Structured Finance & Derivatives 2019 Comparisons

Last Updated November 23, 2018

Contributed By Ashurst

Law and Practice

Authors



Ashurst Ashurst is a leading global firm with a rich history spanning almost 200 years. The firm has 26 offices in 16 countries, with around 400 partners and a total of more than 1,600 lawyers working across ten time zones, so it is able to respond to clients wherever and whenever they need. As a global team it has a reputation for successfully managing large and complex multi-jurisdictional transactions, disputes and projects, and delivering outstanding outcomes for clients. In relation to the structured finance and derivatives sector, Ashurst's key areas of practice include derivatives, structured products, securitisation, debt capital markets and Islamic finance. The firm's dynamic practice, which is well supported by its highly regarded financial regulation, dispute resolution and tax teams, offers specialist advice on a wide range of capital markets and structured finance transactions. Ashurst would like to credit the following lawyers for their contribution to the UK chapter of this guide: Alexander Biles, Don Brown, Vicky Brown, Tim Cant, James Knight, Thomas Picton, Gabrielle Samuels and Inga West.

The starting observation is that the structured finance market covers not one market, but multiple markets. Each of those markets may, at a given time, be driven by different issues and motivations. Having said that, a number of themes are clear.

Firstly, activity has been strong in core securitisation markets, some of which were relatively inactive (at least in terms of public issuances) for several years following the global financial crisis and subsequent sovereign risk concerns.

Secondly, OTC derivatives markets remain robust notwithstanding recent regulatory developments, although the nature of the transactions that comprise that activity has evolved in many cases.

Thirdly, adjacent loan markets are experiencing a peak of activity, which itself drives transactions that are intended to refinance that lending or to demonstrate associated risks. Many of these markets face headwinds or at least interesting times in 2019, often on a macroeconomic basis but also as a result of continued regulatory developments (such as the implementation of the EU Securitisation Regulation or omnipresent Brexit concerns).

Whilst this firm will refrain from commenting on, or purporting to predict, economic or political developments, it predicts that markets will absorb and adapt to regulatory change as they have done on a continuing basis over recent periods.

The term 'acquisition finance' is broad and at times is used to describe a variety of different financing techniques where the purpose of the financing is to fund the acquisition of a company or business. Most commonly, though, it is used synonymously with 'leveraged finance', which is typically characterised by a sponsor (private equity)-backed acquisition of a target group, where there is a high level of debt (relative to sponsor equity) used to fund the acquisition. The other typical feature is that credit support in the form of guarantees and security is provided by the target group itself. The term leveraged finance also includes leveraged refinancings and recapitalisations.

There are many variations in the capital structures seen. A 'traditional' senior debt structure could comprise a revolving facility (provided by bank lenders), an amortising 'A' term facility (also provided by bank lenders) and a non-amortising 'B' term facility, substantially provided by institutional investors, including CDO funds. A capital structure might be 'senior-only' or might include an additional debt layer – for example, a separate second lien facility ranking behind the senior debt in terms of security enforcement – or a more junior strip (subordinated both as to payment and security) such as mezzanine. Whilst the basic elements of a revolving facility and a term loan facility are core to any leveraged finance, it is often now the case that there is no amortising term facility and that bank lenders participate alongside institutional lenders and credit funds in the non-amortising facility or facilities.

For the larger transactions, the term facilities might be replaced by a high-yield bond issue, or indeed a 'term loan B' facility (with or without a further second lien layer). Term loan B describes a leveraged finance loan facility in which the restrictive covenants are substantially based on those typically seen in US high-yield bond documentation.

In mid-market leveraged finance transactions (less than £400 million), the dominant form of structure is a super senior revolving facility and a non-amortising term facility, typically provided by credit funds. When this product first came to market (around 2012), it was represented as a single tranche that aimed to provide senior and junior term debt at a blended interest rate; it was therefore termed 'unitranche'. Under the unitranche label there are now a variety of structures employed, including 'first out, last out' structures that effectively create a super senior unitranche strip, ranking ahead of the main unitranche facility on any enforcement of security.

The principal trend in leveraged finance is the convergence of US and European market structures, and documentation terms. Many concepts such as second lien, unitranche and term loan B originated in the USA and are adopted in European markets as investors look for the best product offerings available. In addition, documentation distinctions between large cap and mid-market transactions is eroding, with trends such as the migration to US high yield-style documentation (cov-lite) infiltrating the mid-market. This means that European leveraged finance documentation increasingly includes incurrence covenants and no (or only one) maintenance financial covenant that must be complied with on regular testing dates. An incurrence covenant only restricts the borrower (and the other restricted entities, as applicable) from doing something (often, incurring a liability of some sort; eg, further indebtedness, or entering into an acquisition agreement) if it cannot meet a specified financial ratio at that time. The only consequence of not meeting the ratio is that the intended action is restricted.

A significant trend in terms of product availability is that many features of the unitranche product, which developed as a credit fund offering, are now also offered by banks, who need to remain competitive.

There is no specific law or regulation governing leveraged finance transactions in England. However, the European Central Bank has published guidance on leveraged transactions (16 May 2017) that significant institutions directly supervised by the ECB are expected to comply with. The guidance aims to restrict leverage levels to below six times, other than exceptionally.

The principal finance documents typically used in leveraged finance transactions are as follows.

  • The facility agreement – there may be more than one facility agreement if, for example, a second lien facility is documented separately to the first lien facility(ies). English law-governed facility agreements typically have a foundation based on Loan Market Association (LMA) documentation. However, the leveraged finance market is increasingly precedent driven and this, coupled with the adoption of terms from the US market, means that in practice there is wide divergence from LMA provisions, particularly in relation to covenant protection offered to the lenders.
  • The intercreditor agreement – this, amongst other things, regulates the relationship between the creditor classes, determines which creditor classes may receive payments and the circumstances for payment suspension, determines the rights of the creditors to take and/or control enforcement action, and determines the order of application of enforcement proceeds.
  • The security documents – in England, a company is able to grant security over all its assets, present and future, in a single universal security document called a debenture, although for future-acquired land, a supplemental instrument will be required to create a legal security interest. In general, security documentation is light; multiple entities are able to enter into a single composite debenture, which will typically include a mechanism for later accession of further group companies (for example, after-acquired entities).

There are typically other important finance documents such as fees letters and a raft of supplementary documents that must be provided as conditions precedent to the facilities being utilised.

In England, a company is able to grant security over all its assets, present and future, in a single universal security document called a debenture that will usually include a series of fixed (specific) security interests (mortgages and/or charges) as well as (in all cases) a floating charge that will cover all assets not effectively covered by the fixed security. There is no need to take separate security over different asset classes, debenture security is the norm.

The norm in syndicated transactions is for English law security to be granted in favour of a security trustee who holds the security on trust for all lenders from time to time, which means that there is no need to update security – or indeed take any other steps – on the transfer of loan assets from an existing lender to a new lender.

There are no significant legal or practical restrictions or limitations as to the type of English assets used as security. Registration fees are low and there are no tax or notarial fees triggered by the taking of security.

Formalities relevant to granting security are straightforward and can be addressed in a single debenture covering all assets. Security should be perfected to ensure priority as against competing third parties and to ensure validity of security as against other creditors. An important perfection step is that security granted by English limited companies or LLPs must be registered at Companies House. There are also asset-specific steps that must be complied with to ensure a perfected security interest. For example, security over land must be registered at the Land Registry; security over shares is typically protected by the security-taker taking possession of the share certificates and signed (but otherwise blank) stock transfer forms; and security over bank accounts and contract claims should be notified to the account bank or contract counterparty.

There are a number of ways of enforcing security in a typical leveraged finance structure, but administration and receivership are most common.

Administration is a formal insolvency process, run for the benefit of all creditors, but can be used by a security-holder as an enforcement mechanism where the security-holder has the benefit of a 'qualifying floating charge'; ie, a floating charge (on its own or coupled with one or more fixed or other floating charges) that relates to the whole (or substantially the whole) of the company's assets. In a leveraged finance context, the English companies within the borrower group will typically grant debenture security that contains a qualifying floating charge.

Administration has a three-part statutory purpose: (i) rescuing the company as a going concern, but if that is not possible, (ii) achieving a better result for the company's creditors as a whole than would be likely if the company were wound up, or if that is also not possible, (iii) realising property to make a distribution to secured or preferential creditors.

Administration can be commenced by application to court for an administration order or, provided the relevant conditions are satisfied, by means of an 'out-of-court' filing procedure. Out-of-court filings can be made very quickly and are cheaper and quicker than a court application. A court application will normally take a few weeks, depending on court availability, but can be achieved very quickly in urgent situations. Often in a consensual restructuring context, secured lenders will prefer the company or its directors to apply for administration (whether in or out of court), but a security-holder can make an out-of-court filing itself if it holds a qualifying floating charge, or apply to court for an administration order, if it does not.

