Covered bonds special focus · Stefan Kramer of Homburger discuss the Swiss taxation system’s...

www.iflr.com IFLR/July/August 2015 51

CONTENTS COVERED BONDS SPECIAL FOCUS

Asian firsts p52Two trailblazersNew deals in Singapore and South Korea both

broke new ground last month. Here’s how

they were structured

BBVA p54Europe’s evergreen market Aaron Baker and Agustin Martin of BBVA provide

detailed insights into the European market and

some major trends on the horizon

European secured notes p58WANTED: regulatory buy-in A new instrument could apply covered bond

technology to medium-sized enterprises’ loans

EMF-ECBC p60Coping with stress Luca Bertalot of the European Mortgage Federation

of the European Covered Bond Council, describes

how the asset class has helped governments in crises

Switzerland p64Taxation constraintsBenedikt Maurenbrecher, Dieter Grünblatt and

Stefan Kramer of Homburger discuss the Swiss

taxation system’s impact on the covered bonds

on an international level

US p69A user’s guide to Volcker Rule complexities Jerry Marlatt and Melissa Beck of Morrison &

Foerster offer covered bond investors a practical

overview of the rule

Covered bondsspecialfocus

Global issuance breakdown p74A map and supporting data revealing issuance volumes from around the world. Courtesy of Societe Generale Corporate &

Investment Banking, GlobalCapital and The Cover

Ashley LeeAsia editor

Singapore DBS has become the first bank to sell a covered bond under Singapore’sCovered Bond Act, despite a lack of clarity over how to create or define theproduct under the new rules.

The Monetary Authority of Singapore (MAS) first issued a consultationpaper on rules for covered bonds in March 2012. However it took more thanthree years for the first to come to market, with DBS establishing its firstdomestic covered bond programme on June 16 of this year.

The $10 billion programme is a step forward for the product in Asia;Kookmin Bank’s recent sale of the first legislative covered bond from Korea isanother. Andrew Vickery, partner at Linklaters in London, believes there arekey differences between the two regimes: “What Singapore’s new law didn’tdo is tell you how to create a covered bond, and define a covered bond inSingapore. That’s different from the new Korean law, which tells you what thecovered bond is, as well as who holds priority as a matter of Korean insolven-cy law.”

Instead, he added, Singapore followed the UK approach. While it issued aframework in which the product needed to operate, it was up to the banksand the markets to develop something that suited their needs and businesses.This meant that it was greenfield in terms of structure. The programme issecured by a dynamic pool of mortgage loans, and was rated AAA by Fitchand Aaa by Moody’s. It is listed on the Singapore Stock Exchange.

Aside from meeting criteria set under Singapore’s legislation and the MAS’sNotice 648, the Covered Bond Label Foundation (CBLF) granted DBS’s pro-gramme its first Non-European Economic Area label; the CBLF only openedits labelling initiative to non-EEA issuers on January 1 of this year.

A new structureDBS’s programme employs two sale techniques. The first is equitable

arrangement, which is typically seen throughout the common law world; it’s afeature of English, Canadian, Australian and New Zealand deals. The other,added Vickery, is a declaration of trust structure that operates when companieshave drawn on their CPF funds.

The deal structure had to take into account the Central Provident Fund’s(CPF) involvement in mortgage loans. Singaporeans can draw upon the por-tion of their accrued pension under the CPF to buy public or private resi-dential property.

That created transfer issues when putting those loans into a special purposevehicle (SPV); CPF would creep up in priority upon transfer which wouldhave a significant impact on collateral value.

Deal counsel dealt with loans involving the CPF with a trust structure,which Vickery said draws from the originator trusts seen in the UK securiti-sation market: “It’s a case of borrowing technology and adapting it for use indifferent contexts.”

The use of the trust mechanism required a separate consultation from theMAS to amend Notice 648; the consultation was released in January and thenotice was amended June 4 – only weeks before DBS launched its pro-gramme.

This structure is designed to allow the CPF loans to be treated as normalloans as long as they are kept within the bank’s ownership and control, whilesatisfying the obligation that they are assets for the deal, said ChristopherWalsh, partner at Clifford Chance in London.

In the originated trust structure, the bank is a trustee of these assets, butthere is no actual or physical legal transfer from DBS, he explained. By wayof this trust mechanic, the assets are ringfenced from the insolvency estate ofDBS itself.

The introduction of that structure required further US law analysis. “Ascovered bonds structures evolve, they must continue to meet the requirements

52 IFLR/July/August 2015 www.iflr.com

COVERED BONDS SPECIAL FOCUS ASIAN FIRSTS

Two trailblazers

New deals in Singapore and South Korea both broke new ground last month. Here’s how theywere structured


ASIAN FIRSTS

of US securities laws to the extent the bonds are offered to US investors,” saidJohannes Juette, partner at Clifford Chance in Singapore.

For example, he said, where the structure involves a trust, that can com-plicate the analysis of whether the customary exceptions from the definitionof investment company under the US Investment Company Act are availablefor the issuer and guarantor, due to questions about actual ownership – ben-eficial and legal – of the assets in the cover pool.

What’s nextSingapore is one of the few markets to introduce legislative covered bondswithout both a developed medium-term note and securitisation market.“When you have a MTN market and securitisation market, it’s not a greatstretch to develop a covered bond market,” said Vickery.

“Both elements – corporate recourse and the asset-backed recourse – arealready in the market, and it’s easier to bring them together,” he added. “Whenthere isn’t a residential mortgage-backed securitisation (RMBS) market, all theissuers must look at their mortgage businesses in a different way, and investorshave to educate themselves about the mortgage market in the country.

Regardless, it’s likely that other lenders will also look to covered bonds tobroaden their sources of funding. Clifford Chance’s Walsh noted that in juris-dictions with new covered bond legislation, it can take at least a year to see thefirst issuance.

“It’s important to put programmes in place while the sun is shining, and ifthere are dark days, they are an option,” he said.

In the Asian markets – as well as those elsewhere – banks will adopt andestablish covered bond programmes even if they don’t intend to tap them reg-ularly. Some may complete small issuances to maintain an active investor base,but those programmes are there for a rainy day or when credit strength weak-ens, Walsh added.

KoreaJust a week before DBS’s deal, Kookmin Bank launched the first programmeunder Korea’s Covered Bond Act; a development that could open the marketto other banks from the country.

Korea remains Asia’s most active structured finance market, but it haslacked legislation implementing a single transaction structure with adequateringfencing protections for covered bonds. The Financial ServicesCommission (FSC) has contemplated the growth of the covered bond mar-ket since 2011, when it released guidelines for their issuance. The first pro-gramme comes over a year after the Korean Covered Bond Act was passed -in April 2014.

“This was the first legislative covered bond in Asia and the first time a dealhad been done under the Korean Covered Bond Act,” said Victor Wang, part-ner at Linklaters. “We had to work out the nitty-gritty of how the deal wouldwork in the context of legislation.”

In the past the most frequent issuer was Korea Housing FinanceCorporation (KHFC), which was able to issue covered bonds under a sepa-rate law. Kookmin Bank sold a structured covered bond in 2009, but investorsbelieved its structure was too complex.

The programme, rated AA+ and Aa1 by Fitch and Moody’s, will allowKookmin to sell up to $8 billion in covered bonds secured by a dynamic poolof Korean residential mortgage loans. Its establishment differs from previousKorean covered bonds sold by both KHFC and Kookmin, which were issuedon a one-off basis; it’s also in line with practice elsewhere.

Previous dealsThe programme’s establishment under the new legislation meant that it had adifferent structure to those seen in previous issuances.

In Kookmin’s 2009 structured covered bond, the issuer had to sell assetsinto the SPV and deal with issues related to entrustment and taking of secu-rity.

“That was more like a securitisation deal, while this is more streamlinedand the documentation looks more like a medium-term programme,” saidKaren Lam, counsel at Linklaters. “The additional contractual features are tobolster ringfencing and protection, as well as specifying the waterfall.”

It also included different assets. “In the structure for Kookmin’s previousstructured programme, the assets included both mortgage and credit cardreceivables,” said Claire Heaton, senior director and Asia-Pacific coveredbonds product specialist at Fitch Ratings in Sydney.

“This is different from the new programme’s assets, as it’s limited to resi-dential mortgage loans and other permitted liquid assets,” she added. “Underthe Covered Bond Act, Korean covered programmes could also include ship-ping loans and other assets specified in the act.”

It’s also different from the KHFC issuances. Under those deals, the coverpools of residential mortgages were originated by participating banks, whichwere then transferred to KHFC for the purpose of creating the cover pool. Itcould only secure one pool against one bond, however, which is why thesewere all one-off deals.

