms to which partieshave agreed, particularly inthe context of complexfinancial instruments”

11 Perpetual Trustee Co. Ltd v BNY Corporate Trustee Services Ltd [2009] EWHC 1912 (Ch), Paragraph 63.


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bankruptcy and the issuer is faced withmaking a payment before the formal onsetof insolvency proceedings or where aninsolvent swap counterparty which hasfailed to procure a replacement swapcounterparty to take its place prior to theonset of the insolvency. This provides theissuer with breathing space while it looks fora replacement swap counterparty willing toenter into a new swap to allow thestructured finance transaction to continue.

However, the ability of the issuer to rely onsuch flawed asset provisions against aswap counterparty incorporated in the USwas dealt a blow in the Metavante case.Although that case did not involve astructured financing arrangement, itnevertheless involved a party which wasout-of-the-money relying on the insolvencyof LBSF to avoid making payments underthe flawed asset provision in a swaptransaction with LBSF. Under the USBankruptcy Code, a party to an executorycontract is not entitled to rely on a flawedasset triggered by the bankruptcy of itscounterparty to delay or avoidperformance of its obligations under thatexecutory contract.

Swaps are a form of executory contract.However, they are generally grantedfavourable treatment relative to otherexecutory contracts for the purposes ofthe US Bankruptcy Code because theCode provides “safe harbour” provisions toexcuse performance of swaps whichprovide for close-out netting arrangementsin the event of the insolvency of one of theparties However, in Metavante, the USBankruptcy Court held that the purpose ofthese safe harbour provisions was toprovide for an orderly close-out of suchtransactions and, accordingly, only applywhere the non-insolvent party promptlyexercised its right to terminate the swap inquestion. If the non-insolvent party did notdo so, it was taken to have waived its rightto terminate, and was not entitled to rely

on any flawed asset provisions to excuseperformance of its future obligations underthe swap. What the judge was particularlyconcerned about was a non-insolventparty which was out-of-the-money relyingon the flawed asset provisions to “ride themarket” until such time as it found itself in-the-money, and terminate at that time.

The judge’s reasoning is not entirelysatisfactory as it appears to conflate twoseparate issues (namely, the right toterminate and the right to rely on a flawedasset provision) into a single issue. Putanother way, it is the failure to exercise theright to terminate promptly which resultedin the swap losing the protection of thesafe harbour provisions, and therefore theinability of the non-insolvent party to relyon the flawed asset provisions. In practice,it may prove difficult to ascertain howpromptly a non-insolvent party must act toterminate, and for how long it is entitled torely on the flawed asset provisions toavoid making payments prior to exercisingits right to terminate. In some cases, thenon-insolvent party may not immediatelybe aware of the insolvency of the swapcounterparty, or even if it is aware, thesheer number of transactions which needto be dealt with in such circumstancesmay mean that there will be a significantperiod of time between the onset of theinsolvency and the termination of theswap. This was certainly the case with theLehman insolvency, and is very likely to bethe case in many structured financetransactions where the issuer is notpermitted to exercise any terminationrights without the consent of the trustee.The experience with the Lehmaninsolvency has been that trustees are oftenreluctant to grant that consent without theapproval of the noteholders, which canalso take a considerable time to obtain.

Further, where the issuer is out-of-the-money, if it is forced to terminate theswaps “promptly” following the insolvency

of the swap counterparty, this may requirethe issuer to unwind the entire structuredfinance transaction if it is unable to find areplacement swap counterparty to enterinto a new swap within that time frame.This is an unsatisfactory outcome forinvestors where the underlying assets maystill be performing as expected.Additionally, if the result of the Perpetualcase to be heard in the US courts is thatflip provisions are not enforceable in theevent of a US incorporated counterparty’sbankruptcy, then it may be thatnoteholders receive little or nothing by wayof payment, if the out of the moneypayment to the swap counterparty absorbsall the assets of the issuer.

As with the concerns arising from theUS litigation running parallel withthe Perpetual case, one solution to thesedifficulties is for structured financetransactions to avoid usingswap counterparties incorporated inthe US, and/or for US swap counterpartiesto utilise subsidiaries incorporated inEngland, possibly backed by a guaranteefrom the US parent company if necessary.This would avoid the need to rely on theflawed asset provisions against a USincorporated entity.

New beginnings:where next?Since the onset of the global financial crisis,it has become more difficult to put swaps inplace for structured finance transactions,and pricing for those swaps has been lessfavourable for investors. Nevertheless,swaps remain a valuable (and in manycases, essential) tool for managing thecashflows and exposures within a structure.While we are aware of transactions being(re)structured to avoid the need for swaps,in our view, swaps are likely to remain afeature of many transactions.

Despite their shortcomings, ratingdowngrade provisions do perform a

valuable role in structured finance swaps,although it is to be expected that they willcontinue to evolve as the rating agenciesseek to reach the most workable solution.However, within the constraints of theexisting criteria, and in light of the difficultieswhich have arisen with these provisions, it isnecessary for arrangers, when structuringtransactions, to give greater considerationto what would actually happen if the swapcounterparty is downgraded and eithercollateral needs to be posted or areplacement swap counterparty needs tobe found. Some suggestions in this regardinclude the following:

• To the extent possible, swaptransactions should adopt market-standard terms. For example, if a poolof mortgages supporting an RMBStransaction pay interest based on amarket-standard “screen” rate, thenrather than the issuer’s paymentobligation under the swap referring to“the amount of interest payable on themortgages”, it would be better todefine this amount by reference to thatscreen rate and a notional amount(subject to an expected amortisationschedule). This would avoid potentialreplacement swap counterpartiesneeding to trawl through thetransaction documents in order to beable to understand the cashflows, andtherefore price the transaction. Ofcourse, the ability to rely on market-standard terms will depend on thenature of the underlying assets. But tothe extent possible, originators andarrangers should bear these factors inmind when selecting the underlyingassets for a particular transaction.

• Consideration should also be given towhether “composite” transactions canbe broken down into separatetransactions. For example, it may bepossible to divide an interest rate

swap into a basis swap, which maybe more difficult to price, and a plainvanilla interest rate swap which wouldbe easier to price.

• To the extent that more time isrequired to find a replacement swapcounterparty, consideration should alsobe given to adjusting to the amount ofcollateral required to be provided bythe swap counterparty. One way ofaddressing this concern is by the useof independent amounts, or includingin the calculation of the swap exposureamounts which represent the expectedpayments required to be made by theswap counterparty on the next fewpayment dates.12 This has the benefitof ensuring that the swap counterpartywill be able to continue making itsscheduled payments over the next fewpayment dates, regardless ofmovements in the mark-to-marketexposure of the swap, while the partiesattempt to find a replacement swapcounterparty. While this is not asubstitute for posting collateral inconnection with the mark-to-marketvalue of the swap, it may provideadditional comfort for the ratingagencies and justify allowing alonger period of time to obtain sucha replacement.

Attention also needs to be given to howthese swap transactions would beunwound if the swap does terminate early.This is particularly relevant in “balanceguaranteed” swaps, where the quantum ofthe payment obligations is dependent onthe size of the portfolio of underlyingassets at a given point in time. Atorigination, the swap is priced on the basisof the expected amortisation of thoseassets over the life of the deal. However,how that amortisation should be modelledon early termination, when the portfolio isto be or has been sold needs to be made

clear if the market quotation mechanismunder the ISDA Master Agreement is toprovide a meaningful valuation. Much ofthis can be addressed in the drafting ofthe swaps at origination, and therebyavoid confusion and uncertainty if atransfer is subsequently required.

It is also possible that the currentdiscussions about introducing “living wills”to manage the orderly winding-up offinancial institutions in the UK (and similarproposals which may be made in otherjurisdictions) may at least partially addresssome of the difficulties associated withfinding replacement swap counterparties(for example, through pre-agreement ofreplacement swap counterparties, so thatthe transfer can occur immediately uponthe relevant downgrade occurring).

Finally, as discussed, the uncertaintiesraised by both the Perpetual andMetavante cases can be minimised byavoiding using US entities as swapcounterparties. Of course, this does notmean US banking groups cannotperform this role. Rather, wherepossible, issuers should seek to transactwith subsidiaries of such groups whichare incorporated in England where, todate at least, the contractual provisionsat the heart of both cases have beenupheld. Most of the US banking groupsalready have locally-incorporatedsubsidiaries which can be used for thispurpose, and where such subsidiariesdo not have the required ratingsthemselves, they can be supported by aguarantee from the US parent companywithout causing the uncertainties whicharise from having a US entity as theswap counterparty directly.

This approach would avoid any of theuncertainties which may arise if the USproceedings running parallel to thePerpetual case find that the flip provisions

12 This is, in fact, consistent with the approach taken by Moody’s in relation to some types of swaps.


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contravene the anti-deprivation provisionsof the US Bankruptcy Code. This isbecause the anti-deprivation will only bitewhere the insolvent swap counterparty is“in-the-money”, but a guarantor can neverbe “in-the-money” in this way, as the issuerwill never owe any amounts to theguarantor. Thus, where the swapcounterparty is out of the money, the issuerwould have a claim against both the swapcounterparty and the guarantor, but wherethe swap counterparty is in-the-money, theswap counterparty’s right to share in theproceeds of the collateral would besubordinated to those of the noteholders.Unless the Court of Appeal decision inPerpetual is subsequently overturned bythe Supreme Court, this arrangementwould be valid as a matter of English law.

Similarly, in the situation arising inMetavante, the issuer would not need torely on any flawed asset provisions against aUS incorporated entity, and would thereforenot need to be subject to the limitations onthe safe harbour provisions in the USBankruptcy Code arising from that case.

The impact of CentralisedCounterparty Clearing andenhanced regulatorycollateralisation requirementsAlthough most of the regulatory initiativesrelating to OTC derivatives are emanatingfrom the US and Europe, the involvementof the G20 as a co-ordinating body forthe regulatory response to the globalfinancial crisis means that the decisions inWashington and Brussels will impact onother nations too. Broadly, the proposalsin play are:

• Use of central counterparty (“CCP”)clearing for OTC derivative contracts.

• Increased use of and incentivisationfor exchange trading for derivatives .

• Collateralisation of OTC derivativecontracts which are not cleared bya CCP.

• Increased regulatory capital chargesfor derivatives that are not subject toCCP or exchange trading.