Once appointed, the administrator, who must be a qualified insolvency practitioner, and as an officer of the court, takes over the management of the debtor from its directors and has wide powers to administer the business and assets of the company, including continuing to trade while he or she works to achieve the purpose of the administration. Usually this will involve a sale of the company's business and assets followed by a distribution of the net proceeds to (among others) secured lenders in accordance with the statutory order of priority.

In contrast to administration, receivership is a security holder-led enforcement process run for the benefit solely of the appointing secured creditor. The holder of a fixed charge can appoint a receiver over the particular assets of the company secured by that fixed charge (for example, real estate or shares) by executing a simple deed of appointment in exercise of powers in the security document, once it has become enforceable. The receiver then realises the asset and returns the net proceeds to his or her appointor. The appointment process can be very quick and the receiver does not need to be a qualified insolvency practitioner.

For some types of security – for example, a charge over a bank account in favour of the account bank – no particular enforcement means is required. The bank can simply enforce against the balance in the account by sweeping the bank account.

Interest expenses incurred on third-party leveraged finance loans should normally be deductible in full on an accruals basis. However, certain anti-avoidance provisions may give rise to a restriction or denial of the tax deductions otherwise expected. Although the UK does not have standalone thin capitalisation rules for the purposes of tax, general transfer pricing rules apply so that a company will only be entitled to a tax deduction for its interest payments to the extent that the lending is on an arm's length basis. A company with borrowings greater than it could and would have borrowed on its own resources – either because it is borrowing from, or with the support of, connected persons – may therefore suffer a disallowance of a deduction for excessive interest paid to a bank or other third party. This is the case even if the connected person giving support (eg, a guarantee) is within the charge to UK tax as the transfer pricing rules extend to UK-to-UK transactions as well as those cross-border. In practice, however, if a deduction has been denied under the transfer pricing rules because the loan was supported by a related party guarantee, a UK resident guarantor will generally be entitled to claim a compensating adjustment in the form of a tax deduction for the interest that the borrower would otherwise have been entitled to claim. Other anti-avoidance measures that could apply to leveraged finance include corporate interest restriction and anti-hybrid rules.

Financial assistance rules apply to prohibit assistance given by public limited liability companies for the acquisition of their own shares (or the shares in a holding company) and to prohibit private companies from giving assistance for the acquisition of shares in a public holding company, which means that the prohibition is of fairly limited application. Where the acquisition target is a public company, it will need to be re-registered as a private company before it, or its subsidiaries, can give guarantees, security or other financial assistance. Re-registration requires the passing of a special resolution of the members of the company (which requires a 75%majority of those voting). It is open to 50 or more shareholders or shareholders representing 5%or more in nominal value of the company's issued share capital to apply to the court for an order that such a resolution be cancelled; such an application must be made within 28 days of the passing of the resolution. It is very unlikely, though, that such an application will succeed, unless the practical effect of the resolution to re-register is to prejudice a specific minority unfairly.

'Corporate benefit' essentially describes a statutory duty on the directors of a company to "promote the success of the company for the benefit of its members as a whole." Where the company has no solvency concerns, the duty is owed to the members as a whole; however, once the company is insolvent, near insolvent or of doubtful solvency, the interests of the creditors become paramount. Where there is no particular concern about corporate benefit, the duty is addressed via the directors' consideration of the duty at a board meeting. In circumstances where there are doubts as to corporate benefit (eg, if the proposed transaction is to grant a cross-stream or upstream guarantee), the normal approach is for the lenders additionally to require a shareholder resolution to approve the transactions, although this will not cure any corporate benefit issue in circumstances where the creditors' interests are paramount. Overall, corporate benefit concerns do not normally cause a significant issue for English companies involved in leveraged finance.

Lender liability under English law does not typically cause a significant issue in leveraged finance. In particular, there is no general doctrine by which a lender may be held liable for a borrower's financial losses. Whilst there are circumstances in which a lender may become responsible for what would be borrower liabilities – for example, in relation to environmental liabilities, pension liabilities and occupier's liabilities – transactions can typically be managed in a way that these risks are avoided or mitigated.

Lenders are, however, subject to all normal principles of English law and therefore subject to claims for breaches of contract, misrepresentation and so on, where applicable.

Loan Market Association standard leveraged finance documentation includes options for borrower debt purchases to be permitted or prohibited. If permitted, the expectation is that there will be a solicitation process and that there will be controls over how the purchase is funded. On completion of the purchase, the relevant debt will be extinguished.

The financial sponsor would not normally be prohibited from purchasing debt; however, such purchases would typically result in disenfranchisement of the purchased debt for voting purposes and the sponsor purchaser would not be entitled to attend or participate in all-lender meetings or to receive reports or other documents prepared at the behest of, or on the instructions of, the facility agent or one or more of the lenders. These disenfranchisement provisions do not typically apply to established sponsor affiliates that are entirely independently managed.

There is an active secondary debt trading market in London. The transfer provisions of leveraged loan transactions are, however, a key focus for negotiation. Transfers to lender affiliates and related funds should be uncontroversial; there is also often a 'white list' of permitted transferees. Beyond that, however, it is common for there to be transfer restrictions.

The conduct of acquisitions of companies whose shares are admitted to trading on an EU-regulated market (such as the LSE) is principally regulated by the City Code on Takeovers and Mergers (the Code). Certain funds is a mandatory requirement of the Code and applies to all offers made for cash (or a cash alternative). Whilst the certain funds concept originates from the public company acquisition market, it is also common to see certain funds requirements in a private company competitive auction context.

During the certain funds period, drawstops are typically restricted to certain events affecting the bidco/its parent (as opposed to the target and its subsidiaries) and therefore within its control, which usually include the following.

  • Non-payment of amounts due by the bidco. 
  • Breach of fundamental undertakings by the core bidder group (eg, the parent and the bidco), including certain undertakings relating to the conduct of the offer and compliance with the Code (where applicable), but also potentially breach of the other main restrictive covenants, such as restrictions on financial indebtedness, acquisitions, granting security and making disposals. 
  • Breach of identified representations made by the core bidder group (as for undertakings), typically representations as to status, power and authority, binding obligations, non-conflict with laws, constitution and other obligations. There may, though, be others; eg, the representation as to all necessary authorisations having been obtained.
  • Insolvency events affecting the core bidder group. 
  • Illegality or invalidity affecting the core bidder group.
  • Change of control of the bidder group.

There were a number of financial restructurings in the UK in 2018. Two of note were those relating to the Noble Group Limited and Stripes UK Holdings Inc, both of which involved use of an English scheme of arrangement and were part of a larger cross-border restructuring.

The Noble Group Limited was the ultimate holding company of a major global commodities trading group, with hubs in London, Hong Kong and Singapore. The company was registered in Bermuda and listed on the Singapore stock exchange. It had some USD3.5 billion of debt (including an English law-governed revolving credit facility, two series of English law-governed notes and a New York law series of notes). As part of the restructuring, the company's business was transferred to a new structure and holding company that was to be listed on the Singapore stock exchange. Key aspects of the restructuring were effected using an English scheme of arrangement together with an interconditional scheme of arrangement in Bermuda. Perhaps untypically for financial restructurings, the Noble scheme affected all the company's creditors, including some non-finance creditors. More usually a financial restructuring will only affect finance creditors.

The English and Bermudian Noble schemes included an option for all creditors to 'risk participate' in a new trade facility, the result of which was that those that chose to participate would potentially receive a significantly enhanced return when compared to those who did not. This was a novel feature in so far as it applied to non-finance creditors.

Stripes UK Holdings Inc involved an English scheme of arrangement of a US company with an establishment in the UK. The scheme dealt with its finance creditors under an English law-governed revolving credit facility, replacing the original facility with a new one and extending the maturity date. The English scheme formed part of a wider group restructuring under Chapter 11 of the US Bankruptcy Code.

The UK has the benefit of good restructuring tools, a very experienced restructuring profession and an excellent judiciary: it is well suited to achieving financial restructurings. Indeed, there has been a steady flow of international companies coming to the UK to make use of the UK's legal tools, experts and courts. However, there are still challenges: as deal structures change, the UK has to adapt its methods to change with them.

