Structured Finance in Brief

Updates and Analysis on current structured finance issues, upcoming events and activities of Reed Smith’s structured finance group

STOP PRESS – CMBS IS TRENDY

Following the onset of the financial crisis in 2007, any mention of ‘commercial mortgage backed securities’ or ‘CMBS’ was regarded as a dirty word and at one point the term was destined to face certain extinction.  Seven years on, several issuances later and following a prolonged upswing in financial market sentiment, not only is the term CMBS back in favour but it is also positively trending.  The upcoming issuance of £750 million of CMBS notes secured by the Westfield Stratford City shopping centre will not only be a defining point for CMBS issuance in 2014, but can also be considered a key step forward towards the re-establishment of CMBS as an essential funding tool for commercial real estate (CRE).

At the end of 2013, many commentators were estimating that CMBS issuance for 2014 would be in the realm of €10-15 billion.  Assuming that Deutsche Bank and Credit Agricole CIB can successfully launch the Westfield transaction, then CMBS issuance for 2014 will sit at just under €11 billion and therefore exceed the lower realm of this €10-15 billion estimate.  As industry participants head off on their summer breaks, there should be a level of euphoria that the CRE industry will have already surpassed the total issuance for 2013 (€8.7 billion) with  a number of months of the year still to run.  With rumours of further deals in the pipeline, there is every chance that 2014 could be regarded as a bumper year for the CMBS asset class.

Although the numbers are encouraging and certainly demonstrate that CMBS has a seat at the European CRE financing table, one of the most striking things about the re-emergence of a European CMBS market has got to be the dominance of various trends, which at times have dwarfed some of the more compelling stories in the market.

Following Deutsche Bank’s €754 million Florentia multifamily issuance at the end of 2012, multifamily transactions came to dominate in 2013, with mega issuances by issuers such as Taurus 2013-1’s €1 billion note issue and GRF 2013-1’s €4.3 billion note issue. Although these deals have given the CMBS asset class a much needed boost, on account of the fact that the payment streams for such notes primarily stem from individuals funding their private residences, the classification of such properties as true commercial real estate has always been questionable.

Against the backdrop of multifamily transactions, there were two CMBS issuances that can be regarded as hugely significant as they ushered in a new era for CMBS 2.0.  Firstly, there was the eagerly awaited Debussy transaction, a CMBS secured by a number of Toys r’Us stores with a CMBS structure that is notable for containing a number of industry firsts.  However the most significant feature of the Debussy structure is that it in effect created a blueprint by which shadow banks, such as investment funds, can provide CRE bridge financing to a borrower and then exit this position through the issuance of CMBS notes.  The other noteworthy transaction for 2013 was Goldman Sachs widening the CMBS 2.0 geographical net with the issuance by Gallerie 2013 srl of €363 million CMBS notes secured by Italian retail property.  A primary driver for such an issuance was attributable to the fact that domestic regulations in Italy require institutions purchasing syndicated loans to have a banking licence, CMBS overcomes this restriction and provides a financing tool which expands the potential universe of investors.

Off the back of the Gallerie 2013 srl issue, the Italian CMBS trend continued into 2014 with the issuance of €355 million notes by Deco 2014 – Gondola and €198.2 million notes issued by Moda 2014 Srl.  Although maybe not the highest profile deal of the year, but certainly one of the more exciting developments in the industry, has been the issuance by Taurus 2014-1 of £211,500 of CMBS notes secured by properties that have been acquired through the enforcement of defaulted loans.  As a result of the Taurus deal, the market has given a clear nod to the CRE finance industry that CMBS should not be confined to prime commercial real estate.  In stark contrast, with the imminent issuance of the £750 million Westfield CMBS notes, the market has also shown that there is also appetite for mega issuances of CMBS paper secured by a single prime retail property.

Given the lumpy nature of the market, it is difficult to put too much emphasis on the presence of the multifamily and Italian trends however given that there can be said to be trends at all, then this has to be regarded as an industry positive.  At the height of the financial crisis, the CMBS product was subject to intense scrutiny and its role (if any) in financing European commercial real estate was frequently questioned with many commentators reaching the view that CMBS as a funding tool would only ever be used to fund core real estate in prime locations.  Transactions such as those mentioned above clearly demonstrate that not only is the CMBS term not extinct but that CMBS is a versatile funding tool that has a greater role to play for financing commercial real estate than many commentators first predicted or in some cases ever hoped for.