The new programme will allow for multiple issuances. The structure forKookmin Bank’s new covered bond programme allows the bank to sell eithersoft bullet or hard bullet bonds, said Heaton. Each has a mechanism in placeto ensure that assets can be liquidated within a time period that will ensurethe repayment of those covered bonds.

Cover pool ringfencingAs a statutory covered bond, the ringfencing was done by statute. However, saidWan, there was a legal quirk under the law: “It was possible to ringfence themortgage loans but cash still carried the risk of the bank holding it [KookminBank]. We needed to include account bank and servicer replacement triggersto account for that.”

While the laws state that there’s a statutory priority rights of claims of thoseassets to covered bond holders, and relative secured parties such as swapproviders and other parties involved, bank accounts are harder to legally seg-regate given cash is fungible, said Heaton.

“To deal with this, some contractual arrangements regarding comminglingof cash assets and set-off risks for borrower deposits were included in thedeal,” she added.

Other features typically found in European covered bonds could not beincluded in Kookmin Bank’s bonds due to uncertainty under the new law.

The inclusion of a waterfall – a common feature in securitisation deals –also required some analysis. But according to Wan, the legislation wasn’t clearabout whether it’s possible to prioritise creditors in relation to the cover pool.It just states that priority creditors – noteholders, swap parties, agents andtrustees – have an equal claim. Ultimately the deal did have a waterfall, whichwas included via contract.


COVERED BONDS SPECIAL FOCUS BBVA

Europe has always led the world’s covered bond markets. Despitesome interesting emerging markets, such as Canada and Australia,and others where potential need exists, such as Turkey and Brazil,

the European market remains unchallenged. In a detailed interview, AaronBaker and Agustín Martín of BBVA, Spain’s second largest bank, examinethe latest market trends, the impact of new programmes and what’s in storefor the next 12 months.

Is increasing market confidence in Europe still hitting sales ofcovered bonds?Covered bonds have always been considered a more evergreen product, withthe issuance window remaining open for longer across market conditions than,for example, senior unsecured bonds. From a primary-market perspective, we seecovered bonds to have a slight anti-cyclical nature to them in contrast to seniorunsecured bonds, whose issuances tend to be more pro-cyclical. Further, on thesecondary market covered bonds tend to exhibit a lower beta than sovereign,SSAs or senior unsecured debt issuances as they tend to be used as strategicallydefensive plays in the event of expected near-term volatility, for example withidiosyncratic events relating to issuers and countries.

Market confidence is something we would be hesitant to define,although in terms of Armageddon scenarios which were being consideredduring 2012, the market has returned to a sense of normality with positiveconsumer sentiment, positive (albeit low) economic growth and less frag-ile banking systems. Such confidence has not affected the sales of coveredbonds materially, but rather valuations have been a primary driver given anintervened market through European Central Bank (ECB) actions.

The Covered Bond Purchase Programme 3 (CBPP3) has been a struc-tural demand support for the covered bond market. However, if we look atthe fact that in the seven months the programme has been running, around17% of outstanding euro benchmark covered bonds have been purchased,scarcity of the product and a general fixed income spread-compression hasprovided the most crucial rationale for declining investor interest. ECBparticipation, albeit reduced from the enhanced levels seen before January15 2015, are still around 10% higher than their pre-CBPP3 levels, and thespread levels have made fund managers and insurance investors less inter-ested in the asset class owing to yield levels due to their fixed managementfee and liability costs.

After last year’s report commissioned by the ICMA [InternationalCapital Market Association], are there still shortcomings inEuropean covered bond issuers’ disclosure of structural aspects oftheir deals, and is this a cause for concern?There is a lot of talk of the transparency of both covered bonds andsecuritisations. Covered bonds in particular are coming under criticism, asefforts have already been made to improve the transparency ofsecuritisations. Covered bonds are subject to a much higher degree ofstandardisation within their respective jurisdictions compared tosecuritisations, given their legal and common supervisory framework.

Collateral information is not necessarily as critical for covered bondscompared to securitisation, as covered bonds only have a secondaryreliance on collateral. This has been amplified against the backdrop of theBRRD [Banking Recovery and Resolution Directive], making the likeli-

Europe’s evergreen marketAaron Baker and Agustín Martín of BBVA give a detailed insight into the European coveredbond market and the major trends on the horizon


BBVA

hood of reliance on collateral even more remote given the reduced proba-bility of a covered bond issuer default. Now, it is more likely that bail-inand resolution will be the order of the day.

Ideally, all jurisdictions would report to the same transparency tem-plate as opposed to a national level template, especially in relation to def-initions and concepts such as the calculation of valuation in loan-to-value metrics. These problems have brought the issue to the fore, allow-ing relevant information to be made more easily accessible; industryefforts spearheaded by the European Covered Bond Council (ECBC)and its related label have made massive strides in these areas.

There are certain instances where line-by-line data would be useful tohave, including the impact of defaults on certain concentrated coverpools (such as Heta Resolution), but this information would be useful inbank analysis in general: we wouldn’t say it’s a covered bond specificissue. One jurisdiction which is already providing loan-by-loan data isthe UK, and if we look at the figures, its monthly usage remains mini-mal.

More information is generally a free option for investors but necessi-tates a cost for the issuers, so some form of balance is needed. Havingsaid that, certain information requested by the CBIC (Covered BondInvestor Council), including stress test results (that is, impact of loan-to-values on a 15% decline in house prices) and stratification tables on bor-rowers and geographic concentration are, admittedly, useful.

Do you think the ECBC’s proposed dual recourse bonds will takeoff?The ECBC’s proposal for dual-recourse bonds is a welcome one, althoughwe do need to take stock of its rationale. By qualifying these bonds asdual-recourse bonds, this proposal seeks that these type of bonds will notbe incorporated into regulatory-defined covered bonds, which areeffectively dual-recourse bonds with a legislative wrapper. The risk here isthat covered bonds could be opened up to a wider variety of asset classesincluded SME [small and medium enterprise] loans as per the structuredSME covered bond by Commerzbank, and the potential opening of theObbligazioni Bancarie Collateralizzate (OBC) market in Italy (a rareexample of a legislative amendment to include covered bonds backed byassets outside the standard Obbligazioni Bancarie Garantite or OBGmarket). Although the latter still awaits secondary legislation.

The real advantage for dual-recourse bonds is their ability to create asecured funding vehicle for a myriad of assets which have traditionallynot been able to be funded in the wholesale markets outside of securiti-sation; such assets include consumer loans, tariff deficits, SME loans, andinfrastructure loans. While the ECBC proposal focuses on SME loansand infrastructure, in reality, a covered bond mechanic can be used tofund any asset on a bank’s balance sheet; we can even demonstrate theflexibility of the product further given that this product can go beyondbanks and also be utilised by corporates.

The product’s spread would likely have been floored at an entity’s cov-ered bond level (covered bonds are more liquid, and crucially, have a lotof in-built regulatory protections such as liquidity coverage ratio (LCR),net stable funding ratio (NSFR), bail-in, swap exemptions, and SolvencyII) and senior unsecured bond level (a senior bond with collateral).Covered bonds may be considered the most relevant comparator in termsof structure because these are both pure funding instruments; seniorunsecured bonds, in the medium term, will have a hybrid funding orcapital position depending on their treatment in the upcoming total loss-absorbing capacity (TLAC) regulations. In our view, success will hingeon the asset-backed securities (ABS) market gaining traction such that

secured funding instruments once again come onto investors’ radars withenticing yield.

Quantitative easing (QE) alongside materially cheap funding (target-ed longer-term refinancing operations – TLTRO) has meant that theneed for funding has dissipated in the European banking system for thetime being. The use of such a dual-recourse bond which will likely needto pay a premium due to complexity and likely illiquidity isn’t really apushing priority for issuers. While it would potentially be a productwhich investors would certainly be interested in given the much reducedyields in the European fixed income market, until accommodative mon-etary policy and yields return to a normal level, the uptake for dual-recourse bonds will remain limited in the near-term. Post-QE, theseproducts would become more compelling as a strategy to diversify fund-ing channels, mobilise the funding of different assets and, should theneed arise, support lending expansion economically where deposits arenot sufficient. Further, from a funding risk perspective, sole reliance oncovered bonds is not considered best practice.

What impact is the European Central Bank’s new covered bondpurchase programme (CBPP3) having on issuances, investors, exitstrategies and spreads?The CBPP3 programme has led to a material change in the investor base,with spread contraction leading to reduced interest in the asset class fromasset managers and insurance investors, and increased interest among bankinvestors. Primary subscription levels show a 10% increase in ECBparticipation compared to pre-CBPP3 levels, but that is not the full storygiven around 81% of purchases take place in the secondary market.Liquidity has subsequently dried up given the main exit strategy for coveredbond holdings, especially in the periphery, was to ride the consolidationprocess; profits have gradually been realised since the beginning of the year,selling the positions ultimately to the ECB.