Over the years, the English scheme of arrangement (either on its own or when combined with one or more other restructuring tools) has proven to be an effective financial restructuring solution for many UK and international companies. One challenge faced by all companies wishing to use an English scheme of arrangement is to ensure that the classes of creditors for voting purposes are properly constituted. The English scheme requires creditors to be divided into classes for voting purposes, according to their rights both before and after the scheme, and in order for the scheme to be approved, each class has to approve the scheme by a majority in number representing 75% in value of those creditors attending and voting in that class. Classes are defined as creditors whose rights are not so dissimilar that they cannot consult together. The idea is to keep classes as big as possible so as not to give a small minority of creditors a veto over the scheme, but also ensure that the classes are representative and do not allow the oppression of the minority by the majority. Getting the analysis right can be difficult and although the UK does now have an established body of case law to help, it is usually fact specific and will depend on what the alternative outcome for the company is likely to be if the scheme is not approved. So while, for example, generally secured creditors will always be in a different class to unsecured creditors, it can be harder to determine if, say, creditors under different secured financial instruments with differing key contractual terms such as maturity dates or interest rates can vote together or not.

The other main challenge debtors in the UK face when seeking to restructure, in common with debtors in any jurisdiction, is how to deal with cross-border aspects of the restructuring. Increasingly companies have foreign assets and creditors, and facilities are governed by a mixture of English and foreign law. It can take some time to decide the optimum restructuring solution: which restructuring tool to use, in what jurisdiction, and to what extent it will be recognisable and enforceable in any other relevant jurisdiction. If and when the UK exits the EU, depending on the nature of the future trading relationship with the EU, this issue may become more complex.

There is no leveraged finance reform pending. The major events that are pending are the UK's exit from the EU and the discontinuation of the London Inter-bank Offered Rate (LIBOR) and similar benchmark rates for other currencies.

The likely market impact of Brexit is, as yet, uncertain. In the case of a hard Brexit, there will be an impact on cross-border financings as UK lenders may need to lend to borrowers into certain jurisdictions out of an EU subsidiary. Lending into the UK is expected to be unaffected. Leveraged finance documentation is not expected to change significantly; English law remains a well understood set of rules for the governing of financing transactions and the English courts remain a trusted forum for the resolution of disputes.

Benchmark reforms will necessitate a change to loan documentation as there is widespread acceptance that discontinuation of a LIBOR (or other benchmark) screen rate requires a more stable solution than the current LMA documentation fall-back to lenders' certified cost of funds. Market participants are working towards the development of new benchmarks, based on 'risk-free' overnight lending rates, but adaptable to the needs of a term lending market. Most new leveraged finance documents now include provisions for majority lender approval of amendments needed to transition smoothly to a new benchmark, which includes pricing amendments that may be needed to maintain the economics of the transaction.

Securitisation transactions in England and Wales are regulated by the Securitisation Regulation (Regulation (EU) 2017/2402) (the Securitisation Regulation), a uniform set of rules applying to the securitisation market in the EU, and the Capital Requirements Regulation Amendment Regulation (Regulation (EU) 2017/2401) (the CRR Amending Regulation), which provides for the prudential securitisation framework, guidelines and technical standards made thereunder for banks and investment firms.

Other than the above and certain tax laws (including the Taxation of Securitisation Company Regulations 2006), there are no laws in England that are specifically provided for the governance of securitisation transactions. 

The market is, however, also regulated/guided by certain other EU directives and regulations that affect securitisation activity in Europe, legislation in England such as the Financial Services and Markets Act 2000 (FSMA), rules of the UK financial regulators (eg, the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA)), codes of conduct, guidelines and other rules issued by industry or market bodies that are relevant to participants in the securitisation market.

A wide variety of assets/receivables may be involved in securitisation transactions, both public and private.

Public transactions commonly include securitisations of residential mortgage loans and receivables relating to credit cards and auto loans. 

However, the underlying assets in respect of securitisation transactions may also include personal loans, commercial real estate and trade receivables, and, less commonly, student loans. Securities collateralised by loan pools or securities that are actively managed (CLOs) are also commonly issued.

Originators of securitisation transactions are subject to risk-retention requirements.

Risk-retention rules applicable in the EU are, from January 2019, specified in the Securitisation Regulation, which is a consolidation of the pre-existing risk-retention requirements contained within the Capital Requirements Regulation, Alternative Investment Fund Managers Directive (AIFMD) and the Solvency II Directive.

The risk-retention rules are applicable to regulated investors, including credit institutions, funds, insurers and reinsurers. The main feature of such rules is to ensure that such investors may only invest in securitisations under which a 'sponsor,' an 'originator' or an 'originating lender' retains a minimum 5% interest in the securitisation. There is also a direct obligation on the originator of a securitisation to ensure that such risk-retention requirement is complied with.

The retention of risks may be effected by any of the following methods: vertical slice, originator share, random selection, first loss tranche (similar to US horizontal slice), or first loss exposure in respect of every securitised exposure in the securitisation.

Transfer of rights to receivables is usually effected by legal or equitable assignment.

There are specific requirements for effecting a 'legal assignment'. Under the Law of Property Act 1925, only the benefits of an underlying agreement relating to the assets may be assigned. The assignment must be absolute and the rights to be assigned must not relate to only part of a debt. In addition, the assignment must be in writing and signed by the assignor, with a notice of assignment given to the underlying obligor.

In relation to the requirement to provide a notice of assignment, English law is flexible on its form and timing. It must, however, make it clear that there has been an assignment and must not leave it to the debtor to infer one.

If these conditions are not met but there is a clear intention to assign, there will be an 'equitable assignment'. In addition, if the assignment relates to a future claim on a debt, that will also be an equitable assignment.

Alternatively, the transfer could be brought about by novation. However, given that this would require all parties, including the debtor, to sign the novation agreement, this is rarely used.

A declaration of trust may also be used to transfer the beneficial ownership in the receivables.

Economic interest in receivables may also be transferred contractually by way of sub-participation, although this does not achieve legal title transfer.

As discussed above, a legal assignment requires a notification of the underlying obligors but an equitable assignment does not. A typical securitisation will not require the originator to notify the underlying obligors, save in certain stressed scenarios (eg, default or insolvency of the originator).

The legal effects of failing to notify obligors include:

  • the transferee (or a security trustee holding security over the receivables) cannot bring an action against an obligor in its own name;
  • a subsequent secured creditor of the originator may gain priority over the transferee if it serves notice on the debtor;
  • each obligor can make an intervening claim against the originator (eg, set-off in respect of mutual debts) arising before notice is served; and
  • payments made to the originator but not passed on to the transferee will reduce the transferee's entitlement to the debt without it receiving any benefit.

These effects can be mitigated through measures like restrictive covenants and warranties in the sale and purchase agreement for the receivables.

Depending on the nature of the assets underlying the receivables sold to an SPV issuer, the sale and transfer of receivables may be subject to applicable consumer protection legislation such as the Consumer Rights Act 2015 and the Consumer Credit Act 1974. As a result, legal due diligence is necessary on the underlying contracts to check for issues that may arise in relation to consumer protection regimes.

One major issue that may arise is that consumer contracts deemed to be unfair could be rendered unenforceable or enforceable only with a court order, which could make any securitisation of the receivables using any such contract very difficult to structure.

Data protection legislation such as the EU General Data Protection Regulation (EU) 2016/679 (GDPR) could be relevant if the SPV issuer receives personal data when it acquires the receivables from the originator. Due diligence will be required to ascertain whether initial data protection notices given by the originator allow this, whether further notification is required and what the legal basis for the disclosure is.

If an originator retains an interest in the assets, there is a danger that a court could deem the securitisation to be a secured loan rather than a true sale of the assets from the originator to the SPV issuer. However, certain structural features are usually permitted, such as:

  • deferring part of the purchase price to be payable to the originator;
  • providing an originator with the right to repurchase financial assets in limited circumstances, such as a breach of warranty or a 'clean-up call' once the principal amount outstanding on the securities issued by the SPV issuer reaches a low threshold;
  • the originator holding a degree of credit risk as a first loss position; or
  • residual profits being payable to the originator as part of the transaction structure.

For the purpose of being recognised as a true sale, typically the pool of receivables should be held beyond the reach of the originator's creditors or liquidator. The SPV that acquires the receivables is therefore usually a thinly capitalised 'orphan' entity set up in a low-tax jurisdiction with an unconnected charitable trust as its shareholder. English law has a long line of cases codifying what constitutes a true sale and identifying key features. The leading case is Welsh Development Agency v Export Finance Co Ltd [1992] BCLC 148.

Features of a transaction that are typically identified in a 'true sale' include:

  • the sale and purchase agreement expresses that the transfer is a sale;
  • the sale and purchase agreement reflects the parties' separate identities and legal roles, with an appropriate purchase price specified and with arm's length terms agreed;
  • the seller should not have equity of redemption;
  • the sale and purchase agreement documents the passing of ownership risk to the transferee; and
  • in respect of funds generated by the receivables transferred, the sale and purchase agreement does not provide for any originator's rights subsequent to the transfer.