Clash of the Titan 2007-1 (Part III): Controversy Thunders On

Previously in Clash of the Titan 2007-1: Zeus has spoken, we took a brief look at the judgment delivered by Richard Snowden QC.  Another interesting aspect of the case which is beginning to generate commentary is that one of the other pre-conditions to the replacement of the Special Servicer is that the successor Special Servicer “has experience in servicing mortgages of commercial property on similar terms to that required under this Agreement and is approved by the Issuer and the Note Trustee (such approval in each case not to be unreasonably withheld)”.

On this point, the court found that the above clause contains two separate and distinct requirements, each of which must be satisfied before the termination of appointment of the Special Servicer can take effect – (i) the experience of the successor Special Servicer and (ii) the approval by the Issuer/Note Trustee.

Snowden QC confirmed that “given the importance of the role of Special Servicer, there is every reason why that parties should have intended that there should be a proper check on the suitability of the Special Servicer for the task; past experience is one, but only one, of the obvious factors that might be relevant in that regard”.  He has, it seems, implied that the Note Trustee and the Issuer should have significant involvement in the effectiveness of that check.

However, that leaves the question, in deciding whether or not to approve a replacement Special Servicer, how might a Note Trustee exercise this discretion?

Snowden QC gave a few examples of grounds on which the Note Trustee or the Issuer might withhold its approval, which include if the Special Servicer was “for example, incompetent, insolvent or in serious financial or regulatory difficulties, subject to the proviso that such judgment should not be unreasonable… Beyond those examples, I do not think it would be sensible or appropriate for me to attempt to elaborate, on a hypothetical basis, any other factors that the Issuer or Note Trustee might take into account in the exercise of their discretion…  Questions of the proper exercise of a discretion are always highly fact-sensitive, and I am simply not in any position to form any view upon whether, and if so how, the Note Trustee might take into account factors such as whether a proposed successor might adopt a strategy which favoured one group of Noteholders over another.”

We expect the answer to be that the Note Trustee might refuse to exercise its discretion, as it will normally have a right to do so.  However, given that many transactions contain language such that the approval “is not to be unreasonably withheld or delayed”, would it be reasonable for a Note Trustee to withhold its approval without first investigating the relevant considerations?  The Note Trustee will need some considerable time to evaluate its position depending on the circumstances at hand, which at the very least might delay the process of replacement.  There is also a danger to proposed successors of interference from incumbent Special Servicers who might have views on their competitor’s ability to replace them in the role, which might descend into a slanging match and create more nervousness amongst Trustees.

The CMBS 2.0 guidelines we think provide useful insight into the Trustees role.  They state – “The role of the trustee should be limited to oversight of mechanical process and passive monitoring of prescribed objective criteria. CMBS transactions should be structured so that trustees are generally not required to exercise any discretion …”.   This is slightly at odds with the implication in the Titan case that the Note Trustee will have to consider the suitability of the replacement in quite the level suggested in the judgment.  Rest assured, in any event, Trustees will proceed with caution and justifiably so.

Whilst the Titan judgment appeared to have taken away the Fitch RACs roadblock (at least for some transactions with documentation similar to the Titan case), an unintended effect of this would be to potentially provide Class A noteholders with a veto in many deals where Trustees would be unable or unwilling to make a commercial judgment on the suitability of the Special Servicer replacement.  Where Trustees exercise their rights to take instructions from the noteholders on behalf of whom they act, the Special Servicer replacement process (although initiated by the junior noteholders) could ultimately result in the trustees turning to the senior noteholders for their approval, directions and indemnification.

For the incumbent Special Servicer, this judgment brings mixed reactions – bad news for those Special Servicers wishing hide behind Fitch’s unwillingness to provide RACs to frustrate any replacement process but good news for those who think that requiring the Note Trustee to exercise its discretion to approve the replacement Special Servicer will cause even more delays to the replacement process.