• More transparency through pre andpost trade reporting and the use oftrade repositories to capture data forOTC transactions, with the possibilityof regulator-imposed position limits.

Several legislative proposals have beenintroduced in the US to promote theseinitiatives and the EU has a proposal ofsimilar effect. Whilst there are differences inthe detail between the various bills currentlycirculating in Washington and between theUS proposals and those of the EuropeanCommission, the overall thrust is similar.

The proposals envisage that standardisedderivative contracts should be clearedthrough CCPs and that non-standardisedOTC contracts should be subject tocollateralisation requirements that are morepenal than the corresponding marginingrequirements of a CCP. There are variousapproaches to determining whether acontract is “standardised” some involvedesignation by a regulator, this involves itbeing accepted by a CCP. Whichevermethod is to apply, there must be a latentconcern that the structured nature of theswaps under consideration could result inthem falling outside the standardisedcategory. If so then, apart from the concernthat this will leave them in a smaller lessliquid market than before, thus exacerbatingthe pricing and replacement cost issuesdiscussed above, they will also bevulnerable to the collateralisationrequirement imposed by the regulators.Consequently, it is likely that they will besubject to collateralisation requirements ofboth of the regulators and the ratingagencies. It is important to note that

collateralisation under the rating agencycriteria only occurs in certain circumstances,whereas it is likely that the regulatorycollateralisation rules will be standingrequirements. Also, it is by no means certainthat the collateralisation amounts required bythe regulators will be less onerous thanthose of the rating agencies.

The proposed increased regulatorycapital charges which are to apply, afterthe effect of collateralisation and nettingare taken into account, are currentlyapplicable to only banks and investmentfirms. Even so, the fact is that most swapcounterparties to structured financetransactions fall into one of thesecategories. Therefore, there is a concernthat the capital charges will add to theincreased costs of institutions enteringinto such swaps, forcing someparticipants out of the market andreducing the liquidity still further.

Institutions will also have to address theincreased transparency and tradereporting requirements, adding morecosts, although these are likely to besmall beer compared with the impact ofcollateralisation. It remains to be seenwhether the ability of regulators toimpose position limits on individualbanks’ derivative exposures willchallenge the market still further.

ConclusionThe global financial crisis, and litigationwhich has arisen as a result of theinsolvency of Lehman Brothers, hasresulted in a need to re-examine theplace of swaps in structured financetransactions. Whilst this presents anumber of challenges, we remain of theview that swaps will continue to play animportant role in structured finance, andthat the lessons learnt from the past 18months will result in more robustderivative structures in the future.

12. Investor disclosure

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SimplicityComplexities of asset-backed securities,depending on the nature of the structureof the instrument and the structure of thecollateral, can be categorised as eitherrelating to the bonds (ranging from theforecasted cashflows, yields andextension risk) or the underlyingtransaction structure. In sometransactions, there may be a simplelooking bond backed by a complexstructure whilst on others there may bemore complex instruments with simplerunderlying collateral.

The complexities of analysing credit risksare of course not unique to the asset-backed securities market. The recentpublic issuances in the UK by Tescos,

Lloyds and Nationwide demonstrate theappetite for pricing credit risk but none ofthese securitisations have allocated thepotential for extension risk which waspreviously allocated to investors in thepre-credit crunch environment.

If securitisation is to retain its importanceto allow banks to match fund their assetsand where funding is to be re-invigoratedfrom the investors in the 5 to 7 yearfloating rate market for funding long-termfinancial assets, unless there is a simpleallocation of extension (and prepayment)risk to the investors as was marketpractice, financial innovation could retain apart to play. UK RMBS master truststructures have however drawn particularcriticism for perceived complexity andembedded risks.

Will innovation be possible and toleratedin structuring instruments such thatcertain tranches retain a relatively certaincashflow profile (without embeddedrisks), subject to credit considerations orwill the market be limited in theforeseeable future to short-termrevolving assets, credit-linked securitieswith longer tenors and soft bullet bondswith an investor put option?

In the short to medium term, we believethat the dynamics will be driven by: (i) theregulatory capital treatment of the financialassets under Capital RequirementsDirective for the originator (and intention tominimise any capital arbitrage betweenoff-balance-sheet and on-balance-sheetpositions); (ii) the depth of and the pace atwhich investor appetite will appear for“A”/”A2” and “BBB”/”Baa2” ratedtranches; and (iii) the resilience of thecovered bond market.

TransparencyThemes to be considered in the contextof improving transparency are: (i)granularity of investor reporting (loanlevel data); (ii) efforts to ensureasymmetrical information knowledgebetween buyers and sellers of asset-backed securities (including dataportals); and (iii) origination criteria,standardisation of asset warranties andthe necessity for pool audits to re-enforce repurchase procedures.

Credit institutions investing in asset-backed securities will, pursuant to Article122a of the Capital RequirementsDirective, have to be able to demonstrateprocedures to monitor performanceinformation on the exposures underlying

In the aftermath of the credit crunch, a concern has emerged as to a perceived lack ofdisclosure by issuers of asset-backed debt securities (both at the time of issuanceand during the life of the securitisation) as a contributor to both market failure (inparticular, in terms of secondary market liquidity) and reticence on the part of investorsto re-invest in such instruments.

Simplicity, transparency and standardisation are the well publicised cornerstonesof efforts by regulators and securitisation market participants to restoreconfidence in the asset-backed securities market, as a precursor to the return ofpublic issuance. However, there is a lot more to simplicity, transparency andstandardisation in the context of asset-backed securities than would seemapparent from such self-explanatory objectives.

Whilst investors will need to be able to satisfy themselves that they are able toand have adequately evaluated the manifest and embedded risks relating tosuch bonds, securitisation is also a process and not simply a product. It allowsoriginators to enhance liquidity to their balance sheet and transfer risk and a toolwhich assists the availability of credit to a host of borrowers ranging fromconsumers to utility companies. Whilst restoring investor confidence remains key,the availability of financial innovation and flexibility to meet the end user’sfinancial objectives cannot be forgotten.

The market has evolved from the securitisation of relatively homogeneousmortgage loans (at a time where the range of mortgage products to the averageconsumer was relatively limited in nature) to a tool to finance football stadiums.We now present our thoughts on the boundaries of the objectives of simplicity,transparency and standardisation and the manner of its likely implementation aspublic issuance re-emerges.

their securitisation positions (with acorresponding obligation on sponsorsand originator credit institutions toensure that prospective investors havereadily available access to all materiallyrelevant data on the credit quality andperformance of the individual underlyingexposures, cashflows and collateralsupporting a securitisation exposure aswell as such information that isnecessary to conduct comprehensiveand well-informed stress tests on thecashflows and collateral valuessupporting the underlying exposures).Investors will have to be able to testrating agencies’ assumptions and arriveat their own views on probability of lossin differing economic scenarios.

Further, it has been suggested that giventhe speed at which the market for sub-prime RMBS deteriorated and the ensuinglack of secondary market liquidity, havingaccess to better granularity of informationregarding the performance of underlyingloans and borrowers and frequentreporting ought to be a priority for themarket going forwards. Without adequateloan level information, investors (buyersand sellers) will be unable to assess thevalue of the securities, which sensitivitywill be exacerbated in times ofeconomic distress.

Although loan level reporting may berestricted by data protection laws andbanking secrecy laws, having conducteda pan European legal analysis, we do notforesee insurmountable hurdles in thisrespect. However, in our view it will notbe mandatory for investors to haveaccess to loan-by-loan level data (asopposed to loan level data) to complywith their due diligence requirementsunder Article 122a. Stress tests aretypically conducted on an aggregatedbasis rather than on an individual assetlevel. To be effective, regular investorreports will have to provide more

granularity than has previously been thecase, and indeed, investors will likelyrequire increased detail in performancereports for purposes of complying withtheir monitoring obligations during thecourse of their investment. Investorreports going forward should, at aminimum, contain narrow categorisationsfor stratification of data with suchcategories properly defined in the contextof the securitisation so that investors canbetter ascertain the true performance ofthe underlying pool. Given the movementby rating agencies to provide moretransparency on rating migration byreference to varying thresholds of defaultand loss assumptions, tailoring thecategorisation of data in investor reportssuch that investors are able to testcurrent transaction data against theoriginal rating approach andassumptions, ought to be a sensiblebalance between the need for investorsto test performance against tensions inproviding loan-by-loan level reporting.

Originators are typically responsible forensuring and certifying their compliancewith origination criteria and warranties inrespect of the asset pool at the time ofsale. Given the perceived abuses aroundself-certification, some have queriedwhether investors will require some type ofthird party auditing (either at the outset ofa securitisation or on a periodic basis). Inour view, for large scale RMBS and otherconsumer credit transactions, wholesaleaudits of the asset pool by an arranger oradviser of the issuer is likely to be a steptoo far from a cost/benefit perspective ascompared to a sensible loan samplingexercise which may typically beconducted. We will however expectexpress disclosure in the prospectus onthe scope and depth of due diligenceconducted on the asset pool – rather thana caveat emptor that there has been noverification of the asset warranties by thetrustee or the issuer. In addition, attention

should be paid to the language used intransaction documentation regardingrepurchase of assets by the originatorupon breach of warranty. In general,parties should avoid the use of materialitythresholds or language that allows theoriginator any latitude to subjectivelydetermine its own compliance withparticular representations and warranties.

StandardisationIndustry bodies and regulators areconsidering developing a standardisedreporting template for originators to

“Greater transparencydoes not necessarilyequate to a need for agreater volume of data, butit does mean access tobetter data. Aggregateddata can be more effectiveand encourage as much, ifnot more, transparency inthe securitisationtransaction. The betterstratification of data so thatrating assumptions can betested and validatedeffectively may, in the end,be more useful thanproviding investors (someof whom may not have theresources to process suchinformation) withoverwhelming pool tapesof thousands of loans”


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provide loan level data to investors.Focus has been on RMBS transactionsto date, but the intention is to createsimilar templates for CMBS and SMEs.The development of these templatesstems from a belief that thestandardisation of the disclosurepackage across transactions will assistinvestors in making comparisonsbetween different transactions andamong different originators. Thesetemplates will provide standardised rawdata for investors to generate their ownmodels and complete stress tests onthe cash flows and collateral values ofthe underlying assets. Should thisapproach be implemented, theincorporation and adaptation of astandardised template may involve asignificant lead time period fororiginators for the necessary overhaul oftheir IT systems. There has also beendiscussion of setting up centralised dataportals for securitisations whereinvestors, rating agencies and othermarket participants can (onsubscription) access loan level data ofall securitised assets for all originators.These completed loan templates wouldbe inputted into this data portal, taggedaccordingly, and dynamic fields thereinupdated on a regular basis. Ratingagency reports and monthly investorreports would be accessible through thedata portal. Investors would also beable to use the data portal to accesssummarised data through searchengines within the portal.