Securitisation transactions usually involve an issuance by an SPV (set up as a private limited company or a public limited company) but they can also be issued through a trust.

A master trust structure may be used for short-term revolving receivables such as credit card debt. Such transaction structure involves creating a revolving portfolio of assets to be held on trust by an SPV (as trustee), with multiple series of notes backed by undivided interests under the trust issued. 

If the SPV is incorporated in England and Wales, it will need to be registered as a public limited company to issue the notes on a marketed basis. A public limited company is required to have a minimum share capital of £50,000 paid up as to one quarter.

For some asset classes, issuer SPVs may be incorporated in other jurisdictions.

English law does not provide for the establishment of multi-compartment companies. However, from a company law perspective, an SPV is not prevented from conducting multiple issuances of notes, although it is typically the case that each SPV is established for the purpose of conducting one specific securitisation transaction.

The concept of consolidation whereby the court treats the assets of an affiliate that is closely associated with a parent as if the assets were all held by the same entity does not apply in English law. Stricter rules are provided for "connected parties" under the Insolvency Act 1986 (the Insolvency Act).

Under English law, a court can lift the corporate veil through the principle of a shadow director, which has a similar effect. A court might hold this to be the case if an SPV was not carrying on business separately from the originator and its directors were simply rubber-stamping the originator's decisions.

To set up the SPV issuer as a 'bankruptcy remote' SPV, the transaction parties must not be able to proceed against the SPV, but only against the securitised assets under a 'limited recourse' arrangement. 

The SPV that acquires the receivables is usually set up as a thinly capitalised 'orphan' entity with a charitable trust (unconnected to the originator) as its shareholder. Bankruptcy remoteness can be ensured through:

  • operating the SPV on a solvent basis;
  • operating the SPV separately from the originator;
  • appointing one or more directors independent of the originator who need to consider and vote on board resolutions separately from the originator;
  • recording their authorisations and resolutions;
  • placing restrictions on the SPV that prevent it from incurring liabilities outside the securitisation;
  • including 'non-petition' clauses in agreements between the SPV and third parties that prohibit the third party from commencing insolvency proceedings; and
  • including limited recourse wording in all significant transaction documents restricting any third-party claim to the SPV's assets.

If the securitisation is characterised as a loan (as opposed to a true sale), the receivables would be classed as an asset of the originator in the event of an insolvency.

If the SPV is not insolvency remote, investors can be protected by a qualifying floating charge over the receivables, although this will rank behind preferential creditors and any liquidator.

A securitisation transaction could be subject to insolvency 'clawback' provisions and may be set aside if it has been identified as, under the Insolvency Act, a transaction at an undervalue or a preference, if a liquidator of the originator disclaims the sale and purchase agreement between the originator and the SPV issuer as an onerous property under the Insolvency Act, or if the sale and purchase agreement between the originator and the SPV issuer was ordered by the court to be rescinded. Potentially any 'security' could be void for lack of registration.

As part of the Capital Markets Union action plan announced in September 2015, the EC proposed an overhaul of the rules applicable to securitisation transactions in Europe. The proposals were set out in two draft regulations: the first providing for a uniform set of rules applying to the securitisation market in the EU (ie, the Securitisation Regulation) and the second amending the prudential securitisation framework for banks and investment firms in the CRR (ie, the CRR Amending Regulation).

These two regulations were published in the Official Journal of the European Union on 28 December 2017 and came into force on 17 January 2018. They have become effective, subject to transitional provisions, from 1 January 2019.

Part I – The New Rules Governing Securitisation Transactions

The Securitisation Regulation sets out the new rules on risk retention, due diligence and transparency for securitisation transactions. In addition, the Regulation sets out the new criteria and framework for "simple, transparent and standardised" (STS) securitisation transactions. STS securitisation transactions will receive preferential capital treatment and benefit from other regulatory advantages such as a proposed exemption from clearing and a proposed relaxation of margining rules for derivatives entered by a securitisation special purpose entity.

Part II – The New Securitisation Capital Framework

With effect from 1 January 2019, the CRR Amending Regulation replaced the pre-existing securitisation capital framework in Chapter 5 of Title II, Part Three of CRR in its entirety.

The new approaches used reflect the securitisation framework published by the Basel Committee on Banking Supervision (BCBS) in December 2014 and amended in July 2016. The July 2016 BCBS amendments built into the 2014 BCBS securitisation framework provide a more favourable capital treatment for STC securitisation positions. STC securitisations are securitisations that the BCBS identifies as "simple, transparent and comparable," and are similar in concept to those that meet the STS criteria, although the criteria themselves differ.

In essence, a factoring transaction is governed by a combination of common law and legislations generally relating to the transfer of intangible assets (in particular, the Law of Property Act 1925, which specifies the requirements for a legal assignment of any debt or other legal thing in action). There is no single law or regulation under English law that governs the transfer of receivables in connection with a factoring transaction and there is no specific regulatory regime that is targeted at covering factoring as a financial product.

Factoring involves a legal assignment of book debts by the company that owns such book debts to a factor, in return for cash. The company sends a copy of the customer's invoice to the factor. The original invoice and a notice of assignment are sent to the customer. The factor enters this into a sales ledger, collects the debt and administers the sales ledger.

Factoring transactions can be structured as recourse transactions, in which the company that is factoring its debts bears the credit risk in relation to debts that are the subject of the factoring transaction, and non-recourse transactions, in which the factor bears the credit risk in relation to the debts.

Non-recourse factoring is a more expensive way to raise capital than full recourse factoring (since the factor bears a level of risk).

Factoring can be contrasted with confidential invoice discounting (CID). Unlike factoring, CID is not disclosed to the underlying debtor and so any assignment to the funder is, pending disclosure to the debtor, equitable rather than legal (see below on this). Also, in CID transactions, it is usual for the company to collect the debts as the collection agent for the funder. In factoring deals, the factor manages the company's debtor ledger and collects the debts.

Transfer of receivables is achieved by effecting a legal assignment or an equitable assignment of the receivables. If the formalities for effecting an assignment under Section 136 of the Law of Property Act are fulfilled, a legal assignment is effected. Otherwise, the assignment will take effect as an equitable assignment.

The basic requirements for effecting a legal assignment are that the assignment has to be (i) absolute (and not purporting to be by way of security only), (ii) made in writing and signed under hand by the assignor of debt or other legal thing in action, and (iii) expressly notified in writing to the underlying debtor.

In the case of factoring, the transfer of receivables is achieved by way of a legal assignment; ie, notice of assignment is served on the debtor at the outset of the transaction, thereby perfecting the assignment for the purposes of Section 136 LPA 1925. In the case of invoice discounting, the assignment of receivables is equitable only, since the transaction is typically undisclosed and notice of assignment is not served on the debtor unless the funder feels this is necessary; eg, after the occurrence of an event of default or if the funder suspects a fraud.

Generally speaking, the sale/transfer of receivables is disclosed to the underlying debtors from the outset in the case of factoring and in the case of invoice discounting, underlying debtors are not usually notified of the sale/transfer of receivables unless there has been an event of default or the funder suspects a fraud.

From a legal perspective, the sale of receivables for purposes of a factoring transaction is, provided that the sale documentation is drafted appropriately, recognised as a 'true sale' under English law.

One point to note is that from an accounting perspective, a sale of receivables for purposes of a factoring transaction may be considered differently and it may not always be recognised as a true sale.

The Business Contract Terms (Assignment of Receivables) Regulations 2018 were made and came into force in November 2018. The regulations aimed at facilitating access to finance for businesses, by disapplying terms in certain business contracts that impose conditions or place restrictions on the assignment of receivables, including terms that prevent a person to whom a receivable is assigned from determining the validity or value of the receivable or its ability to enforce the receivable.

In summary, a receivable is defined as a right (whether or not earned by performance) to be paid any amount under a contract for the supply of goods, services or intangible assets.

The regulations have effect in England, Wales and Northern Ireland, and they apply to relevant contracts that are entered into on or after 31 December 2018.

The regulations do not apply if the person to whom the receivable is owed is a large enterprise or an SPV. In addition, various types of contracts are excluded from the scope of the regulations; for example, the regulations do not apply to contracts entered into in connection with prescribed financial services, contracts that concern any interest in land and contracts where one or more of the parties thereto is acting for purposes that are outside a trade, business or profession.

Specific Legislation for Statutory Covered Bonds

Until 2008, the UK covered bond market was governed by English common law and general structured finance principles. Covered bond programmes were arranged and administered through contracts alone rather than in accordance with any domestic legislative framework.