Whilst a potential replacement Special Servicer might have expected to be appointed by the Issuer or the Trustee as part of the replacement process, they might not have envisaged the extent to which their activities and experience would be put under scrutiny by the Issuer and/or Trustee, given the comments made by Snowden QC in the Titan case.  It seems it is no longer sufficient that a replacement Special Servicer need to exhibit the relevant experience in servicing commercial mortgage loans, if the replacement provisions in the Servicing Agreement are similar to this case, approval of the appointment of the successor Special Servicer needs much more detailed consideration by the Issuer and the Note Trustee, which in turn might mean replacement Special Servicers providing more information about their business and/or intentions for servicing the relevant loans and having to justify their appointment.  Would this put off certain potential replacement Special Servicers from going into this market – having to perform an already difficult task of maximising recoveries on a loan which may have suffered due to poor decisions in the past and also having to justify why they are so suited to perform that role?

So it is possible that the real consequences of this case – which so many in the market hoped would clarify once and for all the issues with respect to replacement of Special Servicers – might be to make Special Servicer replacement even more difficult and protracted.  Perhaps the final word should come, not from Zeus’ but his lesser known first wife, Metis (who presided over wisdom and knowledge).  Perhaps Metis might have extolled the benefits of a free market and competition…

Clash of the Titan 2007-1 (Part II): Zeus has spoken

Well, maybe not Zeus but Richard Snowden QC no less.  On Valentine’s Day this year, we published our blog entitled “Clash of the Titan 2007-1”. Now that the red roses have wilted, the champagne drunk and the chocolates eaten, let us take a look at what the first instance decision in Titan Europe 2007-1 (NHP) has to say about replacing special servicers in European securitisation deals.

In providing directions to the trustee, Richard Snowden QC considered two important issues: Who is the Controlling Party entitled to serve notice under the Servicing Agreement to require the termination of the appointment of the Special Servicer?  What happens if the Servicing Agreement dictates that RACs are required as a pre-condition to the replacement of the Special Servicer but the condition could not be satisfied due to a rating agency declining to provide RACs as a matter of policy?

The “Controlling Party” is typically the party exposed to the first loss position on the structure i.e. either the B-piece lender or if value breaks in the securitised portion, the most junior class of noteholders, i.e. the “Controlling Class”.

The critical issue with this case was that the offering circular and the transaction documents seemed to contradict each other as to whether the Controlling Party was the Issuer or the representative of the Controlling Class.  The court came to the conclusion that the Servicing Agreement (being the contractual document) trumps the Offering Circular (which whilst informative, was not binding).  The judge applied the rules of interpretation of contract and broadly concluded that if the meaning of the contract was unambiguous then that must have been the intended effect of the parties which led to some very unintended consequences such as unwittingly putting the Issuer (a special purpose vehicle with no skin in the game) in the driving seat as the “Controlling Party”.  Is it commercially right for the judge to instate the Issuer as the Controlling Party when the economic interests in the transaction are held by the Noteholders (and the Controlling Class Representative their supposed spokesperson)?  One of the supporting arguments put forward was that the Issuer had assigned its contractual rights to the Note Trustee and therefore as the benefit of the rights given to the Issuer were capable of exercise by the Note Trustee (in the interests of Noteholders), there was nothing commercially absurd about the Issuer being the Controlling Party.  What follows quite unhelpfully is that Snowden left it to the parties to figure it all out, declaring:

But whilst there would appear to be a need for the Issuer and Note Trustee to consider how such matters might work out between them in practice, [he] did not understand [counsel for the Note Trustee contended that it] would be impossible or commercially unworkable..

In doing so, he leaves open some issues that could impede this CMBS transaction in a manner that might not have been intended.  Instead of bringing the Servicer closer to the ultimate investor and increasing the level of transparency and accountability, we end up rekindling the classic love triangle between the Servicer/Special Servicer, the Issuer and the Trustee borne from the contractual burdens that restrict them.  Whether or not this will have an impact on the investors is yet to be seen.

The court also referred to the Fitch announcement whereby Fitch announced that it would not, as a matter of policy, provide RACs during the replacement of special servicers on EMEA CMBS transactions (see our last blog entitled “What the Fitch??!”).

Whilst the Titan Servicing Agreement required RACs confirming that the termination and/or replacement of the Special Servicer would not cause a ratings downgrade, the Servicing Agreement also provided that, admittedly in another circumstance, if a Rating Agency declines to issue such a confirmation then the relevant provision shall be read and construed as though written confirmation from the Rating Agency declining to issue the confirmation was not required.