Covered bonds outside of Germany and from the strongest issuers havetraded inside their domestic sovereign curve, especially since the recentbund weakening. While a feature previously of peripheral markets, this isa new situation for France and Belgium, for example, and bank investorsnaturally switch between sovereign and covered bonds in order to optimisetheir liquidity holdings.

Has CBPP3 had an impact on issuances? We would say they have encouraged issuances given their reduced costs(albeit tempered with TLTRO funds), especially at the longer end of thecurve. However, the requirement for wholesale funding has been reducedgiven substantial European banking system deleveraging since 2012. Thishas left a large number of outstanding covered bonds to be subject to surplusunder existing financing requirements, leading to the European coveredbond market being in a state of negative net supply since 2012. We expectthis to continue until the end of 2016 given the outsized issuances of coveredbonds between 2005 and 2007 rolling off.

“We should expect that 2016will be the last year of net

negative redemptions in thecovered bond market


BBVA

What key trends do you expect to see in the European coveredbonds market over the next 12 months?The expected deceleration of purchases from the CBPP3 programme post-implementation of the Public Sector Purchase Programme (PSPP) has notmaterialised, with the ECB still purchasing roughly a benchmark a day. Thisis likely to continue given musings from the ECB related to using the AssetBacked Securities Purchase Programme (ABSPP) and CBPP3 to purchasewhat they can, and then top-up with sovereign purchases in order to reachtheir €60 billion ($68 billion) monthly target.

With this substantial figure in the background, we expect spreads toremain range-bound, with limited performance potential from the core-periphery convergence; such a trade was very much in vogue last year.Covered bond spreads will likely track (with a delay) sovereign perform-ance, with bank investors specifically looking at the relative value betweenthe two asset classes to optimise their liquidity portfolios. Any underper-formance in sovereigns (such as with the bund tantrum) will likely bereflected, though not fully in covered bond spread movements given thestructural purchases of the ECB. Liquidity will remain a concern forinvestors; those still engaged in the covered bond market will have less free-float paper around given ECB purchases are contributing to a scarcity ofpaper (if the ECB maintains its current pace of purchases, it will ownaround 40% of outstanding euro benchmark covered bond stock bySeptember 2016). We expect that 2016 will be the last year of net negativeredemptions in the covered bond market, due to the maturity of the cov-ered bond issuance overhang from pre-crisis, and any net increase will bedependent on alternative funding costs, mortgage loan production andfinancial institutions’ balance sheet growth.

We will likely see more jurisdictional legal changes as certain Europeanjurisdictions look to update their covered bond frameworks in line withEBA best practices prior to review. Scheduled for 2017, the EuropeanCommission will determine the adequacy of Capital RequirementsRegulations (CRR) eligibility definitions. This has motivated changes inthe Dutch covered bond legislation, becoming effectively the first jurisdic-tion which fully complies with such best practices. We see some interest indual-recourse bonds, but only for issuers with large refinancing needs, sub-stantial non-covered bond eligible collateral (such as SMEs) and thoseplanning the roll-off of their TLTRO funding to a more normalised posi-tion.

The question of ECB exit will intensify as we move into next year, notablyin relation to the tapering of purchases and the need for further re-engage-ment of the pre-CBPP3 investor base. ECB purchases in the primary mar-ket are still around 25%, albeit with jurisdictional differences; there is stillprivate capital interested, although we suspect many investors subscribe inthe primary only to sell after some performance or to crystallise any newissue premiums (at the beginning of the year this was five basis points buthas since decreased) through selling back to the ECB. What is clear is thatspread dispersion between different credits is artificially low, despite theBRRD exclusion of covered bonds from bail-in providing some justificationfor a narrowing between different credits relative to historical relationships.

What emerging markets are looking particularly exciting as far ascovered bonds are concerned?If we look at recent growth areas in the global covered bond product, theyhave all come from outside of Europe, as the latter retains a covered bondoverhang from its pre-crisis growth spurt and subsequent bank deleveraging.Canadian and Australian issuers have substantially ramped up their issuancesbeyond their existing footprint, contributing to around 10% of allbenchmark covered bond issuances in 2014.

Looking at emerging markets, Brazil and Turkey have had recent cov-ered bond laws enacted, although only Turkey has actually issued a coveredbond (Akbank’s local currency issue subscribed by the EuropeanInvestment Bank). Further, Singapore hasn’t enacted a covered bond lawbut has issued regulatory guidelines for their issuance; it has been activelylooking to fix certain technical issues, including the state housing compa-ny having super senior claims on certain collateral, which has halted workon covered bond issuance platforms.

There is a need for covered bonds in both Turkey and Brazil, given thattheir banking systems are rapidly approaching the limit for which their mort-gage books can be funded solely by deposits. However, we would note thatthere are covered bond laws in Peru and Chile which haven’t gained tractionowing to specific legislative issues. The most interesting currency for Turkishissuers is likely the euro, as it taps into the deep covered bond investor basein this area, but the cost is prohibitive due to the cost of currency swaps.Unlike previous attempts in other emerging jurisdictions, the Turkish legis-lation is considered comparable to the gold standard German Pfanbriefe mar-ket, and therefore, an investable product from a covered bond legislation per-spective. For Brazil, we await secondary legislation relating to regulation andhow the Brazilian covered bond market will operate.

We remain supportive of these developments, but in the medium-term,only see these markets as offering a niche for investors who are in an awk-ward set-up. Covered bond investors do not typically look at emergingmarkets (or have the mandates to do so) and emerging market investorstend to target asset classes with higher yields rather than covered bonds. Ifthese issues are resolved, likely through significant marketing periods andnew issue premiums versus competing investments, then we see no reasonwhy emerging markets can’t become a growth spot for the global coveredbond fraternity.

“Recent growth areas in theglobal covered bond producthave all come from outside of Europe


BBVA

About the authorAgustín Martín is the head of European credit research for BBVA, basedin London. He holds a degree in electrical engineering by theUniversidad Pontificia de Comillas in 2001 and a MsC in advancedeconometrics and statistics applied to electrical engineering in 2004from the same university

Martín joined BBVA in October 2005, after the completion of hismaster’s degree in electrical engineering and he worked previously in theSpanish utilities sector. In BBVA he has had different roles within theEuropean credit research team, including as a research analyst instructured credit, investment-grade industrial corporates and since2010, he has headed the covered bonds and ABS research.

In the covered bonds space he is a frequent collaborator and author ofresearch papers in flagship publications and websites such as The Cover,The Covered Bond Report, the European Mortgage Federation andIFLR, among others, and he is a frequent panellist and collaboratorwith the European Covered Bond Council and related publications.

Agustín Martín Head of European credit research, globalmarketsBBVA

T: +44 0207 397 6087 E: [email protected]

About the authorAaron Baker joined BBVA’s credit research team in 2013 as a seniorfixed income research analyst, with a specific focus on covered bondsand ABS. Before this, he worked at the Bank of England, focusing onrisk management of collateral operations. He has also held positions atthe UK Treasury and with Standard & Poor’s structured financepractice.

He is a frequent panellist and collaborator with the European CoveredBond Council and related publications, such as Global Capital’s TheCover and the Covered Bond Report.

He has a MPhil degree in real estate finance from the University ofCambridge and a BSc degree in economics, politics and internationalstudies from the University of Warwick.

Aaron BakerGlobal markets research, European creditBBVA

T: +44 0207 648 7580E: [email protected]


COVERED BONDS SPECIAL FOCUS EUROPEAN SECURED NOTES

Danielle MylesEditor

A proposed new instrument called European secured notes(ESN) presents the most promising opportunity to date ofapplying covered bond technology to medium-sized (SME)

enterprises’ loans.The But the role and timing of EU regulatory relief has divided opinion,

and some query whether banks would issue ESNs given the abundance ofcheap funding in today’s market.

The European Covered Bond Council (ECBC) has recommended thecreation of ESNs as part of its response to the Capital Markets Union greenpaper. The long-term funding instrument uses on-balance sheet and dualrecourse features seen in covered bonds, but also borrows from securitisa-tion technologies. It is intended to be a new and distinct asset class.

This separate categorisation is to avoid tarnishing the 300-year old cov-ered bond concept; a common criticism of deals – such as Commerzbank’sin 2013 – and statutory schemes such as Turkey’s and Spain’s that have tried

to extend the safety and efficiency of covered bonds to finance other assetclasses.

ECBC has proposed two types of ESN. The first is an on-balance sheetdual recourse instrument with a dynamic pool, and the second an off-bal-ance sheet dual recourse instrument with static pool – referred to as the risk-sharing ESN.

