The Financial Services Act of 15 June 2018 (FinSA) and the consultation draft Financial Services Ordinance (draft FinSO) dated 24 October 2018 include significant new rules for the distribution of financial instruments and the regulation of financial services in Switzerland. This article discusses the potential impact of the new rules on Asset-Backed Securities (ABS) in relation to the timing of prospectus review and approval, the obligation to prepare a Key Investor Document (KID) and the regulation of services typically provided by investment banks in connection with ABS transactions. The article is based on the version of draft FinSO published for public consultation.

By Daniel Adler / Daniel Bono (Reference: CapLaw-2019-01)

1) Introduction

The new rules do not contain a definition of Asset-Backed Securities. With the exception of very few mandatory minimum disclosure requirements (which substantially correspond to current SIX Swiss Exchange (SIX) rules), there are no new rules which specifically apply to ABS. Nevertheless, the new rules have an impact on ABS which are typically issued in the form of bonds. ABS can be very diverse in terms of structure and possible underlyings. This article is based on the most common type of ABS in the Swiss domestic market, i.e. ABS based on the cash flow of customer payments from a pool of car leases, so called Auto Lease ABSs. The current market practice for Swiss domestic Auto Lease ABS transactions has been developed for the inaugural Cembra (GE Money Bank) transaction in 2013 and has since been continually updated. Further transactions included additional Cembra transactions as well as transactions by MultiLease and AMAG Leasing. The most important features of a typical Auto Lease ABS transaction in Switzerland are summarized below. 

The leasing company (as originator of the lease assets and seller) sells and transfers a pool of auto lease assets (including lease agreements) to a special purpose vehicle (SPV) which is newly incorporated in Switzerland. The SPV funds most of the purchase price through the issuance of SIX-listed bonds (ABS bonds), another part by issuing a subordinated certificate (subordinated to the ABS bonds) to the leasing company and other funding provided by the leasing company (credit enhancement by overcollateralization). The SPV uses the asset pool to secure its payment obligations under the ABS bonds. The ABS bonds may be split into tranches with varying degrees of subordination to appeal to different types of investors. The subordinated tranches carry greater risk and pay higher yields. Typically, the subordinated tranches have minimum denominations of CHF 100,000 and are, therefore, not for retail investors. The most senior tranche typically has an “AAA” rating from one or more of the three major rating agencies. 

The payment obligations of the SPV under the ABS bonds are limited recourse obligations. Therefore, the ultimate source for payment of interest and repayment of principal of the ABS bonds are cash collections from the lease assets (mainly lease payments and proceeds from the sale of lease vehicles). Available cash collections are distributed subject to a priority of payments (the so called “waterfall”). During the so-called “Revolving Period”, the SPV uses available cash collections from the lease assets, among other things, to pay interest under the ABS bonds and purchase additional lease assets. Following the end of the Revolving Period, the leasing company has the option to repurchase the entire portfolio. Upon exercise of the repurchase option, the SPV redeems the ABS bonds. If the repurchase option is not exercised (or the Revolving Period is terminated for another reason) the SPV ceases to purchase new lease assets and uses available cash collections to redeem the principal of the ABS bonds. Interest rates will then step-up. The leasing company will continue to service the asset pool on behalf of the SPV pursuant to a servicing agreement, subject to the appointment of a replacement servicer upon the occurrence of certain events of default with respect to the servicer. Swiss public ABS transactions do not include derivatives.

This article does not discuss non-Swiss rules that have an impact on structuring Swiss ABS transactions (e.g. through risk retention requirements and selling restrictions). These include the new EU Securitisation Regulation (Regulation (EU) 2017/2402 of the European Parliament and of the Council of 12 December 2017 laying down a general framework for securitisation and creating a specific framework for simple, transparent and standardized securitisation and amending Directives 2009/65/EC, 2009/138/EC and 2011/61/EU and Regulations (EC) No 1060/2009 and (EU) No 648/2012) that entered into force on 1 January 2019, the EU PRIIPs Regulation (Regulation (EU) No 1286/2014 of the European Parliament and of the Council of 26 November 2014 on key information documents for packaged retail and insurance-based investment products (PRIIPs Regulation) that entered into force on 1 January 2018, and the Markets in Financial Instruments Directive (recast) – Directive 2014/65/EU of the European Parliament and of the Council (MiFID II) and related regulations.