On this matter, the court gave the example that if a Rating Agency were simply to stop issuing rating confirmations altogether, then the Special Servicer could not even validly terminate its own appointment no matter that both of the other Ratings Agencies might be willing to give such confirmations, which would not make commercial sense.  In conclusion, Fitch’s policy not to issue Rating Agency Confirmations should not prevent otherwise valid replacement attempts in situations consistent with the Titan, so long as the other requirements are satisfied.  We’ll touch on one of those “other requirements” which is rather controversial in the next blog.

For now, Zeus has spoken and it was indeed an interesting address from Mount Olympus.  However, as the Representative of the E Class Notes has been granted leave to appeal, those may not be the parting last words… See Clash of the Titan 2007-1 (Part III) for a view as to what this judgment means to the various parties in a securitisation of this type and some of the practical issues thrown up by the Titan judgment.

Back(loading) to the Future – the Nuances of EMIR Transaction Reporting Requirements

It’s been barely six weeks since the EMIR trade reporting obligations came into effect on 12 February and, as the regulatory dust begins to settle, parties to derivative transactions are still in the process of assessing their duties under the new regime.  In the lead up to the February deadline, bank and securities firms were busy implementing their client outreach programmes whilst we were busy putting out client alerts and blogging about the new requirements under EMIR.  We continue to help clients with their questions on this significant change to the EU regulatory landscape.

Two aspects of the new trade reporting regime in particular repay some close attention to avoid potential trip-ups.  First, the rules relating to what has been termed ‘backloading’, or, in other words, the requirement to transaction report historic trades.  After some uncertainty in the lead up to implementation, the requirements are now clearer.  Broadly, counterparties need to ensure that all historic trades that were either ‘live’ on 12 August 2012 (the date EMIR came into force), or subsequently became live prior to 12 February 2014 (the date the reporting requirements came into force), are reported.  For these trades, the deadline for reporting will range from just one day to a period of three years after the reporting obligations became effective, depending on the date of the trade and, if applicable, its termination date.  Our client alert sets out these timeframes in more detail.

The second aspect worth paying attention to is how the transaction reporting regime applies to modifications of existing derivative contracts.  In outline, EMIR makes any amendment or variation to an existing trade potentially reportable and the time frame to do so is stringent, requiring reporting within 1 working day.  Precisely what a ‘modification’ looks like has not been spelled out in the regulation and will vary between transactions.  However, it is possible that changes made to any of the reportable information for a transaction, which can be up to 80 data items, could be caught.  As many existing structured finance and securitisation deals continue through the restructuring process, changes to hedging swaps can easily be caught by this requirement and transaction reporting can easily be forgotten in the excitement of the signing and closing process.  A place holder in the signing and closing agenda can be a useful aide memoire.

After the initial rush to meet the February deadline, the questions about the new reporting rules will continue for a while longer.  ESMA have, for example, just confirmed in their latest set of Q&As issued on 20 March that the ‘backloading’ obligations will still apply to transaction counterparties that have been liquidated or become insolvent, albeit the obligation rolls to any entity that assumes their obligations.  Expect the questions to continue!

NPLs – Car Boot Sale!

Time for a spring clean?

Institutions holding non-performing loans (“NPLs”) have been and continue to be, under increasing pressure to divest these and “clean up” their balance sheets in order to free up capital, de-risk and preserve market reputation. Usually, a loan facility becomes non-performing when either payments of principal and interest are past due by 90 days or more, or where payments are less than 90 days overdue, it is expected that payments will not be made in full. Alternatively, other loans can also be regarded as non-performing if they are value impaired (e.g. if the borrower has breached key covenants in its facility or if repayment terms have been altered).

Where a borrower is in financial trouble, it may first look to a lender for restructuring options such as extending its facility, foregoing interest payments or deferring repayments. From a bank’s point of view, holding on to NPLs causes a real issue since they increase a bank’s management costs, with frequent analysis required to monitor the financial position of the borrower and its underlying assets. There are also broader repercussions to consider given that NPLs may tend to limit a bank’s ability to lend. It also potentially drives up interest rate margins thereby creating uncertainty. Divesting NPL portfolios at a discount benefits banks who recoup some value, gain liquidity and distance themselves from the risk factors associated with holding onto distressed assets, such as a potential downgrades in its credit rating or a greater chance of bank insolvency.