However, this meant that the UK was not compliant with EU Council Directive 2009/65/EC (the UCITS Directive), notably Article 52(4). Covered bond programmes that were compliant with this directive received preferential treatment, including higher investment limits. Therefore, the UK's non-compliance meant that UK 'structured' covered bonds were not competitive compared to the regulated equivalents originated by their European counterparts. Therefore, in March 2008, the UK government introduced the Regulated Covered Bonds Regulations 2008 (the Regulations) and brought UK covered bonds in line with the UCITS Directive.

Under the UCITS Directive, covered bond transactions must meet the following four requirements:

  • the issuing bank or credit institution must have its registered office in the EU;
  • the covered bond issuances must be subject, by law, to special public supervision designed to protect bondholders;
  • the cover assets must be sufficient to cover all amounts due under the covered bonds; and
  • the bondholders must have priority claims over the cover assets in the event that the covered bond issuer is unable to meet its payment obligations under the programme.

In 2011 and 2012, amendments were made to the Regulations in a bid to increase transparency in the UK covered bond market. Among other things, these amendments removed securitisation bonds from the list of eligible cover assets and established which liquid assets may be taken into account when calculating the over-collateralisation of the cover pool. These amendments became effective on 1 January 2013 and have bought UK-regulated covered bond programmes further in line with European-regulated covered bond regimes.

UK-regulated covered bonds are supervised by the FCA. Under the Regulations, the FCA has a broad range of enforcement powers, including the power to issue fines to and deregister issuers. It also has a power of veto over any material amendments to the contract.

Under the Regulations, issuers have the option to submit their covered bond programmes to the FCA for approval. Any programmes that are approved by the FCA, and that meet all the criteria laid out in the Regulations, are admitted to a register of covered bonds maintained by the FCA.

In practice, most covered bonds originated by UK credit institutions fall under the Regulations.

Issuances of Contractual (Structured) Covered Bonds

Despite the legislation, there is no barrier to creating unregulated, structured covered bonds through contract law. Their features are often similar to their regulated counterparts, although their structure is created through contractual arrangements rather than through legislation. However, these structured covered bonds do not benefit from all the advantages available to regulated covered bonds. For example, regulated covered bonds generally benefit from a pricing advantage with investors because they are lower risk and are more closely supervised. Similarly, because they are lower risk, regulated covered bonds attract a wider investor base than their unregulated equivalents.

In practice, most covered bonds are regulated; however, the number of structured covered bond programmes increased significantly following the global financial crisis of 2007. Despite losing the advantages that came with being regulated, issuers were drawn to the flexibility of structured covered bonds; for example, in terms of the assets included in the cover pool.

Types of Assets/Loans Typically Comprised in the Cover Pool

The Regulations impose eligibility rules that govern the types of assets that can make up the cover pool. The Regulations specify that the following are eligible.

  • Assets included in Article 129 Regulation 575/2013 (the Capital Requirements Regulation). However, these assets are subject to the following limitations: exposures to credit institutions with ratings below Credit Quality Step 1 (AA-), as set out in the Capital Requirements Regulation, are not eligible and securitisations are not eligible.
  • Certain assets that are not eligible under the Capital Requirements Regulation, including loans to registered social landlords.
  • Liquid assets up to a certain limit (typically, no more than 10%).

Despite this eligibility criteria, the majority of the regulated covered bonds have a cover pool that mainly consists of UK residential mortgages or public sector loans.

Cover assets must be located in European Economic Area (EEA) member states, Switzerland, the USA, Japan, Canada, Australia, New Zealand, the Channel Islands or the Isle of Man. If a cover pool includes non-UK assets, the issuer must receive confirmation that the laws of that jurisdiction will not negatively affect the rights of the security trustee or the cover pool generator.

The cover pool assets must also be of a superior quality. Indeed, if the FCA believes that the assets proposed to be included in a cover pool will negatively affect the interests of the investors or the reputation of the UK covered bond market, it has the right to reject any application for regulated status.

The issuer is responsible for ensuring that all cover pool assets meet the requirements laid out in the Regulations. The issuer and the cover pool generator also have to record their cover assets on a register, which must be available for inspection by the FCA.

Amendments to the Regulations mean that issuers of covered bonds should designate their covered bonds as backed by a liquid asset type (that is, by money or government securities) or by a single asset type (where the cover pool is made up of residential mortgage assets, commercial mortgage assets or public sector loans).

Investors' Recourse to the Cover Pool in the Event the Issuer Defaults

The Regulations ensure that investors will have recourse to the cover pool if the issuer defaults, by requiring all cover assets to be segregated from the issuer. The assets are sold to an SPV acting as the cover pool generator, which then guarantees the issuer's obligations under the bonds. The SPV also provides security over the cover pool assets to a security trustee on behalf of the investors. The segregation of the cover pool, away from the issuer, means that if the issuer were to become insolvent, the cover pool would be less likely to be absorbed into the issuer's insolvency estate.

A key requirement of the Regulations is that the cover pool must be capable of covering all claims attaching to the bonds at all times. The cover pool must be over-collateralised by, at least, the higher of:

  • the regulatory minimum of 108%;
  • any contractual minimum amount;
  • requirements imposed by the FCA; and
  • amounts required to pass the programme's Asset Coverage Test (ACT).

The minimum over-collateralisation level for each covered bond transaction is also considered by the FCA on a case-by-case basis and it has the power to require the issuer to add further assets to its cover pool if it thinks it is necessary.

In a winding-up of the issuer and the SPV, the Regulations state that any claims from the regulated covered bondholders against the cover assets rank in priority to all other creditors. Furthermore, if the proceeds from the cover pool are insufficient, the bondholders will have an unsecured claim against the issuer generally.

Required/Desirable Aspects of the SPV

Most importantly, the Regulations provide that the cover pool assets are segregated from the issuer; therefore, the SPV acting as the cover pool generator must be a separate entity. Furthermore, not only must the issuer have its headquarters in the UK, the SPV holding the cover pool must also be based in the UK.

All regulated covered bond programmes to date have used an LLP as the SPV. The cover pool tends to be transferred to the LLP via an equitable assignment and the purchase price is usually paid by cash, funded by a loan from the issuer or taking a partnership interest in the LLP.

Pending Reform/Proposals

EU Draft Legislation

In March 2018, the EC published a proposal for a directive on covered bonds and a regulation amending, among other things, Article 129 of the Capital Requirements Regulation. The proposal reflects the EC's aim to create an EU framework for covered bonds. However, the impact of this proposed legislation on the UK will depend on if, when and how the UK leaves the EU.

Harmonised Transparency Template

In September 2015, the Harmonised Transparency Template (HTT) was announced by the Covered Bond Label Foundation and the European Covered Bond Council. This was implemented for all covered bond issuers that hold the Covered Bond Label. The HTT ensures that market participants have access to data relating every covered bond to its cover pool assets and to the legislative framework under which it was issued. Issuers are required to release the completed HTT on their websites at least quarterly. Failure to do so will prevent the renewal of their Covered Bond Label.

On 18 September 2018, the Covered Bond Label Foundation released the 2019 version of the HTT.

Brexit

The UK's expected exit from the EU may affect UK covered bond transactions, although the specific impact will be determined by how the country leaves. Due to the government's onshoring contingency preparations, it is likely that if/when the UK leaves the EU, much of the UK covered bond legislative framework will substantially remain the same. The intent of onshoring is not to make policy changes, but to convert the body of directly applicable EU law (including the Capital Requirements Regulation) into UK domestic law.

However, some of the current covered bond legislation may not be workable for the UK after Brexit. Currently, in order to comply with the UCITS Directive, the issuer must have its registered office in the EU. The Regulations require the issuer's registered office to be in the UK. Therefore, the current legislative covered bond framework will not be feasible for the UK after Brexit in its current form and amendments will need to be made if UK covered bonds are to remain compliant with EU law and receive preferential treatment as they do under the EU framework.

The issuance or permission of issuance of collateralised obligations through on-balance sheet structured products programmes is increasingly seen.

Collaterals are typically provided in the form of a charge or pledge over a custody account. Collaterals may be given specifically to one single issuance or pooled across a number of issuances, may be static or dynamic in terms of value and may or may not be limited recourse in nature.

Collaterals are generally comprised of securities that are capable of being held in a custody account. These securities and associated rights will then be the subject of the security interest. The governing law of that security interest will be chosen in accordance with the location of the account to facilitate the recognition and enforcement of the security interest.

In the case of accounts located in London, security will generally be taken by way of an English law charge, although the characteristics of that charge and the eligibility for the protections afforded by the financial collateral regime would vary.

Credit-linked notes may be issued from a bank's balance sheet or finance subsidiary, or by an SPV. In the case of the former, issues will typically utilise a structured products platform of an issuer, together with a dedicated credit product annex or supplement. 