Standardising reporting templates also byimplication requires standardisingdefinitions in relation to a particularfinancial product. In our view, while themovement to standardise thepresentation of all data may providesome clarity, standardised definitions mayin effect have the opposite effect.Accuracy may suffer in the move tostandardise presentation. To be effective,standardised definitions will have toaccount for jurisdictional differences in alegally fragmented European market and,more importantly, the product types (andfinancial innovation) of each originator.Originators will continue to developproducts which will not neatly fit withinprescriptive standardised definitions. Wewould therefore question whether thestandardisation of reporting templates willin fact meet the objective of providingbetter comparative data.

There are also initiatives to createcategorisation of certain asset-backedsecurities which can be independentlylabelled as high quality from an investorperspective. For example, the primecollateral securities (“PCS”) initiative’sstated objective is to “meet therequirements of investors seeking well-defined, high quality standards”. Theproposals firmly state that the scheme isnot intended to be a replacement forcredit analysis or even investor duediligence. Rather, it is intended to be atool for market participants to ensurethat their securities comply with a

notional “gold standard” and animportant step towards restoring marketconfidence and establishing a moreliquid market.

One of the asset classes that perhapslends itself best to the PCS initiative isresidential mortgage backed securities.It is easy to see how a homogenouspool of prime residential mortgages,using a simple paradigm securitisationstructure and containing detaileddisclosure about the underlying assetscan be easily assessed against certainpre-determined criteria.

However, even with residential mortgagesecurities, mortgage products areconstantly evolving to meet the needs ofthe banks’ customer bases. Mortgageslinked to current accounts (off-sets,secured overdrafts, mortgage reserves)are becoming increasingly popular andthese more complicated products presenta new set of challenges for securitisationstructures that are required to changeand evolve in order to meet thesechallenges. It is also worth noting that theasset classes which perhaps lendthemselves best to this initiative are,coincidentally, also the ones that havebeen showing the first independent signsof recovery with the recent public UKRMBS issuances. Whilst there may beinvestor apathy to analyseextension/cashflow risks, we wouldquestion the need for quality kitemarksfrom a credit perspective in a market withan institutional investor base.

13. Lifting the regulatory fog– will the amendments to CRDreveal a new landscape?

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Why are Originators andSponsors being required toretain a portion of risk?The stated aim of the EU Parliament inenacting the new Directive was to align theinterests of originator and investor. Theretention requirements come as part of apackage of measures currently at variousstages of implementation in the EU. Theseinclude new investor due diligence

requirements (as to which see “Investordisclosure”) and regulatory capital penaltiesfor re-securitisation, as to which see “Re-securitisations-holding a costly position,”.As a whole, these measures are aimed ateliminating two of the more risky features ofthe pre-crisis securitisation market, namelythe “originate to distribute” model and thegrowth in re-securitisation activity. Inrequiring originators to retain a significantinterest in their transactions, the hope is

that in securitising assets, originators will infuture be driven more by economic factorsthan by regulatory capital arbitrage.

The Committee of European BankingSupervisors (CEBS) recently issued itsresponse to the Call for Advice from theEuropean Commission as to whether toincrease the retention requirement from5%. The CEBS expressly stated that anincrease in the retention would notautomatically align the interests oforiginator and investor, as originators mayincorporate pricing compensations tooffset the risk. Whether this will be theeffect of the retention even at the 5% levelremains to be seen. The CEBS alsoexpressed some support for a requirementwhich takes into account the originator’soverall incentive, rather than a fixed figure.

For originators, the CEBS advice iswelcome. The EU is scheduled toaddress possible increases in the 5%requirement by the end of the year, and itrequired receipt of the CEBS responsebefore doing so. We will be watching forfurther developments.

How will the retentionrequirements impact currentstructures and assetclasses?Who is affected?

Article 122a impacts any ‘credit institution’exposed to a ‘securitisation position’. This

The prospect of a requirement for securitisation originators to retain a portion ofsecuritised exposures (which has become known as the “skin in the game”requirement) is old news. It has been much discussed amongst market participantsand Directive 2009/111/EC has finally been published, setting out the new Article122a of the Capital Requirements Directive. Now that Article 122a is part of EU law,and the process of Member State implementation will start next year, this article looksat the practical and structural implications of the new retention requirements and theareas where further guidance from national regulators is needed.

Article 122a states that “A credit institution, other than when acting as anoriginator, a sponsor or original lender, shall be exposed to the credit risk of asecuritisation position in its trading book or non-trading book only if the originator,sponsor or original lender has explicitly disclosed to the credit institution that it willretain, on an ongoing basis, a material net economic interest which, in any event,shall not be less than 5%.”

There are four specific ways of retaining a “net economic interest”:

(a) retention of no less than 5% of the nominal value of each of the tranches soldor transferred to the investors (in other words, a “vertical slice” of thesecuritisation);

(b) in the case of securitisations of revolving exposures, retention of the originator’sinterest of no less than 5% of the nominal value of the securitised exposures (inother words, a pari passu share of the pool);

(c) retention of randomly selected exposures, equivalent to no less than 5% of thenominal amount of the securitised exposures, where such exposures wouldotherwise have been securitised in the securitisation, provided that the numberof potentially securitised exposures is no less than 100 at origination; or

(d) retention of the first loss tranche and, if necessary, other tranches having thesame or a more severe risk profile than those transferred or sold to investorsand not maturing any earlier than those transferred or sold to investors, so thatthe retention equals in total no less than 5% of the nominal value of thesecuritised exposures.

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language catches more than thenoteholders. The definition ofsecuritisation position is “an exposure toa securitisation”, so the requirement alsoapplies to counterparties such as swapor liquidity providers. Originators are notgiven express obligations by Article 122a,but they are indirectly required to hold theretained exposures in so far as they wishto sell notes to credit institutions.

What are the obligations of therelevant credit institution?

The retention requirement is satisfied ifthe “originator, sponsor or original lenderhas explicitly disclosed to the creditinstitution that it will retain, on an ongoingbasis, a material net economic interest”.

There is no express primary requirement onthe originator, sponsor or original lender toin fact retain a material net economicinterest on an ongoing basis. The onus ison the credit institution not to invest unlesssuch explicit disclosure has been given.However, prior to enforcement of thesecurity granted by the issuer over thetransaction documents, there is usually nocontractual nexus between the investorand the originator, sponsor or originallender under which this disclosureobligation would be documented.

To address this issue, we wouldanticipate that the originator will need togive a covenant to the Issuer in the assetsale agreement, and to the managers inthe subscription agreement, along thefollowing lines:

“The originator undertakes:(i) to hold a material net economicinterest pursuant to paragraph ((a) to (d)as applicable) of Article 122a(1) ofDirective 2006/48/EC until maturity ofthe Notes and;(ii) to provide all information required tobe made available to Noteholders underArticle 122a (1) to (7) to the Issuer andthe Trustee on request, subject always

to any requirement of law regarding theprovision of such information,provided that there will be no breach ofthis covenant if the originator fails to do sodue to events, actions or circumstancesbeyond the originator’s control.”

As the originator and investor(s) may notbe subject to supervision by the samenational regulator, some discussion mayarise as to the standard with which theoriginator covenants to comply, especiallywhere there is an SEC registration or144A offer contemplated. In the U.S., aretention requirement of 10% may beimposed if current draft legislation isintroduced (although an amendment tothe draft has been proposed which wouldreduce the retention requirement to 5%and allow the retained portion of CMBStransactions to be held by a third partyinvestor). Throughout Europe however, wewould envisage that national regulatorswill impose largely standardisedrequirements for compliance, so acovenant to comply either with Article122a or the national implementing rulesshould not cause undue difficulty.

In the ordinary course, the trustee willreceive the benefit of such a covenantas the issuer will assign its rights underthe transaction documents to the trusteeby way of security pursuant to the deedof charge or security deed. However, itmay also be possible to rely on theoperation of the Contracts (Rights ofThird Parties) Act 1999 to confer thebenefit of the covenant on non-signatories such as the noteholders orother transaction parties.

The Prospectus will also need to makedisclosure of the covenant. It may alsobe prudent for the originator to certifyits holding to the issuer at closing, andthe closing certificate to be disclosed.

How and when is the 5% measured?

Article 122a further requires that “net

economic interest” is to be measured atorigination and shall be maintained onan ongoing basis. How net economicinterest can be measured “atorigination” is unclear – where aportfolio is subject to a ramp-up period,does this mean the interest should bemeasured at the portfolio cut-off date,or perhaps at the date of noteissuance? We may have to wait and seehow the FSA interprets this requirement,or individual financial institutions mayseek their own guidance from the FSA.

The drafting of the new directive statesthat “ongoing basis means that retainedpositions, interest or exposures are nothedged or sold”. As the measure of net

Key points for arrangers andunderwriters

• The application of the retentionrequirement is investor drivenrather than originator driven,however originators are affected ifsecuritised notes are being sold tocredit institutions which fall withinthe CRD

• Article 122a is scheduled to beapplicable to new securitisationsissued on or after 1 January 2011and after 31 December 2014 toexisting securitisations where newunderlying exposures are addedor substituted after that date

• The retention requirements applyto credit institutions holding asecuritisation position, thisincludes liquidity facility providersand swap counterparties

• The retention requirements areaccompanied by detailed duediligence obligations forinvestors and punitive capitalcharges apply for failure to meetthese obligations

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economic interest at origination is 5% ofthe nominal amount (of the exposures ineach of options b to d of Article 122aand of each of the tranches in option a)),this possibly means that the originatormust, for the life of the deal, continue tohold the assets or the notes whichamounted to 5% of the nominal value atthe outset, but is not required actively tomanage the value of its holding as aproportion of the exposure outstandingon an ongoing basis. What is not clear iswhether, in the case of an originatorretaining assets which happen to paydown first so that the originator is nolonger at risk, there would be any breachof the retention requirement, or anycorrecting action required to be taken.Again, this is an area where furtherclarification may be forthcoming fromnational regulators, or may be sought byindividual financial institutions.