Why take on a bad apple?

The reasons for investing into NPL portfolios are varied and divergent. Some may look to sell the loans on the secondary market for a quick profit, others, with management expertise who see potential for improvement in the portfolios and/or future economic factors may hold out for a recovery in its value. There are also some institutions who will buy enough distressed debt to have an influence in the borrower’s restructuring options or insolvency so as to be well placed to acquire control of the company thereby benefiting from profits and value in the business itself.

Buying and selling the loan portfolio

The process of selling a loan portfolio is not always straightforward and is often an expensive exercise (but well worth it if the intention is to gain real risk transfer and capital release). The transaction starts with what may be a lengthy due diligence process on the loans and its underlying security (often replete with incomplete documentation, spread across multiple jurisdictions and involving multiple counsels).

There may also be various loan level issues to tackle which provide impediments to transfer. Potential issues include:

  1. a borrower’s consent may be required to transfer;
  2. security packages may include collateral which is not supported by adequate registration evidence required to show that the seller has a right over the collateral and the subsequent right to transfer it; or
  3. a transfer may only be permissible to a “financial institution” – which can be problematic for sales to private equity firms, hedge funds, pension funds or SPVs.

Potential solutions to these issues include sellers holding the loans on trust with beneficial interest lying with the buyer, efficient and thorough due diligence which flags up issues as early as possible at the outset of the transaction (which can also be instrumental in influencing the price of the portfolio itself, at the bidding stage), amendments to loan documentation or perfecting registration of security to ensure the buyer holds a robust package of collateral.

The seller will almost certainly prefer a transfer by novation wherever possible, creating a direct standalone legal relationship between the new buyer and the borrowers. Transfer by way of assignment (where only the rights and not the obligations are transferred) may not have the effect of removing the loan from the seller’s balance sheet. However, transfer by way of assignment can be useful where the seller’s interest in underlying collateral cannot be novated. Moreover, an assignment can be achieved without notifying the borrower, although this will merely result in an equitable assignment.

What lies ahead for distressed debt?

Following the credit crisis, many institutions in the UK have undergone high profile divestment operations – instigated by the need to comply with stringent capital adequacy requirements. Currently, the ECB is implementing key stress tests amongst the top euro zone banks to ensure balance sheets are looking healthy – with a particular focus on non-performing loans. The distressed debt market is certainly growing and the UK appears to be a popular investment destination in this area together with Greece, Italy, Spain and Ireland. There appears to be a great deal of opportunity for many institutions to recoup distressed debt and estimates suggest that European banks have approximately EUR2.5 trillion of non-core assets available to sell.

So, it’s certainly very true for the NPL market that one person’s trash is another person’s treasure!

Unlocking the Supply Chain: challenges to widening the investor base for supply chain finance and some solutions

Investors in crowded sectors may look on the opportunities created by the supply chain as medieval adventurers once looked on the fabled kingdom of Prester John.  Huge volumes of illiquid credit are created in sale transactions every day as goods and services are sold.  This credit locks up working capital for sellers and limits their appetite to supply their customers.  The effective yield on this form of financing is tied up in price negotiations.

This market is already supplied with credit by third parties through trade receivables securitisation, factoring and other variations on the theme of using trade debts as collateral on a recourse or non-recourse basis.  In some cases this financing (for the right, usually larger corporate borrowers in the right sectors and locations) can be extremely cost effective.  There are also many ways of transferring credit risk on sale transactions which may be paid for by the buyer or the seller.  But a high proportion of trade transactions are not financed or protected in this way and the availability of credit in many sectors can be volatile or non-existent and pricing is inefficient. This all adds up to create opportunities for new capital.

If this is the opportunity, what are the challenges?

Challenge #1: Duration

Receivables tend to be short dated whereas many investors want to put capital to work for longer periods.