There is broad industry support for both ESNs, and the ECBC has,informally, received positive feedback from EU regulators. An officialresponse is expected on September 9 at the group’s plenary session.

Its secretary general Luca Bertalot says that the ECBC is happy to act asa catalyst in the creation of a pan-European market. But it has placed a clearcondition on spearheading ESNs’ development: regulatory cooperation.

“If these instruments are created under strong EU cooperation andunder national legislative framework, then we will have strong regulatoryrecognition that sits somewhere been the covered bond space and securiti-sation space,” says Bertalot.

Regulatory recognitionThe ECBC has created an ESN to-do list for both authorities and theindustry. Ideally, these would progress side by side, but it is presentinga classic chicken-and-egg scenario.

Karlo Fuchs, head of covered bond at Scope Ratings, believes that forESNs to succeed as an asset class, it needs regulatory recognition – includ-ing preferential risk weightings

WANTED: regulatory buy-in

A new instrument could apply covered bond technology to medium-sized enterprises’ loans.But more needs to be done first

“Anything that can spur SMEfunding is a positive

What comes first: regulatory relief or issuance?


EUROPEAN SECURED NOTES

“Of course anything that can spur SME funding is a positive, which iswhy there is such a strong focus on regulators making sure that from a reg-ulatory perspective there is no hindrance and constraints to the market tak-ing off,” he says.

Indeed, one of the reasons why other covered bond-like instruments fornon-traditional assets have not succeeded is because the CapitalRequirements Regulation (CRR) only provides covered bond risk weight-ings to instruments backed by mortgages or public sector loans.

For on-balance sheet ESNs in particular, Bertalot says prudential recog-nition is essential to incentivising bank investors and issuers. “It’s extreme-ly important to provide compensation for the fact that an SME loan will bekept on balance sheet by providing a type of regulatory recognition,” hesays. “Under current EU regulations, it is not convenient to do so.”

But others, including Jens Tolckmitt, chief executive of the Associationof German Pfandbrief Banks, query whether regulatory relief is a pre-req-uisite.

“I don’t like asking for that before the industry has delivered,” he says.“Just saying you have a good product isn’t enough; you have to prove it.”

Proponents of this approach point to the securitisation market, whichthey claim has asked for regulatory recognition before proving itself as a safeproduct.

While preferential risk weighting is proving a point of contention, othertypes of regulatory recognition are less divisive – and could be easier toachieve.

The consensus is that ESNs must be designed under clear, national legalframeworks that are broadly harmonised across the EU. Bertalot says ESNswould be implemented in several member states relatively quickly, usingtheir existing covered bond or securitisation legislation; particularly in Italy,Spain, France, Luxembourg and the UK.

It’s also agreed that, unlike contractual covered bonds, ESNs must besupervised by national authorities. In addition to improving investor confi-dence, the notes would be dual-recourse instruments issued by a credit insti-tution under public supervision meaning they would comply with theUndertakings for Collective Investment in Transferable Securities Directive.

This, in turn, would exempt the notes from bail-in rules and make themeligible for recognition under other EU regulations included Solvency II.

A problem of capital, not fundingIrrespective of whether regulatory relief or a reputation as a reliable productis needed for ESNs to take-off, the European Central Bank’s (ECB) bondbuying programme could present a stumbling block to regular issuance.

The idea of SME-backed covered bonds first gained momentum duringa period when the usual funding sources were closed. Quantitative easing,which began earlier this year, has created a different market dynamic.

“The big question in the current environment is not so much to do withregulation, but whether the instrument is actually needed by banks,” saysTolckmitt.

According to covered bond consultant Richard Kemish, this is why thereshould be a stronger push for the risk-sharing ESNs: “The first structure iseasier, but perhaps offers less value as it is about cheap funding – which isn’tthe main imperative of banks at the moment. The second is more useful to

the extent that it is a risk transfer, capital relief product – but that is poten-tially more difficult to achieve.”

Compared to on-balance sheet ESNs, the risk-sharing variety have morein common with securitisation. Deciding which covered bond features toinclude needs careful consideration.

“I think that some aspects are clearly not going to be applied – such asfull recourse and cross-default – and some will have to apply – like supervi-sory oversight,” says Kemish. “But it’s the parts in between which are notclear, and that is where a lot of thinking has to occur.”

While risk-sharing ESNs pose structuring challenges, a French initiativefrom last year presents some guidance.

The French Banking Federation mandated the creation of a securitisa-tion company which acts as a dual recourse financing platform for the coun-try’s banks. The cover pool is transferred to the securitisation vehicle – calledthe Euro Secured Notes Issuer (Esni) – using the Financial CollateralDirective.

“The French securitisation company Esni was created one year before theECBC’s paper, but it is part of the same global momentum towards creat-ing a harmonised form of long-term financing notes, and it really does meetthe requirements this paper proposes,” says Gide partner Christine VanGallebaert who advised on the deal. She added that it shares many similar-ities with the seventh potential structure detailed on page 24 of the ECBC’scomment letter.

While there are questions over issuance, buyside interest for both typesof ESN is less likely to be a problem. “In this environment, there is so muchdesperation for bonds in the investor base, I think it would be a very easysell to those people who have been crowded out by the ECB’s purchase pro-gramme,” says Kemish.

To ensure that appetite continues, however, ESNs’ underlying assetsmust be consistent and transparent, so that investors know what they areholding as collateral.

Scope’s Fuchs says that what constitutes an SME according to theEuropean Commission is very broad. Given the risk characteristics of anSME loan can vary greatly depending on be so different depending on theborrower’s size, industry or country, regulatory definitions must be finessed.

“To kickstart this asset class, there needs to be a common understandingand standardisation for what constitutes the underlying assets, and readilyavailable information for investors that can be used as a reference point tomeasure credit risk,” said Fuchs.

From a ratings perspective, he says ESNs shouldn’t pose a material chal-lenge. “Of course we have established ways to analyse the assets, so it’s real-ly about how to blend together the different covered bond and securitisa-tion aspects, using the route that the instrument lends itself to the most,”he adds.

“Some aspects are clearly notgoing to be applied – such as

full recourse and cross-default

A ccording to the European Covered Bond Council’s definition,covered bonds are secured debt instruments which meet threecriteria. First, the issuer or the guarantor of the debt instrument

is a prudentially regulated credit institute (a bank). Second, the debtinstruments are secured by a cover pool of mortgage loans (property as col-lateral) or public-sector debt to which investors have a preferential claim inthe event of default. Third, the bank has a continuing obligation to pro-vide a sufficient amount of assets to the cover pool in order to be able tosatisfy the claims of the covered bond investors, and compliance with suchobligation is subject to supervision by a public authority or independentthird party. In Switzerland, there are two different legal concepts whichcorrespond to this definition.

Swiss PfandbriefeOn the one hand, in 1931, the Swiss legislator created the Swiss Pfandbriefsystem by enacting the Federal Pfandbrief Act (Pfandbriefgesetz, or PfG),complemented by a respective ordinance (Pfandbriefverordnung, or PfV).The PfG provides for explicit regulations regarding all key elements of thePfandbrief system, such as the institutions authorised to issue instrumentsunder the PfG, the structure and valuation of the cover pool, and certaininsolvency-related issues. Accordingly, the instruments issued in accordancewith the PfG – the Swiss Pfandbriefe – could be qualified as statutorycovered bonds. The term Pfandbriefe is, however, widely recognised andprotected by law and it is rather unusual to use the term covered bondswhen describing the Swiss Pfandbriefe. According to the PfG, only two

institutions are authorisedto issue Pfandbriefe inSwitzerland, namely thePfandbriefzentrale derschweizerischenKantonalbanken (PBZ), avehicle issuingPfandbriefe for the Swisscantonal banks and thePfandbriefbankschweizerischerHypothekarinstitute(PBB), a vehicle issuingPfandbriefe for all otherSwiss banks. Bothinstitutions are supervisedby the Swiss FinancialMarket SupervisoryAuthority (Finma). Theissuance of SwissPfandbriefe aims atfinancing the mortgagebusiness of the member

banks. PBZ and PBB use the proceeds from the issuance of Pfandbriefe togrant loans to their member banks, which allow the member banks to enterinto long-term mortgage loan agreements with real-estate owners.