What are the sanctions fornon-compliance?If an originator fails to satisfy the 5%requirement there are no express sanctionson the investor or the originator withinArticle 122a. There are however punitivecapital requirements imposed on aninvestor who fails by reason of negligenceor omission to comply with the duediligence requirements set out in Article122a (4) and (5). These require investorcredit institutions to be able to demonstratea comprehensive understanding of, and tohave formal policies and procedures foranalysing and recording;

• information disclosed by originatorsas to the interest they are maintaining;

• the risk characteristics of thesecuritisation positions and theirunderlying exposures;

• the prior performance of theoriginator or sponsor in securitisingthat asset class;

• statements by the originators as totheir due diligence on the pool andany collateral;

• methodologies by which the collateralis valued, and the policies of theoriginator to ensure the independenceof the valuer; and

• the structural features of thesecuritisation which could impact theperformance of the securitisationposition it holds.

They must also monitor performance oftheir securitisation positions as a whole,including the diversification, defaultrates and loan to value ratios of theirentire portfolios.

There are also punitive capital chargesimposed on an originator creditinstitution which fails to disclose toinvestors the level of its commitment toretaining the required exposures asrequired by Article 122a (7). Originatorsare also required to provide prospectiveinvestors with all materially relevant dataon the credit quality and performance ofthe underlying exposures, as well assuch information as is necessary for theinvestor to perform stress tests on thecash flows (see “Investor disclosure”section on page 67 above for moredetails). Breach of this latter requirementalso attracts a punitive capital charge forthe originator.

The fact that there is no sanction for astrict breach of the 5% requirement maysupport a view that the requirement isnot a strict one to be managed activelyby originators, but rather a requirementto take 5% of the relevant exposures atthe outset, and to continue to holdthose exposures through the life of thedeal, providing investors with allmaterially relevant data on theperformance of the pool. However,national regulators are required by Article122a(9) to disclose, by the end of 2010,

the criteria and methodologies they haveadopted to review compliance withArticle 122a, and no doubt this willfurther clarify what is expected oforiginators. We anticipate, considerableinteraction between industry participantsand national regulators, particularly theFSA in the United Kingdom, throughout2010, to develop and refine such criteriaand methodology.

How do the retentionrequirements impact otherregulatory capital rules?In order to exclude securitised positionsfrom the calculation of risk weightedexposures under the CapitalRequirements Directive, regulatedoriginators must transfer significant creditrisk to third parties. As noted by theCEBS, a significant increase in theretention requirement could endanger theability of firms to achieve regulatorycapital relief via significant risk transfer. Inany event, the more of a first loss tranchean originator retains, the higher thecapital charge to the transaction.

In July of this year, Directive2009/83/EC set out some clarificationaiming to align the application of theexisting rules on significant risk transferacross EU member states. This directiveincluded provisions which set out howsignificant risk transfer may be achievedwhen an originator holds a first losspiece or mezzanine piece of atransaction. Alternatively, significantcredit risk will have been transferred ifthe competent authority is satisfied thatthe originator credit institution hasprocedures in place which ensure acommensurate level of risk is transferredwhich justifies the reduction in its capitalrequirement achieved by thetransaction. The latter approach hasbeen the previous practice of the FSA.It is not clear currently how the

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regulators envisage the 5% retentionrequirement and these rules onsignificant risk transfer to interact,although we understand that the FSA isseeking input from market participantsas to how they currently satisfythemselves that significant risk has beentransferred. We would hope that theretention requirement would notadversely impact the FSA’s analysis ofwhether there has been significant risktransfer in a particular case, but furtherguidance to the market is needed.

How will these requirementsbe addressed in ProspectusDisclosure?It is evident to us that the prospectus forany securitisation issuance will be a focalpoint for disclosure required for regulatorycompliance by investors. In our view, it willbe desirable to collate required regulatoryinformation in one place in the prospectus,both for ease of confirmation ofcompliance by investors but also for easeof prudential review by regulators. As thisinformation will be of significant importanceto many investors we believe it will be

placed in a prominent position in theprospectus. Our recommendations,therefore, will be to include a separatepage following the “Summary Information”(or similar) section of a typical prospectus.We would propose that it be called“Additional Information for Investors” andset out, as a minimum, the following;

• compliance with EU Credit RatingAgencies Regulation requirements forprospectuses e.g. “All credit ratingsapplied for in relation to the Notes willbe issued or endorsed by credit ratingagencies established in the EuropeanCommunity and registered underRegulation (EC) No 1060/2009”;

• article 122a compliance covenant (seeabove);

• obligation on originator to provideongoing information;

• how investors can access ongoinginformation; and

• compliance or otherwise withapplicable Industry Codes of Practicee.g. the European SecuritisationForum’s RMBS Issuer Principles.

ConclusionIt is clear that the effect of Article122a cannot be ignored by anyindustry participant. Originators willeffectively be required to comply,whether they are regulatedinstitutions or not, if they want to beable to sell their securitised notes tocredit institutions. We expect thatthe retention and due diligencerequirements will lead to much moreinteraction between marketparticipants and their regulators atnational level. The range of newdisclosure rules and guidelines fromregulators and market bodiesmeans we are likely also to see theextent of pool disclosure becomingan area of greater focus, both priorto investment and on an ongoingbasis. During 2010, the FSA andother regulators will be requiredto produce their implementingrules, and hopefully these willaddress some of the uncertaintiesoutlined above.

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14. Re-securitisation– holding a costly position

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Although the broad consensus is that thenew rule is intended to discourage themarket creating, or investing in, securitiessuch as CDOs of ABS and CDO2s, thebroad definition of re-securitisation,combined with the elusive definition ofsecuritisation itself in Basel II andDirectives 2006/48/EC and 2006/49/EC(“CRD1”), could also be construed tocapture more benign securitisationfinancing models such as thoseemploying two-tier structures and assetbacked commercial paper conduits.

Two tiered structures andABCP conduitsTwo-tier structures present issues underCRD3 to avoid the securitisation beingviewed as a re-securitisation of the firsttier. We consider there are likely to betwo approaches:

(i) first, if the current proposal isimplemented as drafted we wouldimagine that when two tieredstructures are put in place workwould be done to ensure that creditenhancement and tranching onlytakes place at the point in thestructure where the securities areissued. Any intermediate entities (bethey French FCTs, Italian law 130companies or borrowing SPVs in

whole business securitisationsamongst others) would need toensure that all the benefit and risk oftheir exposure is passed directly tothe main issuing company so as toavoid any risk of those intermediateentities being considered as fallingwithin the definition of asecuritisation; and

(ii) second, the term “re” itself in “re-securitisation” indicates a concept oftime so could be construed as onlyapplying to securitisation of alreadyexisting securitisations. If that was thecase, most two-tiered structureswould likely fall outside the ambit ofthis rule which we believe would reflectthe clear intention of the wording andis consistent with the spirit andsubstance of the concern beingaddressed by the rule. Nevertheless, itis hoped that regulators would clarifytheir interpretation of this rule if theproposed wording passes into lawwithout amendment.

If an ABCP conduit has even oneunderlying transaction that could fit thedefinition of securitisation itself then thatcould easily lead to the conclusion thatany investment in the conduit (whether ascommercial paper noteholder, liquidityprovider or credit enhancement provider)would constitute a re-securitisation

exposure. Such a result would beunfortunate as it would increase the costsinvolved in maintaining ABCP conduitswhich provide a valuable source ofworking capital and other finance to manybusinesses which may not be able toaccess such ready liquidity elsewhere.

That said, on a positive note, the thirdcompromise proposed by the EuropeanCouncil on the draft CRD3 dated 12October 2009 (the “Third CompromiseProposal”) included a recital suggestingthat where there is a single class ofcommercial paper being issued by anABCP conduit and the commercial paper isfully supported by the ABCP conduit’ssponsor, then the commercial paper shouldnot generally be considered a re-securitisation exposure. Similarly, whereliquidity is transaction specific, the recitalsto the Third Compromise Proposal suggestit should not constitute a re-securitisationexposure if first loss protection is providedby the underlying originator.

Highly complexre-securitisationsThe EU Commission has expressed aview that re-securitisations that arehighly complex should be entirelydeducted from capital. This view arisesfrom the enhanced due diligence

The recent proposal for a directive of the European Parliament and of the Councilamending Directives 2006/48/EC and 2006/49/EC as regards capital requirementsfor the trading book and for re-securitisations, and the supervisory review ofremuneration policies (“CRD3”) includes provisions which would require bankstaking positions in transactions described as “re-securitisations” to hold aside moreregulatory capital than under the current rules. The directive describes a re-securitisation as a securitisation which has at least one underlying exposure that isa securitisation in its own right. The explanatory memorandum to the proposeddirective explains the risk of high correlated losses and unexpected impairmentlosses on such positions as being the driving cause for the increased amount ofcapital that needs to be held in respect of them.

investigations that now need to beundertaken by investors (under Article122a, paragraphs 4 and 5) which thecommission believes cannot actually bemet in the case of highly complex re-securitisations. Only in cases wherecredit institutions can demonstrate totheir regulators that they fullyunderstand the risks involved in the re-securitisation and have performed therequisite due diligence will they beallowed to risk-weight their exposure.The recitals to the proposed CRD3suggest that re-securitisations ofleveraged buy-outs and project financedebt are of a “highly complex” nature sowould fall within this regime. This would

be a significant disincentive forinstitutions attempting to finance thesetypes of assets through securitisation.

Significantly, the Third CompromiseProposal suggests deleting the proposedrule about highly complex re-securitisations entirely. Given the

complexity that would surroundattempting to define exactly what ahighly complex re-securitisation is andthe fact that re-securitisations are alreadypenalised through a very significant riskweight, this approach would bewelcomed by the market.

ConclusionThere will be a need for institutions to consider historic and new transactionscarefully and make structural adjustments in some cases. Additionally, given thewide definition of securitisation there may be a need to consider some otherfinancial products in light of CRD3 although that is outside the ambit of this section.

It would be helpful to get further clarity from the European Parliament and Council indrafting and from regulators on implementation.