The obvious solution to this problem is to find a sufficient ongoing supply of receivables so that collections are quickly reinvested in new receivables.  This can be structured in the form of a programme with one or more sellers selling receivables into an SPV structure.  While this is the basis for trade receivables securitisation it is also used for more simple financing structures.  The programme must be sized so that sufficient receivables are purchased to create the yield needed for the investors to achieve their expected return.  The seller may be expected to pay a commitment fee to the extent the programme isn’t fully drawn or fund some kind of equity contribution which earns a return when the programme is used but funds payments to the senior investor when it is not.  Alternatively, the programme may be entirely uncommitted in which case the seller choses whether or not to sell and the financier whether or not to purchase the receivables but both are incentivised to maintain the relationship as long as it works economically and have a framework under which they can transact quickly.  

The solutions leave investors with the need to administer some relatively complex processes as receivables are collected and new ones are purchased.  In particular, in the context of a programme the investor must ensure that the quality and collectability of receivables are maintained.  These challenges are unavoidable and as trade receivables tend to be relatively granular require material ongoing work.  However, it may be possible to delegate these roles to a servicer.

In the next instalment of this blog, we will consider challenges which arise in relation to credit risk on receivables.

This and other challenges and opportunities to new investors wishing to provide supply chain finance will be addressed during a Reed Smith after work seminar in London on 11 March 2014.  If you are interested in attending please click on the above link to register.

Clash of the Titan 2007-1

So it’s been just over a year since Fitch issued their press release confirming that as a matter of policy it would not provide rating agency confirmations (RACs) during the replacement of special servicers on EMEA CMBS transactions and indeed, just over a year since our last blog on the matter, entitled “What the Fitch??!”.

At the end of that blog we observed that it was going to be a fun year for CMBS – and wasn’t it just.

We have seen some interesting CMBS restructurings including the £238m LORDS 2 CMBS and the €480m Rivoli Pan Europe CMBS, which included the restructuring of the €105m loan secured on IBM’s headquarters in Madrid.

We also saw the resurgence of German multifamily transactions including the €1.07bn TAURUS 2013 (GMF1) PLC and the €2 billion German Residential Funding 2013-1 PLC transaction but also in new deals in UK with the £380m Deco 2013 Chiswick Park and the £263m Debussy “Toys R Us” transactions; that is, if you can see past the fact that much of the value of the new issuance involved refinanced debt.  Hopefully the bullish researchers at the banks are right in their predictions for 2014.  At this stage, it’s perhaps too early to tell.

What’s therefore perhaps equally, if not, more interesting is how the issue of servicer and special servicer replacements has evolved over the last year.  If you remember we had the three-part blockbuster ‘Windermere XIV saga’; part 1, part 2 and part 3.

It also seems that Fitch’s reluctance to provide RACs continues to cause havoc for junior noteholders seeking to exercise their rights to replace special servicers.  However, it might all be coming to a head with the Controlling Party’s proposed replacement of Capita with Mount Street as Special Servicer of the only loan in the £610m Titan 2007-1 (NHP) care home CMBS following the announcement that due to lack of support from senior noteholders for the replacement on the one hand – and because of the threat of legal action from the Controlling Party on the other – the Trustee has applied to the court for directions “as to matters of contractual interpretation relating to the applicability and satisfaction of the Appointment Conditions”.

We very much hope the issue of whether or not as a result of Fitch’s unwillingness to provide RACs, the rights of controlling parties in CMBS transactions to replace special servicers have been effectively frustrated (until Fitch decides to reconsider its position!) or whether the requirement for a Fitch RAC can now ever be an applicable pre-condition to replacement – can be finally determined through this court action.  I think market participants and particularly incumbent special servicers, controlling parties and trustees will be anxious to see the outcome.

Will the court deal a final blow to the special servicer replacement process and will that lead to re-evaluation of the value attributable to junior notes with special servicer replacement rights or will the court pave the way for a less contentious and more efficient replacement process but which might risk upsetting existing special servicers?  Either way, some clarity for the Trustees and Issuers would be nice.  Watch this space.

Indian Bond Defaults and Bond Restructurings: More Scheming Ahead?

With yet another foreign convertible bond default hitting our desk, we cannot help but wonder what the future has in store for Asian convertible bonds and debt capital markets restructurings.  This is particularly relevant when you consider that Indian companies and banks issued foreign currency bonds aggregating up to approximately $6.3 billion in the first quarter of 2013.  This momentum continued throughout 2013 with Indian companies expected to raise another $10 billion by the beginning of 2014 by issuing foreign currency bonds in the international capital markets.