Structured covered bondsUnder Swiss law, on the other hand, the concept of freedom of contractallows an issuer to structure a covered bond programme based oncontractual agreements with investors and other persons or institutions tobe involved in the transactions. Instruments issued under such contractualagreements qualify as structured covered bonds. The avenue of structuredcovered bonds has only recently been explored in Switzerland, when firstUBS (in 2009) and then Credit Suisse (in 2010) established their respectivecovered bond programmes. The key elements of covered bond structuresare as follows: the Swiss bank, acting through a non-Swiss branch, issuescovered bonds as direct, unconditional and unsubordinated obligations ofthe issuer. The obligations of the issuer under the covered bonds benefitfrom a guarantee issued by a subsidiary of the issuer (mortgage SPV) undera so-called guarantee mandate agreement in favour of the holders of coveredbonds, represented by the bond trustee. Under the guarantee mandateagreement, all liabilities, costs and expenses incurred by the guarantor underor in connection with the guarantee will have to be reimbursed (or pre-funded accordingly), by the issuer. As security for the relevantreimbursement and pre-funding claims of the guarantor, the Swiss banktransfers a pool of mortgage loans, together with the related mortgagesecurity, to the mortgage SPV. Accordingly, if the issuer defaulted under thecovered bonds and the guarantee was to be drawn, the mortgage SPV couldclaim for coverage by the issuer under the guarantee mandate agreement.Failure by the issuer to pre-fund the payments lowered under the guaranteewould allow the mortgage SPV to enforce in the cover pool and to use theproceeds to satisfy its payment obligations under the guarantee.

The cover assets mainly consist of Swiss mortgage loans granted by theissuing bank to Swiss domestic individuals and the respective mortgagecertificates securing such loans. Additionally, cash and other qualifyingsubstitute assets may be part of the cover pool. The structure of Swiss struc-tured covered bonds is unique. It is to some extent driven by the Swiss taxlaw considerations, as well as legal, regulatory, and insolvency law consid-erations.

Swiss versus international capital marketsUnder taxation legislation, interest paid on covered bonds by a Swiss issuermay be subject to Swiss withholding tax. While Swiss investors are used toSwiss withholding tax, experience shows that there is only a limited marketoutside Switzerland for debt instruments subject to the tax. Covered bondsissued to investors outside Switzerland must therefore be issued under astructure which allows the issuer to make interest payments on coveredbonds free of Swiss withholding tax.

Structure of SwissPfandbriefe

Pfandbrief holder

Pfandbrief institutes

Cash

Loan

Right of lien onloan receivable

Right of lien onmortgage

Member bank

Mortgage

loan

Right of lien onproperty

Mortgagee

Property


COVERED BONDS SPECIAL FOCUS SWITZERLAND

Taxation constraintsBenedikt Maurenbrecher, Dieter Grünblatt and Stefan Kramer of Homburger discuss theSwiss taxation system’s impact on the issuance of covered bonds at an international level

www.homburger.ch


SWITZERLAND

If covered bonds are secured by a mortgage over real property situatedin Switzerland, an additional Swiss federal, cantonal, and communalincome tax applies, but only if the interest payment is made to a benefici-ary outside Switzerland. Therefore, identical to the situation in respect ofSwiss withholding tax, it is important that interest payments on coveredbonds issued to investors outside Switzerland should be possible withoutsuch taxes being applicable.

The Swiss withholding tax and the special income tax bifurcate the mar-ket for covered bonds. Swiss Pfandbriefe issued by PBB and PBZ are sub-ject to Swiss withholding tax and, potentially, the special income tax. Theytherefore mainly attract Swiss retail and institutional investors. The struc-ture of covered bonds issued by Swiss banks allows them to make interestpayments in respect of the covered bonds without deduction for Swisswithholding tax and special income taxes. They therefore appeal primarilyto an institutional investor base outside of Switzerland.

Withholding tax rules Under Swiss withholding tax legislation, interest paid by a Swiss issuer otherthan a bank is not in principle subject to Swiss withholding tax (35%),unless the debt instrument under which interest is paid is classified as a bondor debenture. The two vehicles issuing Swiss Pfandbriefe do not classify asbanks for Swiss withholding tax purposes and can therefore issue coveredbonds or covered debt instruments under these rules.

The rules say that where a debt instrument issued by an issuer inSwitzerland other than a bank can be held under its terms at any time bymore than 10 creditors that are not banks, the instrument will be charac-terised as a bond and Swiss withholding tax will apply to the entire amountfor the entire term of the instrument. Accordingly, if PBB or PBZ private-ly place Swiss Pfandbriefe, which under their terms cannot be held bymore than 10 investors, who are not banks, interest paid in respect of suchSwiss Pfandbriefe is not subject to the tax. Swiss Pfandbriefe are, however,usually issued without transfer restrictions, and may therefore be held bymore than 10 investors, who are not banks. They therefore usually classifyas bonds subject to Swiss withholding tax, and only exceptionally as non-taxable instruments.

Swiss withholding tax is also triggered if the issuer in Switzerland otherthan a bank has more than an aggregate of 20 lenders under any kind ofdebt instrument (including private placements, syndicated loans and, sub-ject to certain exemptions, intragroup loans, however not debt instruments

classified as bonds). In such a case, the aggregate ofsuch debt instruments is reclassified as a debenturefor Swiss withholding tax purposes and Swiss with-holding tax will apply on interest payable undersuch debt instruments from the date of reclassifica-tion. Accordingly, if PBB and PBS privately placeSwiss Pfandbriefe, they must ensure that theiraggregate number of investors who are not banksdoes not exceed 20, to avoid Swiss withholding taxbecoming applicable.

Under the Swiss withholding tax legislation,where a debt instrument is issued by a Swiss bankacting through its head office in Switzerland, inter-est paid under the instrument is generally subjectto 35% withholding tax, irrespective of the num-ber of holders of the instrument. An exemptiononly applies if the bond is structured like a loanand is held by another bank (interbank exemp-tion). Lacking any meaningful exemption, coveredbonds issued through the head office in Switzerland

are generally restricted to the Swiss market.

However, where a bond is issued by a foreign branch of a Swiss bank,interest payments in respect of the bond can be made without deductionfor Swiss withholding tax, provided, however, that the proceeds from theissuance of the bonds is received and, so long as the bond is outstanding,used outside Switzerland. Further, debt issuances by a Swiss bank througha foreign branch are permissible only if the branch effectively conductsbanking activities in its jurisdiction with its own infrastructure and staff asits principal business purpose, and constitutes a permanent establishmentsituated and effectively managed outside Switzerland. This branch exemp-tion is restricted to banks only. Other issuers, for instance insurance com-panies, who also provide mortgage loans, are not permitted to issue bondsthrough foreign branches without deduction for Swiss withholding tax.

The covered bonds issued by the Swiss banks under the covered bondstructures outlined above classify as foreign covered bonds not subject toSwiss withholding tax only for so long as they use the proceeds outsideSwitzerland. Swiss withholding tax therefore puts covered bonds in termsof use of proceeds at a disadvantage to Swiss Pfandbriefe, while it putsSwiss Pfandbriefe at a disadvantage in terms of the available markets.Banks in Switzerland without foreign branches are fundamentally in thesame situation as the two vehicles issuing Swiss Pfandbriefe (they are essen-tially limited to the Swiss capital markets). As two big banks have beenmade to change their group structure in response to Swiss regulatoryrequirements addressing the too-big-to-fail (TBTF) issue, the coveredbond structure will no longer be used for new issuances. This is becausewholly-owned subsidiaries, established as new Swiss banking entities andwhich hold mortgage loans, are trapped by the non-use of proceeds restric-tion.

Special income source taxesWhere the cover pool includes mortgage loans, a special income tax leviedat source must also be considered. Recipients outside Switzerland of interest

“The structure of Swiss structured covered

bonds is unique

Swiss covered bond structure

Swiss bank

(Switzerland)

Mortgage SPV AG

(Zurich)

CoveredBondholders

Trustee

SecurityAssignmentfor SecuredObligations

Collateralfee

Covered bonds

Covered bondproceeds

Guarantee fee

Covered bond guarantee

Guaranteedamounts

No withholding tax (Verrechnungssteue)provided proceeds not used in Switzerland

acting throughits head officeas originator,assignor andservicer

acting throughits foreignbranch asissuer


SWITZERLAND

paid on a loan secured by a mortgage over real property situated inSwitzerland are subject to a special income tax levied at the federal, cantonaland communal levels. The tax applies in principle in addition to the Swisswithholding tax. The tax must be deducted by the borrower from theinterest payment and be remitted to the respective Swiss tax authorities. Thetax rates range between 13% and 33% depending on the canton andcommune where the real property is located.

Many of Switzerland’s double taxation treaties, including those with theUK, US, Luxembourg, Germany and France, allocate the right to tax fully thecountry where the beneficial recipient of the interest payment is resident. If atreaty applies, Switzerland reduces the tax at source to nil. However, for suchreduction to apply, the debt instrument must be restricted to permit personsin a treaty country only to be a lender under the instrument.

