Risk Awards 2016
In 2015, Cadwalader Wickersham & Taft proved that necessity is the mother of invention, by rescuing a key US municipal finance tool from the clutches of the Volcker rule just two months before it came into force.
The rule had put the industry "into a bit of a tailspin" according to one Cadwalader partner, but the firm found a way to save tender option bond (Tob) trusts – a structure that provides $3.7 trillion of finance to the US municipal bond market – while staying within the letter of the Dodd-Frank Act.
"We were successful in rearranging the roles in the Tob programmes in a way that solves the Volcker legal problem, but at the same time addresses the industry concerns about not altering the economics of the deal. We were able to do what the regulators' mandate was, which was to find a way to make this work within the way Congress wrote the Volcker rule. This is now the widespread accepted solution for Tobs," says Scott Cammarn, a partner at Cadwalader in Charlotte.
The structure involves the deposit of a long-dated muni bond into a special purpose trust, which then issues two types of securities. One is a short-dated, floating rate security that is bought by money-market funds, and the second is a so-called residual security, which pays the holder the muni bond's income minus the trust fees and interest paid to the floating rate noteholders.
The structure was dragged into the scope of the Volcker rule by a series of cross-referencing definitions, which meant the issue wasn't immediately apparent. Volcker restricts banks from acquiring an ownership interest in, or becoming a 'sponsor' of, covered funds. However, the definition of a covered fund is very broad, encompassing any entity that constitutes an investment company under the US Investment Company Act, which includes Tobs.
This means that if the bank is serving as a sponsor, investment adviser or investment manager to a Tob – roles traditionally played by banks – it would be unable to enter into a credit transaction with that vehicle.
Believing the Volcker rule's capture of Tobs was unintentional, Cadwalader filed a 17-page comment letter on the issue on February 9, 2012. This earned it a call from government officials in the spring to explain their concerns about how the ruling would impact the industry.
We were able to do what the regulators' mandate was, which was to find a way to make this work within the way Congress wrote the Volcker rule
Scott Cammarn, Cadwalader
Nevertheless, regulators refused to budge. The concerns are referenced in the preamble to the final version of the Volcker rule, published on December 10, 2013, but the rule explicitly rejected the industry's concerns and said Tobs were in scope.
"This was a hotly contested item during the rule-making. There were a number of comment letters filed, asking for specific relief for Tob programmes because they are so critical to the municipal finance industry. To the surprise of the industry, the regulators came back in the final rule-making in December 2013 and said the market needed to find a way under the framework of the Volker rule itself to make this work. It threw the industry into a bit of a tailspin," says Cammarn.
Cadwalader was mandated by Barclays and BlackRock to find a solution that worked within the confines of the final text of the Volcker rule.
Other law firms were also trying to find a fix to the issue, but Cammarn says they took a somewhat aggressive approach. The Volcker rule grants an exemption from the covered funds definition for joint ventures, and so several law firms began to argue that a Tob programme fell within this – despite the final rule clearly stating Tobs are caught by the definition of covered funds. This angered regulators, who immediately shut down those efforts.
"Several law firms pursued one theory, and despite some scepticism from various law firms – including this law firm – they proceeded down that path. When the regulators got wind of it, they called the law firms and said 'this will never fly – we don't agree this works'. The industry had a major setback, because one of the solutions that had been widely advocated was no longer viable. So that's where we stepped in," says Ivan Loncar, a partner at Cadwalader in New York.
The solution Cadwalader came up with involved tweaking the roles held by the entities in the Tob structure. The residual security investor is given control over the trust, which makes them the sponsor for Volcker purposes. As the bank that finances the Tob is not viewed as a sponsor, or investment manager, or has acquired an ownership interest, it can remain in the role even though the Tob is still a covered fund. The changes have been implemented by Cadwalader's clients, as well as the rest of the industry as a market-wide solution.
Puerto Rico's $70 billion debt crisis was an equally tricky situation, given the large sums involved and uncertain legal status of the US territory. The firm represented municipal bond insurer Assured Guaranty Corp and its affiliate Assured Municipal Guaranty, which have a combined $5.1 billion of exposure to the territory. As the largest single creditor in Puerto Rico, if the jurisdiction and its agencies are unable to make payments to its bondholders, Assured must cover the cost.
Of that $5.1 billion of exposure, $830 million was to bonds issued by the Puerto Rico Electric Power Authority (Prepa), which are backed by electricity sales to commercial and residential users on the island.