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15. Bank and building societyinsolvencies revisited: theimpact of the Banking Act

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Despite its laudable intentions, theintroduction of the Banking Act 2009 didcause some initial concerns but, nowthat the dust has settled, most of theissues have been worked through and it’sback to business as normal. In summary:

• the wide powers afforded to theauthorities raised various worriesmainly concerning the separation ofassets and liabilities and the re-writingof contracts;

• now that market participants have hadthe opportunity to reflect (and seen thepowers exercised in a relatively benignfashion on one occasion) people havebecome increasingly comfortable;

• there is likely to be minimal impact ondocuments (except that our legalopinions have become slightly longer).

Special Resolution RegimeThe Banking Act 2009 (the “BankingAct”) introduced a special resolutionregime for UK banks and buildingsocieties encountering financialdifficulties. The special resolution regimeprovides three stabilisation options toaddress the situation where a UK bankor building society has encountered, or islikely to encounter financial difficulties,namely: (i) sale of all or part of itsbusiness to a private purchaser; (ii)transfer of all or part of its business to acompany that is wholly-owned by the

Bank of England (known as a “bridgebank”); or (iii) transfer into temporarypublic ownership.

The stabilisation options can only be usedwhere the Financial Services Authority, inconsultation with the Bank of England andHM Treasury, is satisfied that the bank orbuilding society is failing, or is likely to fail,certain threshold requirements and that itis unlikely to be able to satisfy thethreshold conditions in the absence of theexercise of the powers.

The devil is in the detailThe objectives of the Banking Act areto protect the financial system, andthose who invest, from instability andloss of individual rights. At a “bigpicture” level, it provides a level ofcertainty that previously did not exist: youonly have to compare the clinical way inwhich the Banking Act was applied toDunfermline Building Society(“Dunfermline”) to the problems thatensued when Northern Rock plcencountered difficulties a little more thana year before, to see the benefits of theBanking Act in action.

We believe the Banking Act is a “goodthing” for financial institutions. The resort tothe general law of insolvency (implicitlypreferred by some) has shown itself to becumbersome and slow and, at worst, notfit for purpose. Having said that, if you

analyse the provisions of the Banking Actin detail, then it is possible to identifyprovisions that, when taken in isolation,could be cause for concern. We provide asummary of our current views on some ofthese points below followed by adiscussion of how we think the BankingAct would most likely be applied to asecuritisation or covered bond transaction.We conclude with some recommendationsfor addressing issues arising from theBanking Act in future deals.

Expropriation of coveredbondsThe share transfer powers give the Bankof England and HM Treasury the powerto transfer securities issued by a bank.The definition of “securities” in thiscontext is very wide and includes debtsecurities. Since covered bonds are debtsecurities that are issued by the bankitself (rather than by a special purposevehicle) they fall within this definition andthere is the possibility that bank coveredbonds could be subject to a sharetransfer under the Banking Act. Althoughthe Banking Act provides a mechanismfor compensation to be paid in the eventthat assets are expropriated, this maynot be adequate or timely.

This is effectively government riskand, accordingly, market participantsseem comfortable with it. It has not had

The credit crunch was a salient reminder that bank and building society originators arenot immune from insolvency. Structured finance transactions are, of course, designedto withstand the insolvency of the originator and so this fact alone did not causealarm, but the rapid introduction of new wide-ranging powers for financial regulatorsto deal with failing banks and building societies (such as the Banking Act 2009) didcause some initial concerns despite their laudable intentions. Now that the dust hassettled, while a few uncertainties remain, market participants have generally got togrips with the impact of the Banking Act and, at least in this context, it’s back tobusiness as usual.

any impact on the structuring of newdeals and is simply an additional riskthat is brought to the attention ofpotential investors.

Splitting assets and liabilitiesUnder the Banking Act, it is possiblethat only some of the property, rightsand liabilities of a bank or buildingsociety will be transferred to oneperson (and the remainder will betransferred to someone else or leftbehind in the insolvent “bad” bank).This flexibility was included to givethe authorities the option ofseparating the performing (or “good”)assets from the non-performing (or“bad”) assets. This raises the possibilitythat rights and correspondent liabilitiesmay be separated, which potentiallycauses concern for many differenttypes of transaction.

In recognition of these concerns, HMTreasury has imposed restrictions on such“partial transfers” in The Banking Act(Restriction of Partial Property Transfers)Order 2009 (the “Safeguards Order”).

The Safeguards Order only applies to“partial property transfers” as defined inthe Banking Act. Curiously, this definitiondoes not link the partial transfer to aparticular transferee. Accordingly, aproperty transfer instrument that transfers,for example, some of the property, rights,and liabilities of a bank to one party andthe rest to another party would not be a“partial property transfer” despite thepossibility that there may be a resultantseparation of rights and liabilities.

For the reasons summarised below, we

do not think that this drafting anomalyshould cause particular concern in thecontext of structured finance transactionsalthough, because of its effect on nettingand set-off arrangements, it may causegreater concern to parties entering intoderivative transactions. One comfort maybe that it is less likely that a propertytransfer instrument will provide for thetransfer of all the property, rights andliabilities of a failing bank to more thanone party (because there are likely to besome liabilities that the authorities want toleave behind in the “bad bank”).

The Safeguards Order does contain aspecific protection for structured financetransactions: a partial property transfermay not provide for the transfer of some,but not all, of the property, rights andliabilities of a bank which are, or formpart of, a “capital market arrangement”to which the relevant banking institutionis party. This protection suffers from thesame loophole as the definition of“partial property transfer” discussedabove: there is no restriction on thetransfer of part of a capital marketarrangement to one party and the rest toanother party but, again, for the reasonsdiscussed below, we do not think thatthis is a cause for concern.

In this context, the term “capital marketarrangement” takes its definition from theInsolvency Act 1986 (the “InsolvencyAct”) but its use differs from that in theInsolvency Act in two main ways: (i) in theSafeguards Order, it is not necessarilyqualified by reference to a “capital marketinvestment” as it is in the Insolvency Act;and (ii) in the Safeguards Order, it is usedto delineate the boundary of certainproperty, rights and liabilities whereas inthe Insolvency Act, it is only applied in abinary fashion.

A “capital market investment” is,essentially, a bond that is rated, listed ortraded (or designed so to be) or one

that is issued to certain classes ofinvestors. Without this qualification, thedefinition of “capital marketarrangement” would extend to othertypes of transaction such as secured orguaranteed lending transactions.

That aside, once you know what “capitalmarket arrangement” means, it is likely tobe easy to conclude that some property,rights and liabilities of the bankinginstitution form part of one. Equally, it islikely to be easy to conclude that otherproperty, rights and liabilities fall outsidethe capital market arrangement. There is,however, bound to be a “grey area” ofuncertainty at the periphery.

The capital market arrangement safeguardin the Safeguards Order was clearlymodelled on the safeguard that wasintroduced for set-off and nettingarrangements, which are quite differentfrom structured finance transactions.Securitisation and covered bondtransactions do not depend on the identityof the contractual counterparty and thereis, therefore, no need to keep the relevantparts of a transaction together.

Contracts that securitisation issuersand covered bond asset-holdingcompanies enter into generally fall intoone of two categories. Contracts withfinancial support counterparties (suchas swap counterparties, account banksand liquidity providers, etc) are usuallyprotected with rating downgradeprovisions. Contracts with serviceproviders (such as servicers or cashmanagers) are unlikely to be protectedby rating downgrade triggers (becausethey do not need to be) but areprotected by “inability to perform” and“insolvency” termination events. Itwould probably be inappropriate, in anyevent, to try and end this lattercategory of contracts abruptly since atransitional period is likely to benecessary in many cases.

“We believe the BankingAct is a “good thing” forfinancial institutions”


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Assuming that rating downgrade triggersremain effective in the light of the BankingAct (and we believe that the better view isthat they do – see below under “Turningoff events of default”), we see no reasonwhy the various roles in a securitisation orcovered bond need to be held together.For this reason, we are generally relaxedabout the operation of the SafeguardsOrder in the context of securitisation andcovered bond transactions.

Amending the termsof contractsThe Banking Act contains various“continuity obligations” including, amongothers, those placed on (in the case of aproperty transfer) the residual bank andits group companies and (in the case of ashare transfer) the former groupcompanies of the transferred bank toprovide such services and facilities as arerequired to enable the transferredbusiness or entity to operate effectively.

It is worth noting that there is no similarreverse continuity obligation and so thetransferee is not necessarily under anobligation to provide services back to theresidual bank (this would be particularlyrelevant if, for example, all of theservicing assets and infrastructure weresold to a third party but certain loanswere left behind in the “bad” bank). Theauthorities may try to put in place atransitional servicing arrangement withthe purchaser of the servicing assets butthis is not certain.

The “continuity obligations” go furtherthan this, though, and give the relevantauthorities the power to create or modifycontracts or other arrangementsbetween (in the case of a propertytransfer) the purchaser, the residual bankand its group companies and (in thecase of a share transfer) the transferredbank and its former group companies.

These provisions can only be exercisedto the extent necessary to ensure theprovision of such services and facilitiesas are required to enable the transferredbank or business, as the case may be,to operate effectively.

These provisions are of greater relevanceto covered bond transactions rather thansecuritisation transactions since theasset-holding LLP in a covered bondtransaction is likely to be a groupcompany of the bank and, therefore,within the scope of the continuity powers.In this context, it is not clear whethercontracts that are not between the LLPand the bank might be affected by virtueof being part of an “arrangement”between the LLP and the bank.

In the context of partial property transfers(subject to our observations about thescope of the Safeguards Order in“Splitting assets and liabilities” above), theSafeguards Order does provide quite adegree of comfort because it restricts theapplication of the powers associated withthe continuity obligations that wouldterminate or modify property, rights orliabilities which are or form part of acapital market arrangement to which therelevant bank is a party.

While this is helpful, it is worth noting thatthe wording of the Safeguards Orderdoes not match that of the Banking Act(which also extends to imposing rightsand obligations).

Turning off events of defaultThe authorities were obviously concernedthat counterparties would attempt tocircumvent the provisions of the BankingAct by including new events of defaultand other provisions that would betriggered by actions taken under, or inrelation to, the Banking Act. The inclusionof such “poison pill” provisions is,generally, frowned upon by regulators

since it fetters their ability to deal with afailing bank.