Swiss Pfandbriefe do legally benefit from security over real property inSwitzerland, making the tax in principle applicable. The covered bondsissued under the structures outlined above by Swiss banks do not benefitlegally from security over real property. The purpose of the mortgage SPV isrestricted to holding the cover pool and providing the guarantee in favour ofthe holders of covered bonds and benefits from limited recourse and non-petition provisions; therefore, tax authorities could be of the view that, underthe doctrine of substance over form, the position of a holder of coveredbonds is no different from that of a person legally benefiting from securityover real property in Switzerland. It must therefore be ensured that any suchre-classification risk is excluded. This is achieved by insisting that all compe-tent tax authorities (all 26 cantons and the federation) confirm in tax rulingsthat the guarantee of the mortgage SPV does not constitute a security overreal property in Switzerland for the purposes of the special income tax.

Use of repack structure?For a number of debt issuances, the Swiss tax authorities have permittedSwiss issuers to access international debt markets free of withholding tax.They have allowed this through the use of a structure under which the issuerresident in Switzerland issues loan notes which it sells to a foreign multi-issuance vehicle (MPV), typically resident in Ireland, under a purchaseagreement for a purchase price equal to the issue price, less costs. The MPVsimultaneously issues secured notes, which are secured by the claims underthe loan notes (security), which it sells under a syndication agreements to thearrangers for a purchase price equal to the issuance price for the securednotes (the same as for the loan notes) less costs. The arrangers place thesecured notes with investors outside Switzerland (having purchased the notesin the earlier book-building). The performance of the secured notes is linkedto the loan notes. Therefore, the MPV will make payments under thesecured notes only to the extent it receives payment under the loan notesfrom the Swiss issuer or from the enforcement of the security. The loan notes

are restricted in terms of transferability, such that the Swiss issuer is at alltimes in a position to comply with the Swiss withholding tax rules. Thisallows a Swiss non-bank issuer to have up to 10 or 20 non-bank creditorsas lenders without triggering withholding tax on a particular debt issuance,its financial debt in aggregate. Therefore, under such structure, proceedscan be used in Switzerland without Swiss withholding tax.

The structure as described only works smoothly if the loan notes are notsubject to Swiss withholding tax. Swiss banks therefore cannot in principlerely on the structure, except if an entity in Switzerland is interposed and atax refund mechanism employed allowing the intermediate entity to obtaina refund of the Swiss withholding tax, to be withheld by the Swiss bank oninterest payments to the intermediate entity in respect of proceeds on-lent.This is a difficult task to achieve and untested so far.

A silver lining?Investors resident in Switzerland are used to the Swiss withholding tax. Thespecial Swiss income tax on mortgage loans does not apply to Swissinvestors, and as the Swiss Pfandbriefe show, there is a Swiss domesticmarket for covered bonds subject to withholding tax.

Experience shows that bonds subject to withholding tax do not nor-mally find sufficient demand in international markets. In placing coveredbonds internationally, Swiss banks are generally liable to Swiss withholdingtax on interest paid: this remains a significant obstacle. Under the existinglaw, this has only been achieved subject to the restrictions that the coveredbonds are issued by a Swiss bank, acting through a foreign branch; theissuance proceeds are not to be used by the Swiss bank in Switzerland andthe provision of a guarantee covered by mortgage loans is not consideredsecurity over real estate in favour of the holders of the covered bonds.

A silver lining presented itself in the draft legislation issued by the SwissFederal Council on December 17 2014, which signalled flexibility forfuture issuances. The draft legislation proposed to replace the existing sys-tem requiring the issuer resident in Switzerland to withhold Swiss with-holding tax on interest payments by a paying agent system. Under suchsystem, paying agents in Switzerland would have been required to deductSwiss withholding tax at a rate of 35% on any payment of interest on anybond (not only on bonds issued by issuers resident in Switzerland) to abeneficiary resident in Switzerland (subject to certain exceptions). Theinternational disadvantage of Swiss withholding tax imposed on the issuerwould have fallen away. However, the proposed law has been repealedrecently for technical and political reasons. There is, therefore, no easymid-term solution available to Swiss issuers for issuing covered bondsinternationally. Whether more flexibility could be achieved by using arepacking vehicle remains to be seen.

Repack structure

Securednoteholders

(Secured noteholders)

Loan notes

Proceeds

Security

Multi issurance vehicle(eg Dublin)

Loan notes

Proceeds

Swiss issuer

Security assignment ofclaims under loan notes infavour of securednoteholders


SWITZERLAND

About the authorDieter Grünblatt focuses on the tax structuring of national andinternational capital market transactions, collective investment schemes,real-estate investments, structured financial instruments, private equityand fund management structures. He designs acquisitions andreorganisations and advises on employee stock option plans, pensionplans and social security taxes and VAT. Grünblatt regularly contributesto publications on tax-related topics.

Grünblatt joined Homburger in 1997 and has been a partner since2005. He graduated from the University of Basel School of Law in1989. He holds a doctorate (Dr iur) in law from the University of Basel(1994) and an LLM from New York University, where he completedpostgraduate studies with a focus on corporate finance and corporatetax law in autumn 1997. He was admitted to the Baselland Bar in 1996and to the New York Bar in 1998. He has been a certified tax expertsince 2000.

Dieter GrünblattPartner, Homburger

Zurich, SwitzerlandT: +41 43 222 16 20F: +41 43 222 15 00E: [email protected]: www.homburger.ch

About the authorStefan Kramer’s practice focuses on capital markets and banking law. Heregularly advises on asset-based financings (covered bonds andsecuritisations), banking regulation (including regulatory capitaltransactions) and derivatives markets regulations. Other areas of workinclude insolvency law and financial markets infrastructures. He haswritten various books and articles on financial services regulation and isa co-editor of the Commentary on the Swiss Banking Act. Kramer isadmitted to the Swiss bar, holds a doctorate from the University ofZurich (2005) and an LLM from Harvard Law School (2010).

Stefan KramerAssociate, Homburger


About the authorBenedikt Maurenbrecher’s practice focuses on banking, finance andcapital markets. He is experienced in a broad range of transactions,notably in the areas of equity capital markets, secured and unsecuredlending, covered bonds, securitisation and derivatives. He is anauthorised issuers’ representative at the SIX Swiss Exchange.Maurenbrecher also advises on domestic and cross-border aspects ofbanking, securities and investment fund regulation, and regularlyrepresents market participants in related regulatory proceedings andcivil litigation. He is a member of the banking committee and thesecurities committee of the International Bar Association, and heads thebanking committee’s sub-committee on opinions in legal transactions.

Benedikt MaurenbrecherPartner, Homburger


I ncreasingly, we receive questions from prospective investors in cov-ered bonds on whether an investment is prohibited or limited underthe Volcker Rule, which was adopted by the various agencies under

section 619 of the Dodd-Frank Wall Street Reform and ConsumerProtection Act of 2010. The answer is relevant to US bank investors in cov-ered bonds as Volcker Rule restrictions apply directly to US banks, includ-ing US branches and agencies of foreign banks. However, the answer mayalso be relevant to other investors in covered bonds, particularly in dollar-denominated covered bonds, because the answer will affect the secondarymarket liquidity in the bonds.

The best response to this market concern is for issuers of covered bondsto develop a practice of expressly stating in their prospectuses whether aninvestment in their covered bonds is restricted under the Volcker Rule.Until including such a statement becomes a widespread practice, an analy-sis of the status of the issuer under the Investment Company Act of 1940,as amended (Investment Company Act) and the terms of the coveredbonds will be necessary.

The Volcker Rule was designed to prevent or limit bank investments inhedge funds and private equity funds. By its terms, the Volcker Rule pro-hibits or limits a bank from holding an ownership interest in a coveredfund. A covered fund is defined under the Volcker Rule as any entity thatrelies on section 3(c)(1) or 3(c)(7) of the Investment Company Act for anexemption from the requirement to register as an investment companyunder the Investment Company Act because those are exemptions com-

monly used by hedge funds and private equity funds. Unfortunately, thoseexemptions are also used by many other types of entities, including somecovered bond issuers and many asset-backed issuers.

Therefore, in technical terms, the question is whether an investment ina covered bond constitutes an ‘ownership interest’ in a non-exempt ‘cov-ered fund’ as such terms are defined in the Volcker Rule.

Covered bonds may be issued in a one-tier structure, such asPfandbriefe, or a two-tier structure, such as UK or Canadian coveredbonds. The analysis is similar for both structures, except that in a two-tierstructure, both the bond and the guarantee are considered securities for USsecurities law purposes and therefore the status of both entities under theInvestment Company Act must be analysed.