These transactions will often reference a single, relatively liquid underlying credit, although basket transactions or transactions linked to credit default swap indices are also relatively common. Less usually, such structures may reference tranches of a credit default swap index, short credit positions (investor buys credit protection) or hybrid underlyings (that is, some form of underlying credit risk combined with an equity or index pay-off).

In the case of SPV structures, risk will typically be transferred to an SPV through an OTC derivative contract or similar (see below) with the SPV then issuing the credit-linked notes. Such structures may reference underlying credit risks described above or tranches of the credit risks associated with an illiquid underlying credit portfolio; for example, loans or derivative exposures.

Protection buyers may be investment banks, as an extension of their trading and market-making activities, or commercial banks seeking protection and capital relief in respect of portfolios of credit assets. Protection sellers/investors in respect of transactions intended to result in regulatory capital relief will typically be funds of varying types. Investors in transactions representing securitised but otherwise relatively standard credit default swap positions may be institutions or high net worth individuals, in the latter case often by way of private bank distribution.

Credit-linked notes may be issued from a bank's balance sheet or finance subsidiary, or an SPV.

In the case of an issuance through an SPV, the proceeds of the credit-linked notes will typically be invested to generate a return, usually in highly rated securities, in an interest-bearing account or in a repo or similar transaction. 

The issuer will enter into a credit derivatives contract or financial guarantee with the protection buyer/originator and will receive a premium thereunder. 

The premium received, together with the return from investing the note proceeds, will fund the coupon payments under the credit-linked notes. Realised credit losses will be reflected in a loss of principal on the credit-linked notes.

There can be a wide variety of product underlyings. 

A majority of on-balance sheet credit-linked notes will refer to reference entities that are traded on the credit default swap market and will be hedged on that basis. However, credit-linked notes may also be issued to hedge the risks of an underlying in a bond, loan or, less commonly, swap form. Such credit-linked notes will often be expressed on a reference obligation-only basis and may be physically settled.

Where credit-linked notes are issued to obtain capital relief on loan portfolios, a wide variety of portfolios may be utilised, ranging from portfolios comprised of relatively large, idiosyncratic loan assets to high-volume, short-duration assets such as trade receivables. Less commonly, underlyings may be comprised of derivatives exposures.

CLN transactions permit an issuing or originating bank to reduce risk-weighted assets in relation to loans extended by the bank, or other relevant credit risk positions, in accordance with the requirements of the EU Capital Requirements Regulation (EU) No 575/2013.

A majority of CLNs are privately placed. However, public offers in various jurisdictions do occur.

The primary regime for CLN disclosure requirements is the EU Prospectus Directive (where an offer to the public is made or a listing is sought on a regulated market in the EU) or any relevant stock exchange rules if a listing is sought on an exchange-regulated venue. The application of, for example, market abuse regimes may be complex in the case of private underlying assets.

There are no specific pending reforms, with the exception of Brexit. 

The revised EU regime with respect to securitisation transactions will take effect from January 2019 and will accordingly be carried over into UK derivative legislations on Brexit.

The vast majority of structured products that are regularly offered in the UK are auto-callable products and leveraged tracker products (and slight variations). These products are generally linked to mainstream indices and, to a lesser extent, equity shares. The majority of auto-callable products are issued as excluded indexed securities (EIS) products as a wrapper (whereas in continental Europe it would just be an auto-callable note). Other products that are offered in the UK include fixed-term participation products, outperformance notes, supertrackers and structured deposits.

The main issuers who are active in the UK structured products market are Investec, Société Générale, Commerzbank, Goldman Sachs, Morgan Stanley and HSBC. Credit Suisse, Natixis, Citigroup and BBVA are also notable players in the market.

Where a structured product is issued, marketed and sold to UK/EU investors, a number of regulatory obligations apply, depending on the role performed by the relevant entity in respect of such structured product.

The issuer of the structured product is likely to be regarded as a manufacturer of such structured product for the purposes of (i) the product governance requirements under the Markets in Financial Instruments Directive II (MiFID II) and (ii) if the structured product in question will be offered to retail investors and amounts to a Packaged Retail and Insurance-based Investment Product (a PRIIP), the PRIIPs Key Investor Document (KID) Regulation (PRIIPs Regulation). To the extent that the issuer is a MiFID investment firm, it will therefore be required to make a "target market assessment" (ie, identify a general target market of investors that the notes are proposed to be sold to). Similar product governance obligations will apply to the entity that distributes the structured product (distributor), where those distributors are also EU investment firms.

Where the issuer is a 'supervised entity' for the purposes of the Benchmarks Regulation (BMR), which includes investment firms located in the EU, and the structured product being issued references a 'benchmark' that falls within the scope of the BMR, the issuer will need to ensure that the contractual terms contain a robust fall-back mechanism for circumstances where the benchmark materially changes or can no longer be used, for regulatory reasons.

An entity that seeks to distribute structured products to prospective investors is likely to be regarded as carrying out a dealing activity (for example, "dealing as principal" under the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (RAO), or "dealing on own account" under MiFID II, unless the dealer can rely on an applicable exemption. Additionally, a dealer may be providing corporate finance advice to the issuer under the programme (an ancillary service under MiFID II). Overseas dealers that seek to allocate structured products to UK investors may, in some cases, seek to rely on the overseas persons exemption under Article 72 RAO, in connection with dealing services they carry on in the UK.

A number of further considerations apply in connection with the marketing of structured products. In particular, where structured products are being offered to the public in the EEA, the Prospectus Directive (PD) will apply (unless the issuer or offeror is able to reply on an applicable exemption) and the issuer or offeror will be required to prepare a PD-compliant prospectus. The PD will also apply where the structured products are admitted to trading on a regulated market in the EEA.

Where the structured product amounts to a PRIIP and is being offered to retail investors, the manufacturer will also be required to prepare a key investor document, which is a three-page document giving a summary description of the product, the risks associated with it and the costs charged to investors.

Where structured products are marketed in the UK, the UK's financial promotions regime will also be relevant; however, applicable exemptions under the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 are likely to apply where promotions are made to investment professionals/sophisticated investors.

It is possible to issue structured products without needing a licence (and many banking groups have unregulated SPVs that are the issuer). However, typically the offering/dealing in relation to such products requires authorisation (in the UK) from the FCA; for example, as an investment firm with a dealing on own account/principle permission (as noted above). It is also possible for an issuer to be carrying out a regulated activity that requires authorisation given the amendment to executing client orders under MiFID II, which now includes issuing products to clients (ie, a direct relationship).

Where the offer of the structured product falls within the scope of the PD (ie, the securities are publicly offered or listed on a regulated market in the EEA), the relevant prospectus will need to be approved by the FCA (or by a competent authority in another EU jurisdiction and passported into the UK).

UK-based dealers in relation to structured products that are being sold to EU investors will currently be able to rely on existing MiFID II passporting permissions, for the purposes of allocating structured products to EU investors (however, this will not be the case upon a 'hard Brexit'). UK dealers will therefore need to consider the nature of their existing roles and potential alternative structures to enable them to continue performing this role following Brexit.

Under the FSMA, the FCA has product intervention powers, which enable it to prohibit regulated firms from, among other things, entering into certain contracts. This is with a view to advancing the consumer protection objective, the competition objective and the market integrity objective.

These rules may include:

  • requiring certain product features to be included, excluded or changed;
  • requiring amendments to promotional materials;
  • the imposition of restrictions on sales or marketing of the product; or
  • in more serious cases, a ban on sales or marketing of a product in relation to all or some types of client; for example, the FCA has previously banned the retail distribution of contingent convertible (CoCo) bonds to UK retail investors.

The documentation used for the issuance and offering of structured products typically falls into one of two categories.

If the structured product offering/issuance is subject to the PD regime (ie, the securities are publicly offered or listed on a regulated market in the EEA), a valid PD-compliant approved prospectus is required. The prospectus for most issuances consists of a base prospectus (approved by the UK Listing Authority department of the FCA or approved by a competent authority in another EU jurisdiction and 'passported' (ie, notified) into the UK) setting out the terms and conditions of the securities and information relating to the issuer and/or guarantor, which is completed by a document called the 'final terms' that contains the specific details for that particular issuance. However, if the securities cannot be issued under a valid base prospectus (eg, if the payout mechanics are not provided for in the base prospectus or the specific terms and conditions for the relevant underlying asset are not provided for in the base prospectus) then a standalone prospectus (often called a 'drawdown prospectus') will be required for the offering/issuance of the securities that will need to be approved by the UK Listing Authority department of the FCA or approved by another competent authority and 'passported' into the UK.

Otherwise, the documentation typically consists of an unapproved issuance programme (or approved only by the relevant exchange on which the securities are to be listed) setting out the terms and conditions of the securities and information relating to the issuer and/or guarantor, and completed by a document called the 'pricing supplement' that contains the specific details for that particular issuance.