In response, the Banking Act contains thepower for the authority to “turn off”default event provisions in documents.These powers are drafted very widely andcapture not only events of default butalso other rights (such as the right toreceive a sum of money or to change aninterest rate) that counterparties mightwant to be triggered by actions takenunder the Banking Act.

In the context of structured financetransactions, there was some concernthat these provisions may prevent theoperation of rating downgrade triggers incontractual documents. While it is notcompletely beyond doubt, we think thatby far the better view is that ratingdowngrade provisions should still work asintended. The reason for this is that therestrictions in the Banking Act say thatthe relevant instrument made under theBanking Act is to be disregarded for thepurposes of determining whether thedefault event provision has beentriggered. In our view, even if youdisregard the making of the relevantinstrument, the relevant entity has stillhad its rating downgraded and, therefore,the provision should be enforceable.

It is, however, worth noting that thepower to disapply contractual defaultevent provisions is optional. Although itwas exercised in the case of theDunfermline transfers, it may not alwaysbe exercised on future transfers.Counterparties should, therefore,consider whether it is appropriate toinclude events of default and otherprovisions that relate to the taking ofaction under the Banking Act in newcontracts, recognising that it is possiblethat they will not be effective if theauthorities choose to exercise theirdisapplication powers.

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A matter of trustOne of the knottiest provisions of theBanking Act was a provision that, when aproperty transfer instrument makesprovision in respect of property held ontrust, it may also make provision aboutthe terms on which the property is to beheld after the instrument takes effect(which may remove or alter the terms ofthe trust).

Trusts are a key feature of structuredfinance transactions and the uncertaintiesthat this provision introduced regarding therights of third parties was unfortunate.While there were different views initially,many people found comfort in the fact thatthe objectives of the Banking Act includeprotecting and enhancing the stability ofthe financial systems of the UK andavoiding interfering with property rights incontravention of a person’s human rights –neither of which would be achieved if thisprovision could be used to re-write trustdeeds and reallocate settled property.

The authorities gave more definitivecomfort on this point when they madeThe Banking Act 2009 (Restriction ofPartial Property Transfers) (Amendment)Order 2009. This limited the power toremove or alter the terms of a trust to the

extent necessary or expedient to transferthe title of the banking institution in theproperty held on trust to the transferee.While this is not completely satisfactory(since it only applies to partial transfers),it is a welcome indication of theauthorities’ benign intent and, in anyevent, whole property transfers arethought unlikely to occur.

Likely impact on a new dealRecent experience suggests that bankbailouts tend to happen on a Sunday.Although the authorities may have hadsome prior warning, and, therefore, thetime to put in place some preparations,given the complexity of the issues that areraised by the Banking Act in relation tostructured finance transactions, there is aconcern that they may not have enoughtime to give sufficient consideration to theintricacies of a particular deal. There arelikely to be two aspects to this analysis:does the transaction have sufficient valueto merit transferring it and is it possible totransfer it (bearing in mind the restrictionsin the Safeguards Order).

The complexities of structured financetransactions taken together with the wideprotections afforded to them by theSafeguards Order (including the fact thatthe precise scope of some of theprovisions of the Safeguards Order is notentirely clear) may mean that the onlypracticable short-term solution available tothe authorities is to keep the failing bank’srights and obligations under them in the“bad” bank.

This does not, of course, preclude thepossibility of a subsequent transfer at alater date but it may not be what marketparticipants expect.

It is clear that the authorities are keen toprotect the interests of retail depositors(for example, the Safeguards Ordercontains a carve-out from the “capital

market arrangement” protection fordeposits) but the concerns of noteholdersin structured finance transactions may notbe their top priority. This does not suggestthat the authorities are likely to harm theinterests of such noteholders (which, afterall, would not be conducive to the firstobjective of the Banking Act, which is toprotect and enhance the stability of thefinancial systems of the UK) but addsfurther weight to the suggestion thatnoteholders may find their structuredfinance transactions left behind in the“bad” bank.

Since structured finance transactionsare designed to withstand the insolvencyof the originator, this should not be acause for concern (provided ratingdowngrade triggers can still be reliedupon – see “Turning off events ofdefault” above). Any revolvingtransactions are, though, likely to moveinto an amortisation phase (because ofan insolvency trigger or because theoriginator no longer has sufficient“virgin” assets to sell into the structure).

One particular point worth considering is thelikely impact on any servicing arrangements.As discussed under “Amending the terms ofcontracts” above, the servicing (or anysimilar) obligation may remain in the “bad”bank but the assets and infrastructurerequired to carry out that function may havebeen transferred to someone else. In thecircumstances, it would be helpful if theauthorities were to put in place a transitionalservicing arrangement but this is only likelyto be the case if they can see some value incontinuing to undertake the role. Unlessthere is a back-up servicer in place, it isdifficult to see how the servicing role couldbe transferred to a third party overnight(since there are usually systems issues tobe overcome).

It may be worth considering adding acovenant to servicing-type arrangementsthat, in the event that the servicer is unable

Suggested event of defaultThere is exercised in respect of it, orany member of the group, by anygovernmental, regulatory, supervisoryor similar body or official, astabilisation power under the BankingAct 2009, or under similar legislationor regulation, a power (capable ofaffecting the rights of its creditorsgenerally) to transfer a significant partof its property, rights or liabilities, or apower to transfer a significant part ofany shares or other securities issuedby it.

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to fulfil its obligations under the agreement,it will use its reasonable endeavours to putin place a sub-servicing agreement. Ofcourse, if the “bad” bank is placed intobank administration, the enforceability ofthis covenant would then not be certain.

Changes for new dealsThe implications of the Banking Act need tobe considered at the outset of any newdeal. It is worth bearing in mind that, even ifthe main counterparty is not a bank or

building society, the provisions of theBanking Act may still apply if there is a bankor building society in the corporate structure(for example, some UK supermarket chainshave bank subsidiaries and may, therefore,be subject to the Banking Act).

We may also see the introduction of newrepresentations in subscription and dealeragreements to the effect that a bank orbuilding society is not the subject of anyaction taken under the Banking Act and, totheir knowledge, no such action iscontemplated. The first part of thisrepresentation is necessary because there isno central register of actions taken under theBanking Act (although any significant actionis likely to be reported widely in the press).

References to types of insolvencyproceedings in documents are also likelyto need updating to include specificreference to the bank insolvency and bankadministration regimes that have beenintroduced by the Banking Act.

In terms of legal opinions, most law firms’initial reaction was to include a broadreservation, which was not alwaysacceptable to the rating agencies. Asthings have moved on, we have beenable to reduce the reservation’s stringencyand give reasoned opinions in relation tothe application of the Banking Act toparticular aspects of transactions. Thishas, by and large, been acceptable to therating agencies.

ConclusionsGenerally, while there are uncertainties in the detail, the overall effect of the BankingAct has been to introduce a degree of certainty to the financial markets: in future,we know that a failing bank is likely to be dealt with swiftly and clinically by theauthorities. This should, in general terms, be a cause for celebration not concern.

“The only short-termsolution available to theauthorities may be to keepthe failing bank’s rights andobligations under structuredfinance transactions in the“bad” bank”

16. Government asset schemes andtheir impact on securitisation

Government schemes inplace since credit crunchVarious government schemes have beenput in place - or in relation to the ECBmonetary operations, been utilised - toprovide liquidity to financial institutionssince the onset of the credit crunch.These include, notably, the Bank ofEngland Special Liquidity Scheme (SLS)and the Discount Window Facility (DWF),the ECB money market operations (ECBMMO), the US Term Loan ABS Facility(TALF) and the UK Government RMBSGuarantee Scheme. We will not discussthe UK Government Asset ProtectionScheme (GAPS) in this note. GAPS,although using mechanics very similar toan unfunded credit default swap, is nowlikely to be unique to RBS and is unlikelyto have a significant impact on thesecuritisation market as a whole.

The Special Liquidity Scheme (SLS) wasannounced by the Bank of England inApril 2008 with the aim of enabling banksto access liquidity by swapping illiquidABS for UK Treasury Bills. It closed on 3January 2009. Most of the collateralactually received by the Bank of Englandwas from RMBS or residential mortgagecovered bonds. An announcement by theBank of England on 3 February 2009stated that the total nominal value ofsecurities held by the Bank as collateral inthe Scheme amounted to approximately£287 billion. The Bank’s valuation ofthose securities as at 30 January 2009was approximately £242 billion, aneffective discount to par of about 16%. In

January this year, the Bank of Englandalso announced the extension of itsdiscount window facility (DWF) whichcovers a much wider range of collateraleligible for such operation with anextended maturity of up to 364 days. TheDWF has been increasingly used bybanks as part of their balance sheetmanagement and planning.

The ECB MMO, which allowscounterparties to enter into repurchasetransactions with the ECB or a nationalcentral bank, was already in place beforethe financial crisis. To be eligible, assetsmust be a debt instrument, with a zero,fixed or floating coupon and the assettransfer must be a ‘true sale’ governed bythe law of an EU member state. Certainrelaxations to the eligibility criteria weremade in the last year or so in the light ofthe financial crisis, for example, extendingthe scheme to securities in non-eurodenominations, whilst certain otheraspects of the eligibility criteria have beentightened, for example, the restrictions onthe provision of currency hedging and theprohibition of tranches of other ABS beingeligible assets backing the ABS. In July2009, the total value of collateral held bythe ECB was €12.2 trillion (as announcedin a key note speech on 13 July 2009 bythe President of the ECB). For furtherdiscussion on this topic see the sectionentitled “ECB liquidity transactions – arefresher and an outlook on changesto come”.

TALF was announced in November 2008.Its stated aim is to increase credit

availability to households and smallbusinesses by supporting the issuance ofABS collateralised by a variety of loans.The facility allows the Federal Bank ofNew York to lend up to $200 billion to anyUS person or business entity holdingcertain AAA-rated ABS, with a term of upto 3 years (or 5 years in certain cases) ona non-recourse basis to the borrower,secured on the eligible ABS. As at 21October 2009, a total amount of$2,124,921,093 TALF loans have beenrequested. The facility is due to ceasemaking loans collateralised by newlyissued CMBS on 30 June 2010, andloans collateralised by all other types ofTALF-eligible newly issued and legacyABS on 31 March 2010.