Generally, an entity that doesn’t declare itself to be primarily engaged inthe business of investing, reinvesting or trading in securities is not subjectto the Investment Company Act unless more than 40% of its assets con-sist of investment securities and the entity issues securities. The InvestmentCompany Act definition of an investment security is quite broad andincludes essentially all securities (except US government securities andsecurities of majority-owned subsidiaries), loans, mortgage loans, leases,and various other receivables. If an issuer held more than 40% of its assetsin investment securities, it could look to one of several exemptions fromthe requirement to register under the Investment Company. The followingare some relevant exemptions from registration under the Investment


US COVERED BONDS SPECIAL FOCUS

A user’s guide to Volcker Rule complexities

Jerry Marlatt and Melissa Beck of Morrison & Foerster offer a practical guide to VolckerRule considerations for covered bond investors

Company Act:

• Section 3(c)(1) – which limits holders of the securities (other thanshort-term securities) to not more than 100 persons;

• Section 3(c)(5) – which is limited to an issuer that is not engaged in thebusiness of issuing securities redeemable at the discretion of the holdersand which is engaged in the business of purchasing, acquiring or mak-ing specified types of loans (including, in some cases, real-estate loans);

• Section 3(c)(7) – which requires all of the holders of the securities ofthe issuer to be qualified purchasers (as defined under the Act);

• Rule 3a-6 – which exempts from the requirement to register under theInvestment Company Act any foreign bank or foreign insurance com-pany that is regulated as such by its home jurisdiction; or

• Rule 3a-7 – which is limited to issuers that do not issue redeemablesecurities, that issue securities rated in one of the four highest categoriesby a rating agency, that is engaged in the business of holding financialassets, and that does not acquire or dispose of financial assets for theprimary purpose of recognising gains or decreasing losses resulting frommarket value changes.

If an issuer of covered bonds is deemed to be a covered fund becausesection 3(c)(1) or 3(c)(7) is the only exemption available to it, then invest-ment in the covered bonds by a US bank would be prohibited or limitedunder the Volcker Rule unless: (a) the covered fund fell within one of theVolcker Rule covered fund exclusions; or (b) the investment in the coveredbonds did not represent an ‘ownership interest’ in the covered fund asdefined in the Volcker Rule.

While the Volcker Rule analysis by an issuer of securities can be a rela-tively straightforward process, for a prospective investor, particularly in thesecondary market, the analysis can be complex and may not lead to a clearconclusion. The investor’s analysis is typically limited to the information inthe prospectus, and the prospectus may not provide enough informationto make a clear determination of the status of the issuer and the coveredbonds under the Volcker Rule. The task can be more difficult with non-US issuers because if they were not contemplating issuing securities intothe US, they may have given no consideration to their status under theInvestment Company Act and the prospectus may be devoid of helpfulclues.

The analysis of a covered bond under the Volcker Rule may take sever-al different routes. We suggest the following three-step approach as wethink it may be the most efficient.

Initial covered fund reviewThe first step would be to determine whether the issuer is a covered fund oran exempt covered fund. Trying to determine which Investment CompanyAct exemption an issuer relied upon can be a time-consuming process, butthere are a few facts that can be quickly determined that could eliminatethe possibility that section 3(c)(1) or 3(c)(7) was the only exemptionavailable for the issuer to rely upon.

Publicly-registered or public issuerIf the covered bonds were issued in a public offering (an offering registeredwith the SEC) or by an issuer with outstanding SEC-registered securities,the covered bonds could not have been issued by an entity relying onsections 3(c)(1) or 3(c)(7) as those sections are applicable only for issuers ofsecurities who are not making and do not at that time propose to make apublic offering of its securities. Accordingly, if the covered bonds were issuedin a public offering or by an issuer with SEC-registered securitiesoutstanding, no further analysis is required as the issuer must have reliedon another exemption and that would take the issuer and the covered bondsoutside the scope of the Volcker Rule. If the issuer has issued SEC registered

securities, the issuer must be: (i) a registered investment company; (ii) acompany not subject to registration under the Investment Company Act; or(iii) exempt from registration other than under section 3(c)(1) or 3(c)(7).

Express exemptionIf the covered bonds were not issued in a US public offering (issued in aprivate offering or non-US offering), sometimes the prospectus will specifywhat section of the Investment Company Act the issuer relied upon for anexemption. If a section other than sections 3(c)(1) or 3(c)(7) is specified, nofurther analysis is required, as the covered bonds will be outside the scope

of the Volcker Rule and investment in the covered bonds will not be subjectto restriction under the Volcker Rule.

Section 3(c)(5) exemptionIf there is no specific reference to the section of the Investment CompanyAct relied upon by the issuer, it may be possible to determine whethersection 3(c)(5) of the Investment Company Act may be available in orderto rule out the need to rely on sections 3(c)(1) or 3(c)(7). If the offeringdocuments for the covered bonds list the assets held by the issuer, you maybe able to determine if section 3(c)(5) is an available exemption. Asdescribed above, section 3(c)(5) provides an exemption from registrationrequirements of the Investment Company Act for an issuer that is notengaged in the business of issuing redeemable securities, and that is primarilyengaged in the business of purchasing or making various types of specifiedloans. Section 3(c)(5)(C) is most often the exemption available to coveredbond issuers because it provides an exemption for an issuer who has at least55% of its assets consisting of interests in real estate, including residentialor commercial mortgage loans. At least 25% of the remaining assets mustbe real estate-related assets. Note that securitised mortgage loans would notbe qualifying interests in real estate for section 3(c)(5)(C). A periodicinvestor report may be helpful in determining the issuer’s assets.

If the issuer’s assets satisfy the section 3(c)(5)(C) requirement, the issuerwould not be a covered fund under the Volcker Rule and an investment inits covered bonds would not be subject to restriction under the VolckerRule.

Rule 3a-6 exemptionRule 3a-6 provides that a foreign bank or foreign insurance company is notan investment company if it is regulated as such in its home jurisdictionand is engaged substantially in commercial banking activity or writinginsurance agreements or reinsurance of such agreements.

An issuer that qualified to rely on Rule 3a-6 would not be a coveredfund under the Volcker Rule and its covered bonds would not be subjectto restriction under the Volcker Rule.

Loan securitisation exclusionIn the event the issuer does not qualify for an exclusion from the definitionof a covered fund, the loan securitisation exclusion provided in the VolckerRule should be examined to determine if it would be applicable to the issuer


US

“The Volcker Rule wasdesigned to prevent or limitbank investments in hedge

funds or private equity funds

of the covered bonds. To qualify under the loan securitisation exclusion, anissuer must issue covered bonds backed solely by: (i) loans; (ii) rights orother assets designed to assure the servicing or timely distribution ofproceeds to covered bondholders and rights or other assets related orincidental to purchasing or otherwise acquiring and holding the loans; and(iii) interest rate or foreign exchange derivatives that directly relate to thepermitted assets of the issuer so long as they reduce interest rate or foreignexchange risks related to the assets of the issuer. The following are expresslyprohibited as permitted servicing or incidental assets: (a) any security otherthan cash equivalents or securities received in lieu of debts previouslycontracted with respect to the permitted loans; (b) any derivative (otherthan interest rate or currency derivatives described above); and (iii) anycommodity forward contract.

If the issuer of covered bonds satisfied the loan securitisation exclusion,the issuer would not be a covered fund under the Volcker Rule even if itexpressly relied on section 3(c)(1) or 3(c)(7) and investment in the coveredbonds would not be restricted under the Volcker Rule.

The qualified covered bond exclusionThe Volcker Rule excludes from the definition of covered fund an issuerand a guarantor of covered bonds if one of the entities is a foreign bankingorganisation (as defined in the Volcker Rule) and the cover pool consistssolely of assets that qualify under the loan securitisation exclusion. Thisexclusion expressly requires a two-tier structure.

If the qualifying covered bond exclusion applies, neither of the issuernor the guarantor would be a covered fund under the Volcker Rule even ifone of them expressly relied on section 3(c)(1) or 3(c)(7), and the coveredbonds of such an issuer would not be restricted under the Volcker Rule.

Review of restrictive legendsFinally, you may review the offering or transferring restriction in theprospectus to determine if section 3(c)(1) or 3(c)(7) were relied upon bythe issuer when the covered bonds were issued. If an issuer relied on section3(c)(1) or section 3(c)(7), the restrictive legends will restrict initial offersand transfers in unique ways. Offers and transfer will be limited so that atno time will there be more than 100 holders if section 3(c)(1) was reliedon. Offers and transfers will be limited to qualified purchasers (QPs) asdefined in the Investment Company Act if section 3(c)(7) was relied on. Ifneither of these two restrictions appears in the legend, then the issuer maynot be a covered fund. If the legends, for example, include typical Rule 144Aoffering and transfer restriction it is fair to conclude that the issuercontemplated a US offering and did not include the restrictions requiredby section 3(c)(1) or 3(c)(7) because it did not need to rely on one of thoseexemptions. However, if a non-US issuer did not contemplate offeringcovered bonds in the US, it may not have conducted an InvestmentCompany Act analysis.