The Story so far

The convertible bond has always been a favourite of corporate India.  Turning back the clock, one would recall that, particularly between 2005 and 2008, several companies across multiple industries used a variety of structures to access the international debt capital markets by issuing foreign currency convertible bonds (FCCBs) to investors. Such issuers included National Thermal Power Corporation, Indian Oil Corporation, Bharat Petroleum Corporation, Power Finance Corporation, Tata Steel, Tata Communications, Vedanta, Bharti Airtel, Amtek Auto and Rural Electrification Corporation (just a few names amongst an endless list of issuers back in the day).

Fast forward to 2014 and FCCB defaults have dominated recent headlines (think major companies like Sterling Biotech, KSL and Industries and Suzlon Energy).

The double whammy!

To cut to the chase this is what happened.  Firstly, Stock prices of most FCCB issuers fell sharply post-2008, due to the global financial crisis as well as Indian macro issues.  FCCBs worth more than $7 billion were due for redemption.  Many companies faced a severe funding crunch, since most FCCBs did not get converted as a result of the conversion price being higher than the market price (with the conversion option out, of course, no lender wanted equity!), and consequently required refinancing at higher prevailing interest rates.  Secondly, the depreciation in the value of the rupee coupled with the fact that most of the foreign currency exposures were unhedged, exacerbated the issue and ballooned the principal repayment due in rupee terms, consequently complicating the refinancing challenges.

From a legal perspective, the process is often a messy one: in addition to the usual steps which a Trustee would take of confirming the occurrence of an event of default, providing default notices to the issuer and the noteholders, receiving pre-funding from the issuer, obtaining an indemnity and instructions from noteholders, a “Section 434 Notice” is often delivered too.  A Section 434 Notice  is a statutory demand (or “winding-up notice” – not to be confused with a “winding-up petition”) requiring the issuer to make payment of the full outstanding amount due under the bonds within 21 days.  Assuming such amount is not paid a winding-up petition may then be lodged – whilst unlikely that the issuer will actually be wound up it is a useful tactic to apply pressure on the issuer often leading to a restructuring of the bonds or a buy-back by the issuer.  The key in this situation is to find an experienced Indian law firm to assist with this process.  In addition to the winding-up process in India, an aggressive noteholder may also consider bringing proceedings in England in addition to a winding-up in India.  Although the volume of FCCB defaults decreased in 2013 compared to the previous year, there are a few big ones due for redemption in the second half of this year – so better to be prepared!

Then we have restructurings.  You will sometimes see a “Scheme of Arrangement” being used to implement a restructuring.  A Scheme of Arrangement is a court-approved, binding arrangement between creditors.  It is often used where there are multiple types of creditors (not just bondholders).  But it can be useful where there are only bondholder creditors to circumvent the requirement to obtain 100% noteholder consent generally required for amendments under a New York law governed indenture (a Scheme would typically require approval by a majority of – but not all – bondholders).  In our experience, these can be tricky to navigate from the Trustee’s point of view (particularly in view of Trustee’s fees and indemnity arrangements) – consider for example the role of the Trustee in the voting process (ideally the Court should direct the Trustee not to vote).  Is the Trustee protected in other jurisdictions other than that of the jurisdiction of the Scheme – for example, if the Scheme is under Singapore law and the Notes are governed by New York law and there are US noteholders, could the Trustee have potential liability in the US?  In such a situation there are often ways for the Trustee to protect itself.  The Trustee will also need to ensure that all Noteholders have the opportunity to vote in the Scheme and that none are disenfranchised.  These and other issues are critical to be aware of – the next Scheme may be right around the corner.

Winds of change

FCCBs and depository receipts rules are administered by the government of India (the Government of India).  The Issue Of Foreign Currency Convertible Bonds and Ordinary Shares (through the depository receipt mechanism) Scheme, 1993, has undergone several piecemeal amendments to meet the emerging needs of the economy.  Particularly, in view of the new Companies Act in India (the Companies Act), the Government of India is now looking into a comprehensive review of the FCCB  rules.  Therefore, along with the ongoing restructuring of numerous historic transactions, market participants are also keeping a close watch on the regulatory developments and the impact that such regulations will have on legal documentation, transaction structures and issuers.

