Davis Polk & Wardwell established its credentials in the field of structured products on June 24, 1996, when Mark Green, special counsel at the US Securities and Exchange Commission, replied favourably to a letter from lawyer John Brandow, requesting no action when a filing links an unrelated issuer to equity securities. "We are allowed not to put information on the underlying company in the bank documents, we are also allowed not to take liability on it, which in the US is an unusual concept," says Warren Motley, a partner in the corporate department at Davis Polk, and an associate on the Morgan Stanley deal.
Once established, Davis Polk saw the opportunity, invested in the business, and now Brandow heads an equity derivatives group that boasts more than 35 securities and tax lawyers.
Davis Polk has continued to apply its skills to a rising market, and then construct the legal niceties that innovations in a falling market require. The tumbling market has brought variety, but has instilled the requirement for transparency and ease of understanding.
A series of FX deals mark the firm's dedication to overcoming complexity. The pick of the bunch is the listing on the NYSE Arca of Chinese renminbi and Indian rupee products: the Market Vectors-Chinese Renminbi/USD ETNs, based on the performance of the S&P Chinese Renminbi Total Return Index issued by Morgan Stanley; and the Market Vectors-Indian Rupee/USD ETNs, for the same issuer but this time based on S&P's India Rupee Total Return Index. The complication was that the integration of currencies that are not convertible, says Motley.
"We helped Morgan Stanley with the design of an index that is based on the forward contract rate rather than on the spot currency rate," says Motley. ETNs differ from regular structured products in that the sale relies on the effectiveness of marketing campaigns that drive investors to sign up. "From a 1933 Securities Act point of view, this is interesting because the documents are signed off on the advertising and the promotions which are reviewed by regulators," says Motley. "But when you are doing a note rather than a fund, all forms of the offering document need to be filed and comply with the Securities Offerings rules of 2005."
"At the end of 2005, the SEC changed the laws on the marketing of documents, making the rules more flexible," says Motley. "These were some of the first notes issued to take full advantage of this flexibility."
Davis Polk also took a hand in carry trade deals, completing three for Morgan Stanley and one for UBS. The latter was marketed at end 2007 and traded in January using the bank's Strauss Index, which includes a version of the carry trade by investing in short-term money market instruments in five markets, using US dollars, euros, sterling, yen and Swiss francs. The note structure includes principal protection, while the index provides leveraged exposure to these currencies. In addition, there is an adjusting algorithmic investment. "The trick here is in describing the index, and also the note mechanics because of periods when you get paid and do not get paid," says Motley.
The firm has also taken a lead in commodities. "Two or three years ago, we would not have included commodities for retail," says Motley. But now the volume of business the firm does in this field is impressive - the firm has acted on 10 SEC-registered commodity deals in 2008 to the value of $1.532 billion - although the volume figure is skewed by the inclusion of typically large exchange-traded notes.
In February 2008, Deutsche Bank launched leveraged commodity double-short and double-long ETNs linked to gold, and with Davis Polk and NYSE Arca convinced the SEC to change its rule that exchanges could not allow leverage on the downside. "When you have leverage on the downside with a note structure, if you started on day one and the index went down 50% you would have to defease the bond, because you would be down to zero," says Motley. "A 50% decrease would eat up 100% of your reserve." The solution came in the form of a nifty mechanism created by Davis Polk that "resets the amount you are playing with every month. Say the index declines 10%, when you started the next month you would start with $80 rather than $100," says Motley.
In the equities markets, Davis Polk acted for Morgan Stanley on a delta 1 product based on its Style Select index, incorporating MSCI Japan. Another delta 1 product followed, based on Morgan Stanley's Modelware and including filters. These filters are based on a comparison of companies based on their balance sheets and income statements.
And then there were deals that the same bank linked to mutual funds, for the first time. "There is a link to the no-action letter, which had been extended to exchange-traded funds but not to mutual funds," he says.