Where the structured product is offered in the form of a structured deposit, the documentation involved will generally comprise (i) a deposit agreement and/or confirmation between the relevant deposit-taker and the distributor setting out the terms of the deposit, and (ii) the relevant marketing brochure or other materials that set out the terms of the structured product.

Manufacturers and distributors that are subject to the MiFID II product governance rules will set out their various roles and responsibilities in a written agreement (which may in practice take the form of a MiFID II annex to an existing distribution agreement). This agreement will reflect the duties of both parties under MiFID II (including the responsibility of the manufacturer to identify a 'general' target market for the structured products and the distributor's duty to identify a more 'specific' target market).

Where one or more of the structured products being distributed are also subject to PRIIPs KID legislation, the annex is also likely to set out the relevant roles and responsibilities of the manufacturer and distributor under the PRIIPs Regulation.

A distribution agreement or annex of the nature described above will set out the functions of the manufacturer and the distributor, and the manner in which they will co-operate to fulfil their respective obligations. The manufacturer will provide undertakings reflecting its various responsibilities under MiFID II (eg, to provide accurate, clear and not misleading documents and information to the distributor, and potentially also to provide the distributor with views as to potentially appropriate distribution channels for the product). Similarly, the agreement will reflect the various obligations the distributor is required to fulfil, as further detailed below.

The relevant duties of the distributor under MiFID II are set out in PROD 3.3 of the FCA Handbook. In general terms, the duties of a distributor under MiFID II are to (i) understand the financial instruments it distributes to clients; (ii) assess the compatibility of the financial instruments with the needs of the clients to whom it distributes investment services, taking into account the manufacturer's identified target market of end clients; and (iii) ensure that financial instruments are distributed only when this is in the best interests of the client.

Where the product in question is a PRIIP, the distributor will be under additional obligations (for example, the requirement to provide retail clients with a key information document in good time before a given transaction is concluded in accordance with the PRIIPs Regulation).

Where the manufacturer and distributor are MiFID firms, the general (and potentially also the specific) inducements regime will be relevant. The general inducements rule prevents investment firms from paying benefits to, or receiving benefits from, third parties (unless the relevant benefit can be said to enhance the quality of the service to the client).

Where distributors receive fees from manufacturers, it is likely that the manufacturer will be required to disclose any fees payable. Furthermore, MiFID II contains an additional prohibition on third-party benefits in connection with portfolio management and independent investment advice, other than certain specified minor non-monetary benefits (which will also be relevant where, for example, a distributor proposes to carry out an advised sale to a client).

Where a distributor receives fees, it is typically a percentage of the aggregate nominal amount of the issuance of the relevant series of securities. This fee can be paid directly to the distributor, or may be received by the distributor by purchasing the securities from the issuer or dealer at a discount and then selling them to the investors at par (or at an amount above the price they paid to the issuer). Distributors occasionally receive fees based upon the performance of the securities (or the performance of the underlying assets that the securities reference), although this is less frequent.

Structured products may be listed on the LSE main market (the regulated market) and the LSE professional securities market, although structured products are more often seen being listed on exchanges in Luxembourg and Ireland.

Listing of structured products is typically sought for one of a number of reasons that include (but are not limited to):

  • investor requirements (eg, certain investors can only invest in listed securities);
  • for tax reasons (eg, EIS);
  • if settlement through the Certificateless Registry for Electronic Share Transfer (CREST) is required;
  • investor demands (eg, due to a perception that listed securities have had to satisfy listing requirements and therefore may be seen to have had an additional level of scrutiny); or
  • perceived liquidity (although for technical listings this is rarely a major factor).

In order to list securities on the main market of the LSE, the issuer will have to comply with the Prospectus Directive requirements in relation to such securities (ie, there will need to be a valid prospectus that complies with the relevant requirements under the Prospectus Directive regime) and the LSE listing rules. In order to list securities on the professional securities market, issuers must comply with the LSE listing requirements.

Under Section 85 of the FSMA, it is unlawful for an issuer to offer transferable securities (which will include certain structured products) to the public, unless a prospectus has been prepared (which has been approved by the FCA). It is a criminal offence to breach Section 85 of the FSMA (although a number of exemptions apply to the general rule).

Where the offer is made to certain types of 'qualified investor' (which will include, for example, professional investors), the issuer will be exempt from the general requirement. Equally, the issuer may be exempt from the prospectus requirement, where the offer is directed at fewer than 150 persons (other than qualified investors, in a given EEA state), or where the minimum amount paid by the person acquiring the relevant product in connection with the offer is at least EUR100,000 (or an equivalent amount in another currency).

A number of pending reforms may impact the issuance and offering of structured products in the UK.

Brexit

UK issuers currently are able to rely on a valid prospectus or an authorisation in respect of a regulated activity (such as dealing in structured products) being passported from the UK to another EEA jurisdiction to list securities on a regulated market or distribute securities in such jurisdiction. Similarly, issuers incorporated outside the UK (but in another EEA member state) can rely on a valid prospectus or an authorisation being passported from their home member state to list securities or distribute securities in the UK. There is still a great deal of uncertainty as to how this will operate if the UK fails to agree a deal for exiting the EU (ie, if there is a 'hard Brexit). However, the UK Listing Authority has indicated that any approvals/authorisations in place prior to the date on which the UK leaves the EU will continue to be valid after such date until the relevant expiry.

PRIIPs KID

Firstly, the European Supervisory Authorities (ESAs) have recently published a consultation in which they have proposed changes to the PRIIPs KID regime (including the inclusion of past performance as well as simulated performance in the KID) and depending on the outcome of this consultation, there could be amendments to the regime that impact the issuance and offering of structured products, and secondly, the UK's proposed implementation of the PRIIPs KID legislation in the event of a hard Brexit may lead to different KIDs being required for PRIIPs sold to retail investors in the UK and those sold outside the UK (but in the EEA).

Prospectus Regulation

The new Prospectus Regulation came into force in July 2017. Certain provisions applied since July 2017 and July 2018, but the remainder of the legislation will apply from 21 July 2019, after the UK leaves the EU. The EU (Withdrawal) Act 2018 will only convert EU legislation that is in force before exit day into UK law. HM Treasury has indicated that it is the government's intention to domesticate the remaining provisions of the Prospectus Regulation, but it is not known when this will take place.

CFDs/Binary Options

In 2018, the European Securities and Markets Authority (ESMA) agreed on temporary intervention powers to prohibit the marketing, distribution or sale of contracts for difference (CFDs) and binary options to retail investors. The FCA has now proposed permanent measures in relation to the sale of retail CFDs and binary options, to apply to firms acting in or from the UK, that will (i) ban the sale, marketing and distribution of binary options to retail consumers, and (ii) restrict the sale, marketing and distribution of CFDs and similar products to retail customers. "Closely substitutable products" for CFDs include options that have similar payout structure and risk features as CFDs, which are sold under a variety of commercial labels, including turbo certificates, knock-outs or delta-ones. The proposed binary option ban would also include certain 'securitised' binary options. In both cases, these products were either carved out or not included in ESMA’s temporary intervention measures.

A firm that enters into an OTC derivative will, in the absence of an exemption, be carrying out a regulated activity (ie, dealing as principal or agent in a specified investment). The OTC derivative may be a future, option, or contract for difference, all of which are "specified investments" under the Financial Services and Markets Act 2000 (Regulated Activities Order) 2001.

There are certain instruments that have the characteristics of derivatives, but are nonetheless currently considered to fall outside the regime, such as certain crypto assets.

There are specific exemptions for firms who are dealing on own account or who are, for example, dealing in commodity derivatives as an ancillary part of their overall business (such as for the hedging of physical energy trading). In some cases, it may be possible for third country firms to carry out OTC derivative transactions with a UK entity, where such activity falls within the overseas persons exemption set out in Article 72 of the RAO. Where there is no exemption available, a firm will be required to acquire authorisation under Part 4A of the Financial Services and Markets Act 2000.

As a consequence of Brexit, the UK will (subject to negotiations) be considered a third country, under applicable EU law, meaning that UK firms that enter into derivatives with EU 27 counterparties may be considered as providing a regulated activity within the jurisdiction of their client. There is no harmonised third country regime and different member states therefore have varying approaches in relation to whether a UK firm entering into a derivative with a counterparty in their jurisdiction requires authorisation.

For example, certain jurisdictions (such as Ireland) have exemptions that enable overseas firms to carry out business with professional clients in the local jurisdiction (without the overseas firm needing to be authorised locally). Similarly, in many jurisdictions, a UK firm that has an existing derivative contract with a counterparty in an EU jurisdiction will need MiFID permissions to carry out certain life-cycle events, including contractual 'rolls' and 'compression'.

