In the recent past, Swiss domestically oriented covered bond structures have become increasingly popular. Under recent successfully established domestic, purely Swiss law governed covered bond structures, Swiss issuers have been able to replicate traditional English law elements of covered bonds under Swiss law, enabling the covered bonds to be assigned a triple-A rating. This article discusses the key features.
By Stefan Kramer / David Borer (Reference: CapLaw-2019-27)
1) Background
Traditionally, Swiss structured covered bonds have been issued by the UK branch (or another non-Swiss branch) of a Swiss bank into the international market. To a considerable extent, such Swiss structured international covered bonds were built on features developed in the context of covered bonds structured under English law (including a UK trustee concept), but the resulting structure was tailored to reflect specific Swiss legal, regulatory, tax and insolvency law aspects.
In the recent past, more Swiss domestically oriented covered bond structures, including a listing on the SIX Swiss Exchange, have become increasingly popular. Under recent successfully established domestic, purely Swiss law governed covered bond structures, Swiss issuers have been able to replicate traditional English law elements of covered bonds under Swiss law, enabling the covered bonds to be assigned a triple-A rating.
2) Structural Elements of Covered Bonds
The key elements of recent (international and domestic) Swiss structured covered bonds can be summarized as follows:
1. The Swiss bank issues covered bonds as direct, unconditional and unsubordinated obligations of the issuer.
2. The obligations of the issuer under the covered bonds benefit from a guarantee issued by a subsidiary of the issuer under a so-called guarantee mandate agreement to, or for the benefit of, the covered bondholders.
3. Under the guarantee mandate agreement, all liabilities, costs and expenses incurred by the guarantor under or in connection with the guarantee will have to be reimbursed (or pre-funded accordingly) by the issuer.
4. As security for the relevant reimbursement and pre-funding claims of the guarantor, the Swiss bank acting as issuer transfers a segregated pool of mortgage loans, together with the related mortgage certificates, to the guarantor.
Accordingly, if the issuer defaults under the covered bonds and the guarantee is to be drawn, the guarantor could claim for coverage by the issuer under the guarantee mandate agreement. Failure by the issuer to pre-fund the payments drawn under the guarantee would allow the guarantor to enforce the segregated cover pool and use the proceeds to satisfy its payment obligations under the guarantee.
The segregated cover pool assets mainly consist of Swiss mortgage loans granted by the issuing bank to Swiss domestic borrowers and the respective mortgage certificates securing such loans. Additionally, cash and other qualifying substitute assets may be part of the cover pool.
3) Certain Key Features of Swiss Domestic Covered Bonds
a) Applicable law
The traditional Swiss international structured covered bond programmes implemented by the two Swiss G-SIBs in the past decade featured a combined English | Swiss law structure, combining the requirements of issuing into the international market with the particularities of a cover pool consisting of Swiss mortgage assets.
Under such a combined English | Swiss law structure, the covered bonds as well as certain agreements essential for the functioning of the covered bond programme, such as the trust deed governing the role of the trustee and the intercreditor deed governing the priority of payments in relation to the proceeds of the cover pool, were governed by English law. Conversely, the agreements governing the transfer of the mortgage assets and the relationship between the issuer and the guarantor are governed by Swiss law. Swiss law governed agreements include, in particular, the security assignment and transfer agreement under which the mortgage loans and the related mortgage certificates are transferred to the guarantor and into the cover pool.
In contrast, under pure Swiss domestic structures, the covered bonds as well as all other transaction documents (to the exclusion of any swap agreements) are governed by Swiss law. Accordingly, transaction features that are typically inherent to covered bond transactions involving an English law governed part (including, in particular, a UK trustee structure as well as priority of payments and limited recourse provisions) need to be appropriately replicated under Swiss law.
b) Domestic issuer
Domestic covered bonds are typically issued out of the Swiss head office of the issuer and listed on the SIX Swiss Exchange. Therefore, contrary to Swiss international structured covered bond programmes providing for the issuance out of a non-Swiss branch, interest payments on Swiss domestic covered bonds are subject to Swiss withholding tax. That said, the Swiss domestic market continues to see demand from Swiss institutional and retail investors, which are generally used to instruments subject to Swiss withholding tax. Accordingly, domestically oriented issuance structures for covered bonds may become even more popular in the future.
c) Segregated cover pool
The cover pool consists of mortgage loans granted to Swiss residents, which are secured by real estate located in Switzerland. For purposes of the covered bonds, the claims arising under such mortgage loans are transferred as a security to the guarantor together with the related mortgage certificates. Accordingly, the guarantor will acquire the relevant mortgage claims together with legal title in the mortgage certificates, which represent the lien on the residential real estate encumbered.