The RMBS Guarantee Scheme wasannounced on 19 January 2009 and dueto expire by the end of 2010 following itsextension. The stated aim of the schemewas to improve banks’ access towholesale funding markets, help supportlending, and promote robust andsustainable markets over the longer-term.The Government provided two types ofguarantee attached to eligible AAA ratedasset-backed securities, includingmortgages and corporate and consumerdebt: the ABS Credit Guarantee whichcovered the obligations of an issuer tomake payments of interest and principalwhen due, and the ABS LiquidityGuarantee which guaranteed the issuer’sobligations under a call or put. So far theRMBS Guarantee Scheme has not beenutilised by any originators.

Various government schemes in place have inevitably dictated, to a varying degree,the structure and documentation for liquidity trades structured during the creditcrunch. In this section we will explore the various governmental schemes anddiscuss how they have impacted the securitisation documentation, in particular, inrespect of asset transfer and buy-back, simplification of note tranching andabsence of excess spread stripping, lack of currency hedging and more stringentongoing reporting requirements.


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The use of securitisationtechnique anddocumentationA notable common theme of thegovernment schemes is the utilisation ofsecuritisation techniques both in terms ofstructuring and documentation. By wayof example, transactions structured forthe ECB MMO and the SLS areeffectively single investor securitisations.The RMBS guarantee is essentially atraditional stand-alone or master trustRMBS with the additional benefit of thegovernment guarantee or funding supporton the exercise of a call.

From our experience for most of theECB and SLS liquidity trades closed inthe past two years, existingsecuritisation structures anddocumentation are widely used withadaptations, where necessary, to fit therelevant transaction into the eligibilityrequirements of the relevant scheme.Although no transaction using a RMBSguarantee has closed so far, it isconceivable that the paradigm structureand market standard securitisationdocuments will be used again addingthe guarantee language as the additionalbuilding block.

How have the governmentschemes shaped theparadigm securitisationstructure and documentationpost credit crunch?The adaptations thatoriginating/structuring banks have tomake to fit the relevant transaction intothe government schemes broadly fallwithin the following categories: (a) assettransfer; (b) tranching of note and excessspread strip; (c) restrictions on theprovisions of support by the originator;and (d) ongoing reporting requirements.

(a) Asset transfer

It is a long established criterion of theECB operations that only a “true sale”of the underlying assets may beeligible for ECB money marketpurposes. It is also clear that the ECBis the ultimate arbiter of whatconstitutes a true sale and not legalanalysis. Synthetic transfers throughcredit-linked notes or credit derivativeshave been expressly prohibited. Thecriteria are not specific on whetherless common types of asset/risktransfer would be eligible, e.g.originator trust structure or securedloan structure, regardless of their legalanalysis. For example, we haveexecuted some transactions usingEnglish law or Irish law governedoriginator trust structures which wereaccepted (correctly in our view) bycentral banks as eligible securities onthe basis that an originator truststructure is “enforceable against anythird party … and beyond the reach ofthe originator and its creditors,including in the event of theoriginator’s insolvency”. Central banksin continental European jurisdictionswhere there is no trust concept mayhave difficulties in recognising this typeof transfer notwithstanding the legalanalysis of the technique vis-a-vis the“true sale” criterion. As to this andother aspects of the “true sale”analysis, see further the sectionentitled “ECB liquidity transactions – arefresher and an outlook on changesto come”.

(b) Tranching of note and excessspread strip

A notable structural feature of theliquidity trades is the simplicity of notetranching and lack of capitalisedinstruments as a means to strippingexcess spread from the deal (e.g.residual certificates). More often than

not, notes issued in the liquidity tradeswill only have an AAA tranche to berepo-ed with central banks (sometimeswith horizontal slices to reflect theassets splits for the purpose ofsatisfying the SLS legacy assetsrequirements) and an unrated juniortranche to be held by the originator.We have been involved in manytransactions where only a single AAAtranche was issued and the creditenhancement was achieved by theestablishment of reserves funded bythe originator. The need to achieve anefficient structure - which was one ofthe primary drivers and innovations ofdeals pre-credit crunch - has beenreplaced by the need to maintain theAAA rating of the notes to obtainfunding/secure liquidity.

(c) Restriction on the provision ofcurrency hedge and liquidity support

The ECB announced in September2008 that securities are no longereligible for the currency swap providerto the issuer or the guarantee of suchsecurities or to the bank that providesliquidity support of more than 20% ofthe nominal value of the ABS.

Given the pricing of a third partycurrency hedging in the currentmarket, the former has resulted insome deals being structured withouta currency hedge in place. This hasnecessarily resulted in structuring anddocumentation changes which allowthe currency mismatches to be dealtwith by additional collateralisation andmore cumbersome calculations to beconducted by cash managers.

As an alternative, many UK originatorshave issued Sterling securities - whichare eligible for the ECB MMO untilDecember 2010 - subject to anadditional haircut to encourageinvestors. On some of these Sterling


89 New Beginnings

transactions, some central banks haverequested that Sterling interest payablein respect of the securities to be repo-edwith the relevant central bank should notbe paid until a period agreed with therelevant central bank has elapsed, inorder to avoid the relevant central bankreceiving Sterling denominated notesand returning such amount to theoriginator as manufactured interestunder the relevant repurchasetransaction. Again we have introducedstructuring to meet this request bycreating long first coupon notes coupledwith mechanics that allow an amountthat is equivalent to the quarterly interestamount that would otherwise have beenmade to be retained by the relevantissuer without breaching, for taxpurposes, the payment conditions forUK securitisation companies.

(d) Ongoing reporting requirement

In the liquidity trades, the ECB and theBank of England have tried to imposemore stringent reporting requirementson the servicer. The ECB, in particular,is presently considering loan levelinformation disclosure on a loan-by-loan basis. These reportingrequirements, if implemented, are likelyto have long-term impact on

securitisation transactions in the future.For a more detailed analysis of ongoinginvestor reporting, see further thesection entitled “Investor disclosure”.

Contrary to the adaptations made to fit therelevant transaction in the eligibility criteria,a reverse side of the coin is thattransactions structured for the central bankschemes are mainly for the purposes ofliquidity and balance sheet management.As a result, it is desirable for the originatorto be able to “claw-back” the assets at anytime from a structuring perspective whenthe originator intends to exit the relevantschemes. This has resulted in manybespoke seller buy-back options built inthe liquidity trades which are eitherstructured by way of options to buy backassets by the originator (e.g. an option forthe originator to buy all the assets in theportfolio at par at any time or following theoccurrence of certain triggers) or options tocall the notes which are exercisable by theoriginator or a combination of both options.These options, though maximising theflexibility afforded to originators to exit therelevant transaction, have given rise tosome true sale opinion issues to beconsidered by transaction counsel.

In addition, a notable consequence of the“retained” feature under central bankschemes is that the originator will not beable to obtain capital relief in respect ofthe assets put under these schemes onthe basis that it has not transferredsufficient amounts of risk in respect of therelevant assets. These deals are thereforealmost exclusively for liquidity purposesrather than obtaining capital relief. As aresult, the issues that are often hotlydebated on transactions structured with aview to obtaining capital relief in additionto funding (e.g. originator implicit supportin the context of asset buy-back) areoften moot in these liquidity trades.

In transactions funded by the centralbanks, post-transaction amendments (in

particular, in relation to transactionsrepo-ed with the Bank of England) couldbe an involved process. This is primarilybecause notes issued for the Bank ofEngland trades tend to have a longerfunding period (contrary to the ECBtrades where notes are typically repo-edwith central banks on a one or threemonth rolling basis). Given the Bank ofEngland is essentially the onlynoteholder of notes repo-ed with theBank of England, obtaining their consenthas become necessary where thetrustee is unable to make determinationon the basis of non material prejudice.We have structured and standardiseddocumentation to facilitate this process.

Will these influencescontinue when the publicmarket comes back?Following the note issuance out of thePermanent programme by Lloyds and theSilverstone programme by Nationwide, itis hoped that the public RMBS marketwill come back in the short term.Consensus is that the market, when it isback, will not be back to the level andsophistication of the pre-credit crunchlevel. We would also expect there to be abifurcated market where central bankliquidity trades (as discussed above) willcontinue to be structured and executedwhile at the same time (and possibly inthe same issuance) transactions will beexecuted with notes intended to be soldto public investors. It is therefore unlikelythat the structure and documentation puttogether solely for the liquidity trades willcontinue in their current form when thepublic market gradually reappears.However, we believe some of the factorsmentioned above will become “standard”in the market, particularly as ourexpectation is that many transactions(especially RMBS) will not seek regulatorycapital relief.

“The need to achieve anefficient structure –which was one of theprimary drivers andinnovations of dealspre-credit crunch – hasbeen replaced by the needto maintain the AAA ratingof the notes to obtainfunding/secure liquidity”


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17. ECB liquidity transactions– A refresher and an outlookon changes to come

New Beginnings 92


The ECB’s schemeThe ECB has provided critical liquidity to themarket over the last two years. A cornerstoneof its liquidity operations has been its rulesregarding the types of assets it will acceptas collateral for liquidity purposes.

Eligible assets – a refresherThe ECB accepts two types of assets ascollateral for its liquidity schemes –marketable assets and non-marketableassets.

Marketable assets generally include:• corporate debt with an issuer or

guarantor rated “A” or above;

• ABS rated “AAA”; and

• regulated covered bonds rated “A”or above.

Non-marketable assets are essentiallycredit claims (e.g., loans) and non-marketable retail mortgage-backed debtinstruments.

What’s not eligible?A number of factors may renderparticular securities ineligible.The main ones being:

• an issuer established outside the EEAand any of the other non-EEA G10

countries (which renders securitiesissued by Cayman Islands or JerseySPVs ineligible);

• the securities not having a ratingfrom one or more recognisedrating agencies (or, for ABS securitiesissued on or after 1 March 2010,ratings from two or morerecognised rating agencies - seeGrandfathering below);

• the currency not being euro, sterling,US dollars or yen;

• the securities not being the mostsenior tranche;

• for ABS issued after March 2009, theunderlying assets comprising assetbacked securities; and

• for ABS, the acquisition by theissuer of the underlying collateral forthe ABS not being a “true sale”governed by the laws of an EUmember state.