If there are express indications that the issuer contemplated a US offer-ing or otherwise expressly contemplated transfers to US person and did notinclude the restrictions required by section 3(c)(1) or 3(c)(7), it may bereasonable to conclude that the issuer is not a covered fund under the

Volcker Rule, and an investment in the covered bonds is not subject to theVolcker Rule.

If, after this initial review, it is still not clear whether the issuer is exemptfrom the covered fund definition, we suggest switching to an analysis todetermine whether the covered bonds may constitute an ownership inter-est.

Ownership interestAn ownership interest is defined in the Volcker Rule as any equity,partnership or similar interest. The Volcker Rule provides that a similarinterest means an interest that: (i) has the right (other than in an event ofdefault) to select or remove a general partner, managing member, memberof the board of directors or trustees, investment manager, investment adviseror commodity trading adviser; (ii) has a right to receive a share of the incomeor profits; (iii) has the right (other than in an event of default) to receive theunderlying assets when senior interests have been paid; (iv) has the right toreceive all or a portion of the excess spread; (v) provides that interest to bepaid on the securities may be reduced based on losses on the underlyingassets; (vi) receives income on a pass-through basis or has a rate of return thatis based on the performance of the underlying assets; or (vii) has anysynthetic right to any of the foregoing. If the securities have none of therights listed above, the securities will not constitute ownership interests forpurposes of the Volcker Rule.

For most covered bonds, the covered bonds will not have any of theseven enumerated rights that meet any of the criteria of ownership inter-est. Care must be taken, however, to evaluate both the terms and condi-tions of the bonds and any rights available to bondholders under agree-ments related to the issuance of the bonds and, in particular, in a trust deedor bond indenture. Although the complete terms of the agreements maynot be readily available to investors, if any of the seven enumerated rightswere made available to investors, it seems very unlikely that the issuerwould fail to disclose such significant rights in the prospectus.

Covered bonds that meet any of the seven elements in the second pre-ceding paragraph should be examined in detail for a determination ofwhether they constitute an ownership interest in a covered fund. Withrespect to the covered bondholders’ right to select or remove a general part-ner, managing member, member of the board of directors or trustees,investment manager, investment adviser or commodity trading adviser, theanalysis should focus on the type of role such entity plays with respect tothe cover pool, and under what circumstances the covered bondholders canexercise such control. Management changes as a result of events of defaultare treated differently from management changes at the option of the hold-ers. Removal of an asset manager that controls assets of the issuer andwhose actions and decisions impact the financial health of the issuer areviewed differently from removal of a covered bond indenture trustee whoserole is limited to administrative functions enumerated in a trust agreementor similar document.

With respect to interest payments reduced based on losses of underly-ing assets, it is unclear if the mere inclusion of that provision in the cov-ered bond is enough to constitute a ‘similar interest’. For example, theholders of covered bonds will usually not have their interest paymentsreduced as a result of realised losses in the cover pool as described in (v)above because, first, the bonds are obligations of the issuer and, second,there is significant over-collateralisation to address that risk. Only if theissuer becomes insolvent and there are significant losses in the cover poolwould the conditions arise where interest payments might be reduced. Butwhen those conditions arise, typically all outstanding covered bonds areaccelerated and paid out pari passu. If they sustain losses, it is due to thesame risk of loss that any secured senior debt holder is subject to and not


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“The Volcker Rule analysis canbe complex and may not leadto a clear conclusion

similar to the risks taken by an equity holder. While the Volcker Rule doesnot address a covered bond in this context, the losses that a covered bondmay be exposed to should not be viewed as the type of loss contemplatedby (v) above.

Only if covered bonds are issued by an entity with no capitalisationother than the cover pool assets should losses on the bonds qualify as thelosses contemplated by (v) above. Given the breadth of the definition ofownership interest, only covered bonds that exhibit specific characteristicsof equity (such as participation in profits or losses or the right to select orremove a person with investment discretion) should qualify such coveredbonds as an ownership interest. Although the regulators promulgating theVolcker Rule used some general examples in an attempt to provide claritywith respect to certain securitisation structures and provisions in the finalrule and related release, it is not clear how much weight should be given toeach characteristic in the absence of regulatory or judicial guidance. Assuch, if it is determined that the covered bonds are ownership interests (orit cannot be determined with certainty that they do not constitute owner-ship interests) the analysis should shift back to the nature of the issuer andwhether the issuer constitutes a covered fund.

Rule 3a-7 reviewIf an initial covered fund review is not dispositive and the covered bonds inquestion have (or may have) one or more characteristics of an ownershipinterest, then, in the event that the covered bonds in question are: (i) ratedone of the four highest categories assigned to long-term debt; or (ii) the salesof such covered bonds are limited to accredited investors or qualifiedinstitutional buyers (each as defined under the Securities Act of 1933, asamended), then such covered bonds should be analysed to determine if theissuer may qualify for a Rule 3a-7 exemption. This section provides anoutline of Rule 3a-7 requirements. The definitive Rule 3a-7 may be foundat 17 CFR 270.3a-7.

In the event of the insolvency of a covered bond issuer, the covered poolassets are the only source of cash flow available to make payments to hold-ers, similar to a securitisation, which would satisfy the first prong of theRule 3a-7 test. The covered bonds are reliant on the cash flows from thecover pool to make such payments on the covered bonds, and the coverpool assets are assets that automatically convert to cash within a finite peri-od of time, satisfying the definition of financial asset under Rule 3a-7.

With respect to the ratings requirement at the time of initial offering, areview of the prospectus may confirm if such requirement is met. If the

covered bonds are not rated in one of the four highest rating categoriesassigned to long-term debt, the exemption under Rule 3a-7 could still beavailable if sales of the covered bonds are limited to accredited investors orqualified institutional buyers. This limitation should be apparent in thesale and transfer restriction legend in the prospectus.

Rule 3a-7 places restrictions on the purchase and disposal of issuerassets. Such actions may only be taken in if the following conditions aremet: (i) the action is taken in accordance with transaction terms or condi-tions set out in applicable transaction documents; (ii) the action does notresult in a ratings downgrade of the issuer’s securities; and (iii) the assets arenot purchased or sold for the primary purpose of realising a gain ordecreasing a loss in market value. A review of the prospectus and transac-tion agreements should disclose whether assets may be purchased or soldto realise a gain or decrease a loss in market value. Usually the trustee orasset manager is restricted in its ability to purchase or sell assets except asexpressly set out in the applicable transaction agreements.

With respect to the requirement relating to the appointment of atrustee, the identity of the trustee should be disclosed in the prospectus.Note that under Rule 3a-7 the trustee must be a US bank and meet cer-tain minimum financial requirements. Unfortunately, many non-USissuers may not use a US bank as trustee.

Most covered bonds are issued under a trust deed, bond indenture orsimilar instrument that provides that the entity holding the cover poolassets has a fiduciary relationship with bondholders. The trustee must havea perfected security interest in the cover pool assets or a similar interest inthe assets under the laws of the home jurisdiction of the issuer.

If the Rule 3a-7 exemption is applicable, then the covered bond issuerwill not be a covered fund under the Volcker Rule and therefore an invest-ment in the covered bonds of the issuer will not be restricted under theVolcker Rule.

If the Rule 3a-7 exemption is not applicable, then the covered bondissuer in question may be a covered fund under the Volcker Rule, and thecovered bonds may constitute an ownership interest in a covered fundunder the Volcker Rule, and be prohibited or limited investments underthe Volcker Rule. In this case, a prospective investor can only resort to con-tacting the dealer for the covered bonds or contacting the issuer directly forassistance in determining whether the covered bonds are impermissibleownership interests in a covered fund.


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About the authorJerry Marlatt is senior of counsel in the capital markets group ofMorrison & Foerster. He represents issuers, underwriters andplacement agents in public and private offerings of debt, covered bonds,surplus notes, securities of structured investment and specialisedoperating vehicles, and securities re-packagings.

Marlatt is co-author of Considerations for Foreign Banks Financing inthe US, published by International Financial Law Review (2012,updated 2014), a contributor to Covered Bonds Handbook, publishedby Practising Law Institute (2010, updated 2012-2014) and a chartermember of the United States Covered Bonds Council. He was namedDealmaker of the Year in 2013 by The American Lawyer for his work asissuer's counsel on the first covered bond deal ever registered with theSecurities and Exchange Commission.

Jerry MarlattSenior of counselMorrison & Foerster

New YorkT: +1 (212) 468-8024E: [email protected]: www.mofo.com


COVERED BONDS SPECIAL FOCUS GLOBAL ISSUANCE BREAKDOWN


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