Whilst there are positive signs for greater international investor confidence in the Indian capital markets, as witnessed from the recent increase in international transactions, there may be further opportunities for investors and borrowers (particularly in view of the Reserve Bank of India’s (RBI’s) permissions to refinance FCCBs (subject to certain criteria) through external commercial borrowings (ECBs) and debt capital market transactions).  International investors may have a greater role to play in 2014 with a flurry of transactions expected to hit the international debt capital markets this year.

New Year, New Troubles for US regulators: Volcker Rule challenged before federal courts

It’s been a busy Christmas and New Year’s season for US regulators. After three years of work, the Federal Reserve Board announced in mid-December that five federal agencies have issued final rules to implement section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Volcker Rule”), which is intended to limit proprietary trading by banks. But their job was hardly done.

US regulators came back to work after the holiday to find that portions of the final version of the Volcker Rule have been challenged in a lawsuit over claims that requiring small banks to divest their holdings in certain collateralized debt obligations known as trust-preferred securities or TruPs C.D.O.s will cause 275 small banks about $600 million in losses and impact their ability to lend to consumers and businesses.

The American Bankers Association, an industry lobby that represents several community banks, objects to the portion of the rule that will force banks to sell TruPs C.D.O.s, and has filed a complaint before the U.S. Court of Appeals for the District of Columbia Circuit seeking a court order blocking the rule from taking effect before the end of the year (source: New York Times). The group claims that the regulators did not properly analyze the economic cost of this portion of the rule on small community banks and the impact on their capital levels.

Then, on 14 January 2014, the regulators released a final interim rule to permit banks to retain interests in TruPs C.D.O.s under the following conditions:

  • The TruPs C.D.O. must have been established and the interest issued prior to 19 May 2010;
  • The bank must have acquired its interest in the TruPs C.D.O. on or before 10 December 2013; and
  • The bank must reasonably believe that the offering proceeds of the TruPs C.D.O. were invested primarily in Qualifying TruPs Collateral which is defined as any trust preferred security or subordinated debt instrument that was issued prior to 19 May 2010 by:
    • a depository institution holding company that as of the end of any reporting period within 12 months immediately preceding the issuance of such trust preferred security or subordinated debt instrument had total consolidated assets of less than $15 billion; or
    • a mutual holding company.

In order to reduce the burden of determining if a particular TruPs C.D.O. satisfies the requirements of the interim final rule, the banking regulators have issued a non-exhaustive list of qualifying TruPs C.D.O.s.

The interim final rule becomes effective on 1 April 2014. The regulators also solicited comments on whether the interim final rule is consistent with the Volcker Rule and the portion of Dodd Frank governing TruPs C.D.O.s treatment with respect to bank regulatory capital. Comments are due 30 days after the interim final rule is published in the Federal Register (which should be in the next few days).

This is considered a ‘win’ for the market in the prolonged Volcker Rule saga. It remains to be seen whether the regulators will also ‘yield’ to similar requests made by the market with regard to non exempt securities and other flaws of the Volcker Rule identified by industry lobbies.

One unintended consequence down, how many more to go?

You Don’t Need EMIRacle – Trade Reporting for SPVs Made Easy

EMIR’s trade reporting obligations come into effect on 12 February and counterparties to derivative transactions are currently scrambling to ensure they have all the appropriate systems in place to ensure compliance. For large financial institutions, this has already involved many months of hard work and, even still, many are not optimistic about meeting next month’s deadline. At the other end of the spectrum, the administrative burden on one-off or low volume commercial counterparties should be relatively light, and ensuring that the reporting obligations are covered not therefore too taxing.

What then of SPVs – which are neither operational goliaths like their derivative counterparties nor autonomous commercial entities capable of assessing the implications on cost, resources and time of each option open to them?

Well, the good news is that Article 9 of EMIR – which enshrines the trade reporting obligation – permits SPVs, like any other counterparty, to delegate their reporting function (but not its obligation) either to its bank counterparty or to a third party.

Our latest client alert explores all this in more depth, setting out in practical terms what steps SPVs should be taking now in order to ensure they comply with all their obligations.

So if you don’t yet know your pre-LEI from your LEI, your LOU from your GLEIS or your UTI from your UPI, we are here to help.