2) New Prospectus Rules

a) Current Market Practice

Market practice for public Swiss ABS transactions with respect to prospectuses differs from other, more standard Swiss bonds. A stand-alone preliminary prospectus is used during the marketing and offering phase. Typically, a preliminary prospectus is identical to the final prospectus but for certain information that cannot be included in the preliminary prospectus because it is not yet known as at its date (this information is left blank in the preliminary prospectus and mainly consists of pricing information, e.g. nominal amount, interest rate, tenor of the bonds and issue price). Because it is not required under current rules, the preliminary prospectus (as offering prospectus) is not approved by the SIX. Following pricing of the ABS bonds, a final prospectus that completes the information left blank in the preliminary prospectus is made available to investors. Because the final prospectus is used as a listing prospectus, it is reviewed and approved by the SIX.

Furthermore, the SIX reserves the right to approve ABS transaction structures on a case-by-case basis. In the case of complex structures which deviate significantly from the ABS structures customary in the Swiss market, the approval process may be time critical.

b) Ex-ante Prospectus Approval Procedure

Pursuant to the new prospectus rules, a prospectus approved by a FINMA supervised review body must be published for any public offer of securities to investors in Switzerland (unless an exemption applies, e.g. an offering to professional clients only or a minimum denomination in of at least CHF 100,000) and the admission to trading on a stock exchange or a multilateral trading facility (MTF) in Switzerland (except where the securities are only admitted to a trading segment for professional clients). This is called ex-ante prospectus approval because the prospectus must be reviewed and approved by the review body prior to its publication. Because the SPVs that issue ABS bonds are typically newly incorporated entities, the review body may apply the minimum review period for new issuers of at least 20 calendar days. For inaugural issuances, in particular in case of complex structures, the minimum review period may fit well into the overall project timetable and ex-ante approval of the preliminary prospectus may be an option. The review bodies may not accept the term preliminary prospectus for the reviewed and approved prospectus. 

Pricing information not included in a reviewed and approved prospectus can be completed (without triggering an obligation to prepare a formal supplement in the sense of article 56 FinSA) pursuant to article 40(4) FinSA. We note that the wording of article 40(4) FinSA appears to be too narrow for debt securities. However, it should be construed in such a way as to include all pricing information typical of bonds. Because article 40(4) FinSA does not define how a document that updates the pricing information should look like, a final prospectus in line with current market practice (as opposed to a pricing statement typically used for equity transactions) should be an option. This would be preferable for investors because they would then have a single document that includes all relevant information.

c) Ex-post Prospectus Approval Procedure

The new rules provide for an alternative review and approval procedure for debt (and certain other) securities based on article 51(2) FinSA and article 62 draft FinSO. The aim of the new review and approval procedure is to maintain key aspects of current Swiss market practice that shorten the time-to-market and are regarded as important competitive advantages for the Swiss bond markets. This will be achieved by allowing offerors to postpone review and approval until the date of admission to trading and to use (non-approved) offer documents for the public offer that, for typical debt offerings, is initiated with the announcement that books are open for orders (so-called called ex-post approval). Core elements of the ex-post approval procedure are a confirmation by a Swiss bank or securities firm that the most important information about the issuer and the securities is available at the time of publication and the statutory presumption that the most important information about the issuer is available if shares or debt securities of the issuer (guarantor or security provider) are listed on a Swiss or recognized foreign market (stock exchange or MTF) in article 62(3) draft FinSO.

Typical ABS bonds would qualify as bonds pursuant to article 3(a)(7) FinSA and, therefore, be eligible for ex-post review and approval. However, because ABS bonds are typically issued by newly incorporated SPVs, the statutory presumption discussed above would not be available. We expect that ABS bonds will be marketed on the basis of (preliminary) prospectuses in line with current market practice. Whether ex-ante or ex-post approval will be used will depend on the final wording of the relevant provisions in the FinSA (participants in the public consultation commented that the wording should clarify that the confirmation only concerns formal review for compliance with minimum disclosure requirements) and required time-to-market. Generally, the ex-post approval process should be more attractive because it offers greater flexibility.

d) Minimum disclosure requirements for ABS bonds

Annex 2 of the draft FinSA contains minimum disclosure requirements for debt securities and section 3.6 thereof specific disclosure requirements for Asset-Backed Securities. The minimum disclosure requirements are substantially based on the current minimum disclosure requirements set out in section 4 of the SIX circular no. 4 (practice regarding the listing of bonds). The main elements are that the prospectus must include a transaction summary as introduction to the prospectus that explains the main features of the transaction, followed by a transaction overview that gives an overview over certain elements of the transaction and the main risks related thereto.