Cadwalader, as part of an ad hoc group of Prepa bondholders and bond insurers, came up with a restructuring plan for Prepa to ensure it could continue to service its debts. The idea was for Prepa to raise electricity prices for customers to a level that would enable it to pay the bonds it has issued – something it had been unable to do since 1989 due to political pressure.
The securitisation structure is just one idea that's being developed right now for that situation with Prepa
Lary Stromfeld, Cadwalader
The restructuring proposal would see the creation of a bankruptcy-remote special purpose entity (SPE) that would issue new securitised bonds backed by customer receipts. That entity would operate under a new law, with electricity rates set according to a formula that is sufficient to pay the securitisation bonds, rather than being influenced by the political will of the country's utility and energy commission.
"One of the unique challenges in Puerto Rico is the absence of any bankruptcy law or bankruptcy court with jurisdiction over the numerous debtors and their creditors. We have been working with numerous debtors and creditors with competing interests to try to achieve a consensual resolution," says Lary Stromfeld, partner at Cadwalader in New York. "The securitisation structure is just one idea that's being developed right now for that situation with Prepa," he adds.
The bond insurers, Assured and MBIA, also proposed to set up a debt service reserve fund (DSRF) to make debt service payments on behalf of the SPE bonds if the customer receipts are insufficient to pay the required principal and interest. The DSRF would be funded by a $462 million issue of surety bonds by the insurers, and a $65 million cash deposit by Prepa.
The restructuring plan was agreed on December 24, subject to several conditions being satisfied, including the passage of specific legislation in the territory. Moody's described the restructuring agreement as credit positive for Assured, noting that the involvement of the insurers in the plan "highlights the value that financial guarantors can provide in restructuring troubled credits, as well as the leverage they hold during the negotiation process".
While the Tob and Puerto Rico situations affect only a narrow range of parties, the incoming requirements for counterparties to collateralise their uncleared derivatives trades will impact thousands of entities.
The rules, which are being phased in across the European Union, Japan and the US from September 2016, include significant changes to current practice – for instance, restricting the types of collateral that can be posted. This will require a restructuring of existing credit support annexes (CSAs) for them to become compliant with the new rules before they come into force.
Given the number of CSAs involved, it is unfeasible to renegotiate these manually, so the International Swaps and Derivatives Association and Markit are creating an electronic tool to achieve this on a larger scale via a protocol. Cadwalader is acting as Isda's counsel for the tool, alongside the group's UK and Japan counsel, Allen & Overy and Linklaters.
"Rather than hundreds of thousands of relationships being negotiated bilaterally, all with one target date, parties can go to Isda and use the tool to get a prepackaged solution that can be implemented in bulk," says Jeff Robins, a partner at Cadwalader in New York.
Although the international standard was finalised by the Basel Committee on Banking Supervision and the International Organization of Securities Commissions in September 2013, national regulators have gone their separate ways in creating disparate – and occasionally clashing – rules, which leaves uncleared swaps users in a bind when transacting cross-border.
"Margin is a complicated problem to solve, because we're dealing with several sets of regulations at the same time, and any two parties may have to solve for different sets of regulations applicable to their particular situation," says Robins.
The Isda protocol seeks to solve this by allowing a party to plug into the electronic system – developed by Markit – and state the type of entity it is, and where it is based. Firms answer a series of questions on the platform, and these determine which regulations the parties are subject to, and whether it is just initial margin or variation margin that needs to be exchanged.
A separate part of the tool allows parties to use this information to develop contracts, tailored to the regulations they are subject to, where they can choose what they wish to post as margin. Following any bilateral negotiations between firms – which can also take place on the system – the protocol produces an amended, or brand new CSA.
"There are many different variables based on what law you're subject to, what type of entity you are under that law, and then most laws have a further variable depending on the nature of the counterparty you're facing. All those classifications and pairings create hundreds, if not thousands, of different combinations. We're designing this in a way that if you are a hedge fund organised in the UK and you are facing a bank organised in the US, it'll only show you questions that are relevant to that very specific situation," says Stromfeld.
As the final rules in some jurisdictions are still to be finalised, the tool has not yet been released to the public. Development and testing may need to be conducted in stages as rules are finalised in different jurisdictions, he adds.
The week on Risk.net, July 14–20, 2017Receive this by email