The UK covered bond market received a boost in July when the Treasury and the Financial Services Authority (FSA) announced that they will fall into line with the rest of the EU on the regulatory treatment of these instruments.
The EU has established criteria for covered bonds that are prescribed in Council Directive 85/611/EC25 on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (the Undertakings for Collective Investment in Transferable Securities (Ucits) directive).
Covered bonds that comply with the Ucits directive benefit from higher prudential investment limits and preferential credit risk weightings. The aim of Article 22(4) of Ucits is to identify bonds where the issuer is a credit institution and the bonds have an asset pool that contains eligible assets which are ringfenced from the assets of the issuer upon its insolvency.
Levelling the playing field
Even though UK covered bonds are based on well-accepted market standards and benefit from a high level of legal certainty, because they do not comply with the Ucits directive they do not have the benefit of higher investment thresholds and more favourable risk weightings. The Treasury believes it is both important and appropriate for UK issuers to be able to compete on a level playing field in the EU open market. The Treasury has therefore developed a proposed legislative framework for UK-recognised covered bonds to provide the necessary underpinning for Ucits 22(4) compliance.
The approach that the Treasury has taken is principles-based. The ultimate aim is for industry participants to use the legislative framework as a starting point and develop their own contractual provisions that will support the legislative underpinning. However, some critics of the legislative framework may have preferred a less flexible approach in regard to certain elements of the regime, such as the criteria to determine covered bond asset quality.
The draft regulations do not impose detailed qualitative criteria on the covered bond asset pool. The Treasury would welcome views on whether the proposed legislative framework should have some prescription as to the quality of UK-recognised covered bonds.
The proposals also provide for the establishment of a register of UK-recognised issuers and their programmes of issuance. It will be necessary for an issuer to apply to the FSA for admission to the register in such manner as required by the FSA (yet to be finalised), but will basically mean that an issuer will have to satisfy the FSA that it is Ucits 22(4)-compliant.
The FSA will be required within six months to make a decision on whether to admit the issuer and/or its programme to the register.
The Treasury has sought guidance on whether the proposed time limits for the process are practical or whether there should be different time limits for recognition of the covered bonds where the issuer has already been recognised. Ucits 22(4) envisages the ringfencing of an issuer’s assets from the general insolvency of the issuer, but does not prescribe the means to achieve that outcome.
There appear broadly to be two approaches to this issue within the EU:
– either the assets continue to be owned by the issuer and ringfenced by legislation (the integrated model); or
– the assets are transferred to an owner other than the issuer (the special purpose vehicle model).
The Treasury’s aim to provide choice and flexibility means that it has included a form of integrated model within the legislation so that industry participants may decide which structure best suits their particular circumstances.
In the case of the integrated approach, however, various provisions of the existing insolvency law will need to be changed.
Even though the legislative regime is designed to be flexible, the FSA will have significant enforcement powers. The most significant of these is the removal of an issuer from the register, making the issuer unable to issue any more UK covered bonds.
The FSA will also have the power to require issuers to add additional assets to an asset pool if it is not satisfied that the assets contained within the asset pool are sufficient to cover all claims attaching during the whole period of the validity of the covered bonds. In determining the amount of any penalty, the FSA will be required to have regard to the seriousness and nature of the contravention and the extent to which the contravention was reckless or deliberate.
It is worth noting that the costs of any FSA direction enforced by an injunction or court order would be substantial, and particularly in the case where the issuer no longer exists they would be borne by the asset pool.
Third party advice
The proposed legislative regime provides that an issuer is responsible for ensuring it complies with the regulations and it will be required to declare formally compliance at recognition. It must also obtain declaration of compliance on a range of matters from a suitably qualified independent third party professional adviser.
The Treasury believes that the use of third party verifications provides clear resource and costing benefits for itself and for the FSA. Issuers will, of course, have to address the cost of obtaining any third party professional declaration. Legal and financial advisers will have to think carefully about whether they will be required to provide opinions that fall outside the scope of what an adviser would normally provide in such circumstances.
For instance, the regulations provide that whatever structure an issuer proposes to use to issue the bonds, it must provide the necessary bondholder protection through private law arrangements, and that the structure is effective to achieve the legal ringfencing of assets.
The issuer would have to rely on an independent verification by a third party legal adviser to satisfy this part of the regulations. The financial adviser may be called on to provide an independent verification that there are enough assets in the covered bond asset pool to meet the claims of bondholders. It may well be appropriate for the FSA to prescribe the form of this verification and the type of analysis and assessments to be made in reaching an opinion.
It is unclear what interplay legal and financial opinions will have in the successful admittance of an issuer to the covered bond register. It is arguable that the FSA is placing an excessive degree of reliance on third party advisers to ensure an issuer’s compliance with Ucits 22(4).
The future will show whether the new regime will be a sufficient base to set long-term standards for the UK covered bond market and whether its introduction leads to market growth while providing robust bondholder protection.
The Treasury has advised that the consultation period will end on 15 October and that the new regime is expected to come into force on 1 January 2008.
Alan Newton is head of structured finance and Will Higgs is an associate at Freshfields Bruckhaus Deringer