3) Key Information Document

Subject to certain exemptions, the manufacturer of a financial instrument within the meaning of article 3(a) FinSA that is offered to retail clients domiciled in Switzerland must produce a Key Information Document (KID) (Basisinformationsblatt or BIB) (article 58(1) FinSA and article 80(1) draft FinSO). The offer does not have to be a public offer pursuant to article 3(h) FinSA. The new rules contain broad exemptions for financial instruments, typically issued by corporates for the purpose of financing. Most relevant for ABS bonds as debt securities is article 59(1) FinSA that exempts debt securities without derivative characteristics. 

The FinSO does not define debt securities without derivative characteristics
directly, instead article 86(2) draft FinSO defines “debt securities with derivative characteristics” as “derivatives and debt instruments whose payoff profile is structured in the same manner as that of a derivative according to article 2(c) of the Financial Market Infrastructure Act of 19 June 2015 (FMIA)”. In addition, article 86(3) draft FinSO contains a (non-exhaustive) list of examples for debt securities without derivative characteristics (e.g. bonds with early redemption rights). Pursuant to article 2(c) FMIA, derivatives are financial contracts whose value depends on the performance of one or more underlying values. While the performance and value of the underlying assets affect interest payments and principal repayments on ABS bonds and therefore their value (as the sole source of interest payments on ABS bonds are collections from the lease assets in the portfolio), there is no direct relationship on payoff and value typical of derivatives (e.g. Credit Linked Notes).  

Therefore, an ABS bond would be exempt from the obligation to prepare a KID under the new rules as a debt security without derivative characteristics unless the terms and conditions of the ABS bond include other features that would result in an obligation to produce a KID. By contrast, under the PRIIPs Regulation, a Key Information Document would be required for an offer of Asset-Backed Securities to retail investors in any EEA country.

4) Financial Services and Rules of Conduct

The FinSA defines “financial service” in article 3(c), inter alia, as the acquisition or disposal of financial instruments or the giving of personal recommendations on transactions with financial instruments (investment advice), provided that each such activity is carried out for a client. Financial services are subject to the applicable regulation under the FinSA, including rules of conduct. 

In Asset-Backed Securities transactions, the originator (e.g. the leasing company in Auto Lease ABS) appoints one or more investment banks to provide certain services. These services typically include (i) advice on transaction and offering structure (Advisory Services) and (ii) the subscription (Underwriting) of the issued Asset-Backed Securities by the investment bank(s) as first taker(s) from the issuer (Initial Purchase). We believe that these services should not qualify as “financial services” pursuant to article 3(c) FinSA.

– Advisory Services do not qualify as a purchase/sale of a financial instrument under article 3(c)(1) and (2) FinSA or investment advice within the meaning of article 3(c)(4) FinSA. The purpose and subject matter of the Advisory Services is not a personal recommendation to make an investment, i.e. to either buy, sell or hold a specific financial instrument, but rather advice to a borrowing client with respect to how and when to raise funds from the capital markets; in short, on how to turn a planned issue of new securities into action. 

– Initial Purchase does not fall under the provisions of article 3(c)(1) and (2) FinSA on the acquisition or disposal of financial instruments for clients or the transmission of respective client orders. These provisions regulate securities trading activities that a financial services provider carries out for its clients. The Initial Purchase of securities by an investment bank constitutes a securities trade between issuer and syndicate banks who act on their own behalf and for their own account and such a transaction is therefore not an order or an instruction from the issuer to trade a financial instrument on its behalf. By contrast, the sale of Asset-Backed Securities by a bank to its investing clients would constitute the execution of a client order and, therefore, a financial service under FinSA. 

Unfortunately, the wording of article 3(1) draft FinSO creates some ambiguity on this point. It specifies that the acquisition or disposal of financial instruments is deemed to be any activity which, such as intermediation, is specifically aimed at the acquisition or disposal of a financial instrument. Based on the statements made in the explanatory report of the Federal Council dated 24 October 2018 on the draft FinSO, we understand that the main rationale of article 3(1) FinSO is to regulate certain activities in relation to the marketing and distribution of foreign investment funds to investors in Switzerland. This should be clarified in the final version of the FinSO.

By contrast, the scope of the EU MiFID II Directive expressly covers, inter alia, the underwriting of financial instruments and/or placing of financial instruments on a firm commitment basis (referred to as “Investment Services and Activities” in section A of annex I) and advice to undertakings on capital structure and services related to underwriting (“Ancillary Services” in section B of annex I). 

Therefore, in order for corporate finance advisory services (i.e. Advisory and Initial Purchase in connection with capital market financing through the issuance and placement of securities) to qualify as financial services pursuant to FinSA and be subject to the rules of conduct under FinSA, such activities should have been explicitly listed in article 3(c) FinSA in observation of the legality principle.

Daniel Adler (daniel.adler@ubs.com)
Daniel Bono (daniel.bono@nkf.ch)