In case of insolvency of the issuer, the covered bondholders benefit from the guarantee issued by the guarantor which is backed by the assets in the cover pool, in addition to their direct recourse to the issuer. While mortgages in the cover pool have been transferred to the guarantor for security purposes only and, therefore, have remained on the balance sheet of the issuer, in the case the issuer is insolvent, the assets in the cover pool would be segregated from the estate of the issuer. Accordingly, as the guarantor is the title owner of the cover pool assets it may, subject to any avoidance action, manage and enforce such assets independently from any insolvency procedure concerning the issuer. If an enforcement event occurs, the guarantor is entitled to liquidate a sufficient part of the cover pool assets by collecting the mortgage claims (if and when they fall due) or, subject to certain restrictions, by way of a private sale of mortgage assets to an eligible investor.
d) Role of the trustee and bondholders’ representative
Under the traditional Swiss international structured covered bond programmes, an English law bond trustee representing the rights and interests of the covered bondholders was appointed under an English law trust deed. Under English law, the trustee holds the benefit of the rights, powers and covenants in the covered bonds on trust for itself (in its own name) on behalf of the covered bondholders. Due to the English law trust structure, the covered bondholders are not exposed to the counterparty risk of the trustee even if the trustee is holding assets and|or claims in its own name on behalf of the covered bondholders. In its capacity as representative of the covered bondholders, the trustee is also a party to certain essential transaction agreements.
As opposed to English law, Swiss law does not know the concept of a trustee. Accordingly, in a pure Swiss law covered bond structure, the powers of the trustee need, to the extent possible, to be replicated under Swiss law with a view to provide a similar level of protection for the investors. However, as there is no substantive trust law in Switzerland, it is not possible to establish a trustee structure similar to the English law trust arrangements.
In particular, Swiss law provides that if covered bonds are publicly offered by a Swiss issuer without the involvement of a non-Swiss branch, the bondholders form a community of bondholders (Gläubigergemeinschaft) by operation of law and the mandatory rules on bondholders’ meetings (Gläubigerversammlung) and the representation of the bondholders by the bondholders’ representative (Anleihensvertreter) pursuant to the Swiss Code of Obligations apply (Swiss Bondholder Provisions)1. The Swiss Bondholder Provisions provide for a legal concept that allows the community of bondholders to resolve on any matters affecting the interests of the bondholders based on a majority vote. If approved by the applicable majority, the resolution of the bondholders’ meeting will be binding on all bondholders. Moreover, the community of bondholders may transfer certain powers to a bondholders’ representative. The bondholders’ representative has the powers transferred to him by law, by the terms and conditions of the bonds (subject to certain limits set by applicable law) or by the bondholders’ meeting. To the extent the bondholders’ representative is entitled to exercise certain rights on behalf of the covered bondholders, individual bondholders may no longer independently exercise such rights. The main statutory rights of the bondholders’ representative include, amongst other things, certain monitoring rights in relation to the issuer, and the right to request the issuer to call a bondholders’ meeting. Under a recent purely domestic Swiss covered bond programme, the concepts of the bondholders’ representative and certain contractual features were combined to equip the “Swiss law trustee” with sufficient powers to provide for a level of protection of the covered bondholders that has enabled the covered bonds to be assigend a triple-A rating. For this purpose, the entity acting as “trustee” is appointed to act both as contractual trustee and as bondholders’ representative in the sense of the Swiss Bondholder Provisions. While both such roles are assumed by the same legal entity, the role of the contractual trustee is separate from the role of the bondholders’ representative: In its role as trustee, the relevant entity is appointed by the issuer and the guarantor under a (Swiss law governed) trust agreement to safeguard the rights of the covered bondholders with respect to the cover pool. For this purpose, the contractual trustee becomes a party to the certain essential transaction agreements.
Moreover, in light of the fact that Swiss substantive laws do not know the concept of a trust, the bondholders’ representative is authorized in the terms and conditions of the covered bonds to hold and enforce the rights under the guarantee as direct representative (direkter Stellvertreter) in the name and for the account of the covered bondholders.
e) Limited recourse and priority of payments
Swiss law does not provide for a specific statutory regime allowing the creation of a bankruptcy remote special purpose vehicle such as the guarantor. Therefore, Swiss covered bond transactions typically involve a number of contractual features to increase the bankruptcy remoteness of the guarantor. Transaction documents usually provide that any rights and claims of transaction parties and investors against the guarantor (including under the guarantee) are limited to the amount available to satisfy the relevant obligations (so-called limited recourse) and cash collections are distributed with contractually agreed priority of payments (so-called waterfall).
Under Swiss substantive law, limited recourse provisions can be replicated as a contractual arrangement under which the relevant transaction parties agree to their claims being limited in amount, from time to time, to the funds available to the guarantor to satisfy the relevant claim after giving effect to the relevant priority of payments. While parties to the transaction documents can validly agree to such limitations of their claims based on the concept of freedom of contract, it should be noted that creditors of the guarantor that are not a party to the transaction agreements (for example, tax authorities and other non-contractual creditors of the guarantor) are not subject to the limited recourse. Therefore, the corporate documents and transaction agreements are designed to limit, to the extent possible, any unpaid claims by such third parties.
4) Outlook
The recent successful launch of purely domestic covered bond programmes shows that it is possible to sufficiently replicate traditional English law key structural elements of covered bond transactions under a pure domestic structure. Since structured covered bond programmes provide for a diversification of funding sources and have proven to be a robust funding tool in times of liquidity constraints in the market, it will be interesting to see whether other issuers will follow the path.
Stefan Kramer (stefan.kramer@homburger.ch)
David Borer (david.borer@homburger.ch)
1 According to a draft bill proposed by the Swiss Federal Council in March 2019, the Swiss Bondholders Provisions are envisaged to be amended with a view to allow, subject to certain conditions, for rights of the bondholders’ meeting and the bondholders’ representative to be waived or altered in the terms and conditions.