For Christopher Schell, a partner in law firm Davis Polk’s derivatives and structured products team, his firm’s success in this year’s Structured Products Americas Awards is down to one thing: the company’s deep bench.
“We have some of the best derivatives and structured products lawyers on the Street, some of the best bank regulatory lawyers and some of the best tax and investment management lawyers,” says Schell, who is based in New York. “This area touches on many areas of legal practice and bank activity so that clients really value the range and quality of our people.”
Such a range is vital. Recently regulatory developments mean that banks’ structured products issuance has, in many cases, required a fundamental rethink of their corporate structures. The reason is the introduction by the Financial Stability Board of its total loss-absorbing capacity (TLAC) framework – and the finalisation by the Federal Reserve of its implementing rule in December for US banking organisations.
The framework, designed to ensure that systemically important financial institutions hold sufficient buffers of capital to weather another financial crisis, restricts the ability of large banks to issue structured notes from the bank holding company. The response, for many, has been to establish subsidiary issuers.
But that ostensibly straightforward solution has created myriad complexities, says Schell. “The first question was whether such structures worked to comply with the rule, which required in-depth analysis, as well as discussions with the regulators.”
Creating subsidiary issuers also complicated regulatory requirements for major institutions when drawing up their ‘living wills’, which specify how they would be resolved in an orderly manner at a time of significant financial stress. Ensuring that responses to TLAC led to corporate structures that remained compatible with these living wills required “careful thought” and “serious coordination between the firm and the bank’s various internal teams”, he adds.
The firm has also been working closely with clients on issues relating to the construction of structured products, especially around the proprietary indexes to which a growing number are linked. Scrutiny around governance and potential conflicts of interest has increased since the Securities and Exchange Commission reached a settlement with UBS in October 2015 over a lack of transparency and consistency in calculating an index used to price structured notes.
“Issuers really need to understand how the plumbing works behind the scenes; how these assets are chosen and how they are valued. It’s not sufficient for a front-office structurer to come up with a good idea and then leave the pricing valuation to another area that’s not well understood,” says Schell.
That work extends beyond issuers: a growing number of fintech firms are developing indexes designed to monetise the data they are collecting, which they license to structured note issuers. As an example, he cites a firm that has developed algorithms that seek to predict stock movements in reaction to a specific event – such as a jump in employment numbers, or a natural catastrophe – and is considering structured notes as a way to provide more widespread access to these trading strategies.
Issuers really need to understand how the plumbing works behind the scenes; how these assets are chosen and how they are valuedChristopher Schell, Davis Polk
“We’ve seen a big uptick in fintech clients who are interested in our help in putting together these types of indexes. They are often shocked at how many issues and minefields there are [around the development and administration of indexes], many of which are becoming familiar to our larger clients,” says Schell.
Technology is driving another trend in the structured products marketplace: the adoption by issuers of open architecture distribution platforms that allow them to issue white-labeled structured products through other banks and distributors. Here, too, innovation can bring legal headaches, he says.
Issuers need to do the fundamental ‘know-your-distributor’ work, notes Schell. “Are they selling the product to suitable investors? It continues to be an issue.” But, more recently, concerns have also emerged around the online education and training some of these platforms offer, which need to pass regulatory muster, as well as features that use online tools to match investors with products. “These can raise not just suitability but also [Investment] Advisers Act issues in the United States” if they are deemed to be offering investment advice, he says.
Certainly, Davis Polk has won plaudits in the market for its work beyond the bread-and-butter business of advising on new issues and providing tax advice. Its lawyers “have been at the center of many of the latest market developments in the past year,” says one dealer, and “they have shown a level of consistency that is very hard to match.” They have been “very involved in topics that related to product development,” agrees another.
But this year’s focus may shift from product development to regulation, says Schell, as the new Washington administration pursues its Wall Street reform agenda. “We certainly expect changes to the Volcker rule,” which restricts proprietary trading by banks, he says. “That had a large impact on [the structuring of] certain esoteric structured notes to institutional investors. Reform could have a similar impact in the opposite direction.”