There are additional consequences, in terms of margin and clearing requirements, in relation to a derivative entered into or currently existing between UK and EU counterparties (including derivatives carried out intragroup, between a UK and an EU group member).

In relation to UCITS vehicles and Solvency II insurers, there are restrictions as to the nature of OTC derivative transactions that can be entered into (and the basis for entering into such transactions). UCITS vehicles will be permitted to enter into derivative transactions, but will be subject to the exposure requirements set out in the UCITS Directive (and COLL 5.3 where local UK rules apply). Similarly, under Solvency II, the use of derivatives by Solvency II insurers is possible, where such transactions meet the 'prudent person principle', or otherwise where the use of derivatives contributes to a reduction of risks, or facilitates efficient portfolio management.

Fund managers, subject to the AIFMD, are not under such regulatory restrictions. Managers can therefore enter into OTC derivatives, subject to the contractual restrictions placed on them by the investment management agreement. Consideration should, however, be given to the leverage restrictions applying under AIFMD and the extent to which OTC derivatives form part of the overall level of leverage employed by the AIF. There are additional considerations in respect of the European Market Infrastructure Regulation and Capital Requirements Directive IV, in relation to initial/variation margin and capital treatment; however, these considerations do not vary depending on fund type.

There are a number of industry-standard product-specific master agreements governed by English law that are capable of being used to enter into transactions that could be characterised as derivative transactions. 

For example, there are a number of market associations for commodity (including emissions) and energy traders that have published master agreements for trading energy products. The General Agreements concerning the delivery and acceptance of power or gas published by the European Federation of Energy Traders (EFET) are two of the more commonly used examples of such master agreements. While the EFET General Agreements permit parties to enter into options, which are a transaction type capable of being characterised as derivative contracts, in practice parties will often split their trading activities so that energy derivatives are traded under an International Swaps and Derivatives Association (ISDA) Master Agreement and physical energy trading transactions are traded under an EFET General Agreement.

Similarly, (i) bullion transactions and options can be undertaken under the International Bullion Master Agreement published by the London Bullion Market Association (LBMA) and the Foreign Exchange Committee for the trading of gold or silver bullion, and (ii) FX transactions and currency options can be undertaken under the 2005 International Foreign Exchange and Currency Option Master Agreement published by the Foreign Exchange Committee, the LBMA, the Canadian Foreign Exchange Committee and the Japanese Bankers Association jointly (or its predecessors).

Parties may also enter into cross-product master netting agreements that provide for close-out netting or set-off of early termination amounts payable under multiple trading master agreements between the parties. The 2003 Cross Product Master Agreement – jointly published by, among others, the British Bankers’ Association and ISDA – is an example of this type of agreement and EFET also publishes several forms of master netting agreement. Despite these market-standard master netting agreements, many financial institutions will have their own versions of such agreements.

Credit institutions and investment firms in the UK and the rest of the EU will typically obtain legal opinions to confirm the enforceability of the netting and collateral arrangements contemplated by the master agreement under which they trade. In the event of their counterparty's insolvency, these opinions are required for such arrangements to be recognised for the purposes of their capital calculations under Capital Requirements Regulation (EU) No 575/2013.

As a general matter, netting and collateral opinions under English law have positive conclusions. That is particularly the case where the arrangement constitutes a "financial collateral arrangement" for the purposes of the Financial Collateral Arrangements (No 2) Regulations 2003 (SI 2003/3226), as amended, or where the close-out netting provision in the relevant master agreement contains a flawed-asset clause, which makes a party's obligation to perform under the contract subject to the condition that the counterparty is not in default nor is default imminently likely.

Where the close-out provisions of the relevant master agreement operate on the basis of set-off rather than a flawed-asset clause and the arrangement is not a financial collateral arrangement, English law netting opinions will typically be qualified by reference to the application of mandatory insolvency set-off under the Insolvency (England and Wales) Rules 2016 (SI 2016/1024). With respect to other qualifications typically included in English law netting opinions, see 7.4 Stay Acknowledgement.

The close-out netting provisions set forth in the 1992 ISDA Master Agreement and the 2002 ISDA Master Agreement are generally viewed as enforceable under English law on a number of grounds.

First, the single agreement provisions of the ISDA Master Agreements are generally held to be enforceable.

Second, close-out netting provisions are generally viewed as enforceable on the basis that those provisions represent a mechanism of account rather than a deprivation of value.

Third, to the extent that these provisions are viewed as, in substance, set off provisions, they are in any event broadly consistent with mandatory provisions of English insolvency law. The operation of rights of set-off is generally viewed as outside the scope of the moratorium on the enforcement of security that applies in certain types of insolvency/rehabilitation proceeding.

Finally, and to the extent applicable to the particular case in question, enforceability of close-out netting is mandated by EU-level legislation, including the Financial Collateral Directive as implemented in the UK. That position is not expected to change as a result of the UK's exit from the EU.

Note that particular issues may arise with respect to certain types of counterparties.

The election of automatic early termination is not generally recommended, as this may potentially result in uncertainty as to the timing of termination and exposure to market movements as between termination of rated hedging transactions and market closure.

There is an English law opinion on the enforceability of close-out netting under the 1992 ISDA Master Agreement and the 2002 ISDA Master Agreement.

The English law opinion is subject to certain qualifications that are not uncommonly applied to enforceability opinions given under English law. For example, certain rights and obligations may be qualified by the nature of remedies available in the English courts, as well as doctrines of good faith and fair conduct, and laws based on those doctrines and other principles of law and equity of general application.

Stay powers may be invoked pursuant to the UK implementation of the EU Bank Recovery and Resolution Directive (BRRD) in relation to a bank or firm within its scope. In the UK, the requirements of the BRRD are implemented into national law mainly through the UK Banking Act (and relevant statutory instruments). 

The Bank of England, as the UK national resolution authority for BRRD purposes, has a variety of powers to stay or otherwise override the rights of counterparties facing entities in resolution under certain financial contracts. National law implementing the BRRD in the UK provides that neither a crisis prevention measure nor a crisis management measure, nor any event directly linked to the application of such a measure, is allowed to constitute a trigger for contractual termination, netting or set-off rights, or enforcement of security in relation to the institution in resolution or a member of its group on a cross-default basis. In each case this is subject to the condition that payment, delivery and collateralisation obligations continue to be performed under such financial contracts. This is referred to as the 'General Stay'. 

The Bank of England is also provided with a set of tools to deal with banks or firms within its scope that are failing or likely to fail and thereby address banking crises pre-emptively to safeguard financial stability and minimise taxpayers' exposure to losses incurred by financial institutions. In addition, the UK Banking Act grants ancillary powers to the Bank of England to suspend temporarily enforcement or termination rights that a party might otherwise be able to exercise under a contract with an in-scope bank or firm as a result of resolution measures in respect of such bank or firm, as well as to modify contractual terms and/or to disapply or modify laws in the UK (with possible retrospective effect) to enable the resolution tools under the UK Banking Act to be used effectively.

Thus the Bank of England is empowered to impose a stay on enforcement of rights of termination and close-out in financial contracts where an institution is subject to resolution measures. Together with the provisions relating to General Stay, these are to enable an orderly valuation and resolution of the institution's liabilities without increasing the risk of financial contagion. The effect of this stay should be recognised in EEA countries that implement the BRRD; however, where the relevant financial contract is governed by the law of a non-EEA state, there is a risk that the stay would not be recognised under such law. Accordingly, there is a contractual recognition rule in the UK to seek to achieve the same outcome by requiring in-scope banks and firms to include an equivalent restriction in their financial contracts.

Such rule is based on the definition of "financial contract" in the BRRD and applies to obligations under swap agreements and derivatives contracts. However, obligations under financial contracts with designated payment and securities settlement systems, recognised central counterparties, central banks or central governments are excluded.

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Law and Practice in UK

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Ashurst Ashurst is a leading global firm with a rich history spanning almost 200 years. The firm has 26 offices in 16 countries, with around 400 partners and a total of more than 1,600 lawyers working across ten time zones, so it is able to respond to clients wherever and whenever they need. As a global team it has a reputation for successfully managing large and complex multi-jurisdictional transactions, disputes and projects, and delivering outstanding outcomes for clients. In relation to the structured finance and derivatives sector, Ashurst's key areas of practice include derivatives, structured products, securitisation, debt capital markets and Islamic finance. The firm's dynamic practice, which is well supported by its highly regarded financial regulation, dispute resolution and tax teams, offers specialist advice on a wide range of capital markets and structured finance transactions. Ashurst would like to credit the following lawyers for their contribution to the UK chapter of this guide: Alexander Biles, Don Brown, Vicky Brown, Tim Cant, James Knight, Thomas Picton, Gabrielle Samuels and Inga West.