Close links –further tightening?Counterparties wishing to use theliquidity schemes cannot have “closelinks” with the issuers of the securitiesthey want to use as collateral. The

primary prohibition is on submittingcollateral which a counterparty hasissued or guaranteed itself. There arealso other rules prohibiting other types of“close links”, such as the rule that if acounterparty submitting collateralprovides any foreign exchange hedgingto the collateral, such collateral will notbe eligible. To date, counterpartiesproviding interest rate hedging, orliquidity support of up to 20% of therelevant transaction, have not fallen foulof the “close links” rule. In addition, acounterparty servicing assets has notbeen regarded as having a “close link”with the securities being submitted forcollateral purposes. While there hasbeen no official announcement in relationto any tightening of these rules, there isspeculation that the close links rules willbe tightened, in particular in relation tointerest rate hedging and liquiditysupport in general.

To guard against a transaction ceasing tobe eligible for ECB liquidity purposes,consideration should be given to theinclusion in the transactiondocumentation of provisions allowing fora change of interest rate counterparty orliquidity provider should that becomenecessary to comply with any new “closelinks” rules.

This section looks at the rules governing collateral eligibility for the ECB's liquidityscheme, which has been a lifeline to the market over the last few years. Wediscuss the ECB’s recent rule changes and offer our observations as to wherefuture rule changes may be made.

The 20 November announcement that the ECB will require two ratings instead ofone for ABS effective from 1 March 2010 and comments that the ECB would liketo wean the market off its lifeline are likely to lead to a significant reduction in thenumber of deals being structured for ECB liquidity purposes.

As the ECB’s rules change from time to time, it is important, where possible, toensure that there is enough flexibility in deal documentation to allow for continuedeligibility after a rule change.


True saleFor ABS to be eligible, the transfer of theunderlying assets to the issuer must be a“true sale”. This requirement is wellknown and national central banksroutinely request legal opinions to confirmthe true sale analysis. However, therehave been some extensions of the truesale requirement in particular deals whichhave been challenging for marketparticipants to satisfy.

Traceability of “true sale” to originationand underlying assets: Historically, fortrue sale purposes, the national centralbanks have never looked further back thanthe sale of the assets from the originator tothe issuer of the securities. However, inrecent transactions, this approach hasbeen changing. For CDOs of ABS issuedbefore March 2009, requests have beenmade for comfort that not only was thesale to the issuer of the underlying ABS atrue sale but also that the underlying ABSthemselves were true sale transactions (avery difficult requirement to satisfy unlessthe counterparty requesting eligibility hadarranged the underlying ABS transactionsand could provide the true sale legalopinions delivered in relation to them).There is nothing in the rules whichsuggested that such an interpretationmight be made and an extendedapplication of the rule without warning wasnot a welcome surprise. In addition, we areaware of CLO transactions where true salecomfort has been required, not only inrelation to the sale by the originator of aportfolio of loans to the issuer of thesecurities, but also in relation to theoriginator’s own acquisition of individualloans from the market. Again, it came as asurprise to the market participants in thosedeals when the national central bankextended the true sale requirementbeyond the sale of the underlyingcollateral by the originator to the issuer ofthe securities.

Originator Trusts: The legal status oforiginator trusts in English law equates tothat of a “true sale” and structures usingEnglish law trusts have been accepted bynational central banks on manyoccasions. That said, there has been oneinstance recently which we are aware ofwhere an Austrian originator truststructure was rejected as being ineligibleby the relevant national central bank.Although we do not anticipate any issueswith tried and tested originator trustmodels (Austrian law is different toEnglish law) there is a possibility thatnational central banks may analyse thelegal aspects of trusts and how readilythey equate to a “true sale” in moredepth going forward.

National central bankarbitrageThe central bank of the country wherethe securities being submitted are listedgets the job of determining whether ornot the relevant securities will be eligiblefor collateral purposes.

Market participants have sometimesnoticed different approaches appearing tobe taken by the various national centralbanks over the interpretation of eligibilitycriteria and turn-around times forapplications. As a result, counterpartieshave sometimes tried to arbitrage thesedifferences in order to achieve aparticularly fast turn-around or theacceptance of a particular type of asset.The differences in approach were broadlyseen as being due to the way the nationalcentral banks were very separateinstitutions and did not (or did not appearto) have a particularly joined-up approach.

Recently, national central banks havebeen communicating a lot more and as aconsequence of this their interpretation ofthe eligibility criteria has become moreuniform. Accordingly, it would appear that

the opportunities market participants mayhave had for central bank arbitrage havelargely disappeared.

In terms of organisation, the nationalcentral banks have started to allocatecertain tasks to one of their number toallow for greater consistency inapplication across member states. Forinstance, the French national central bankcentrally decides on the theoretical valueof securities whose value cannot bedetermined in the market and where atheoretical valuation needs to be made.

Asset valuationsThe absence of any real market for manyABS securities means that theoreticalvalues have to be assigned to suchsecurities in order for the ECB to be ableto calculate how much it can lendagainst those securities. In someinstances, the values attributed by theECB to ABS securities submitted forcollateral purposes have beensignificantly less than par. Counterpartiesfaced with low valuations havesometimes been successful in obtaininga higher valuation, particularly where theoriginator of the receivables has agreedto provide enhanced disclosure on theunderlying assets.

To assist with valuation of ABS submittedas collateral, there was speculation thatthe ECB would publish new requirementsstipulating minimum ongoing disclosurestandards that would need to be adheredto. On 24 November 2009, a member ofthe executive board and governingcouncil of the ECB published an articlestating that the ECB was studying,together with investors, originators andrating agencies, the introduction of loan-by-loan information requirements forABS. The purpose of such disclosurerequirements would be to improve thequality of the surveillance processes

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conducted by investors and ratingagencies and to help restore confidencein the ABS market. The introduction ofsuch disclosure requirements would alsoallow for easier valuation of securitiesrelying on a theoretical valuation.

GrandfatheringThe grandfathering of changes to theECB’s eligibility criteria is not guaranteed.In instances where grandfathering is notpermitted, transactions which satisfied thecriteria at the time they were put into thescheme may no longer do so and wouldneed to be withdrawn if they do notcomply with the new or changed rules.

If changes are not grandfathered, sufficientprior notice may be given so that marketparticipants are not taken by surprise. Forexample, additional haircuts to ABStransactions and changes to the closelinks rules came into force on 1 February2009 with no grandfathering, althoughprior notice had been given to the marketthat these changes would be made.

An example of when changes werepartially grandfathered was in March 2009when ABS of ABS and CDOs of ABSbecame ineligible. However, the ECBgrandfathered the use of these types ofassets until 1 March 2010 provided they

were issued prior to 1 March 2009. As of1 March 2010, all ABS of ABS, or CDOsof ABS, will cease to be eligible forcollateral purposes.

On 20 November 2009 the ECBannounced that ABS issued on or after 1March 2010 must have ratings from two ormore rating agencies that meet theminimum rating requirement in order to beeligible. ABS currently in the ECB’s liquidityscheme that do not meet this requirementare being partially grandfathered until 1March 2011 as of which date all ABS inthe scheme, irrespective of when they wereissued, will need to meet this requirement.

Secured structures usingnon-ABS criteriaAs there are different eligibility criteria forABS, corporate bonds and coveredbonds, there may be scope for structuringassets into one category if they do not fitinto another. For instance, ABS securitiesrequire an “AAA” rating to be eligible, butthis is not of course always possible. Forsuch transactions, one entity (with an “A”rating itself or issuing with the benefit of aguarantee from an entity with an “A”rating) could issue bonds guaranteed byan SPV. The guarantee from the SPVcould be secured on the underlying

assets, similar to what happens in manycovered bond transactions (but withoutthe issuer actually being required (or able)to satisfy the requirement to issue aregulated covered bond). With this type ofstructure, assets not capable of backingan “AAA” rated ABS can be used tosupport or enhance an obligation issuedby an entity (or guaranteed by an entity)with an “A” rating, without the structurefalling within the ABS rules and, therefore,without the need to get an “AAA” ratingand provide a true sale opinion.

The futureThe ECB’s open market operations werenever intended to be a permanent formof financing for credit institutions. Withthe financial recovery that is under way,we expect a continuing tightening of therules on what will constitute eligiblecollateral going forward.

Credit institutions which currently relyheavily on the ECB for their fundingrequirements will need to take care toensure that they can structure assetsthat will be compliant with future rulechanges or be in a position torestructure existing deals to makethem compliant.

Esther CavettPartner, London

T: +44 20 7006 2847M: +44 777 591 1251E: [email protected]

Susan RosePartner, London


Corporate Trusts

Clifford Chance contactsTo discuss any of the issues in this publication, please contact one of our market experts below:

Claude BrownPartner, London


Matthew CahillPartner, London


Andrew ForryanPartner, London


Kevin IngramPartner, London


Rachel KellyPartner, London


Jessica LittlewoodPartner, London


Steve CurtisPartner, London


Emma MatebalavuPartner, London


Prashanth SatyadevaPartner, London


Neil HamiltonPartner, London


Peter VoiseyPartner, London


Structured Debt

Christopher WalshPartner, Abu Dhabi

T: +971 2 419 2520M: +971 50 6507422E: [email protected]

Simeon RadcliffPartner, Moscow

T: +7 495 725 6415M: +7 985 410 41 59E: [email protected]

Debashis DeyPartner, Dubai

T: +971 4 3620 624M: +971 50 6507117E: [email protected]


95 New Beginnings

Farid Anvari

Simi Arora

Oliver Campbell

Andrew Carnegie

Timothy Cleary

Stefan Erasmus

Nauraj Gabisi

Max Gliner

Nicolas Gonzalez

Jennifer Mitchell

Yasuko Moriwaki

Marie-Isabelle Palacios-Hardy

Ryan Patryluk

James Pedley

Mark Redinger

Michelle Savage

Cameron Saylor

Francesca Segurini

Johanna Sheppard

Will Sutton

Anne Tanney

Sarah Woodland

Maggie Zhao

We would like to thank the following people for their contributions to this publication:

Acknowledgements

© Clifford Chance LLP, November 2009.

Clifford Chance LLP is a limited liability partnership registered in England andWales under number OC323571.

Registered office: 10 Upper Bank Street, London, E14 5JJ.

We use the word ‘partner’ to refer to a member of Clifford Chance LLP, or anemployee or consultant with equivalent standing and qualifications.

This publication does not necessarily deal with every important topic nor coverevery aspect of the topics with which it deals. It is not designed to provide legalor other advice.

Aspects of English law covered in this publication are up-to-date as at20th November 2009

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New Beginnings 96

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