A market of two
halves
Benedikt Maurenbrecher, Dieter Grünblatt and Stefan
Kramer of Homburger on Swiss law's two different yet
complementary concepts of covered bonds
A
ccording to the European
Covered
Bond
Councils
definition, covered bonds are
secured debt instruments which
sadsfy the following criteria: (i) The issuer or
the guarantor of the debt instrument is a
prudentially regulated credit institute (i.e., a
bank); (ii) the debt instruments are secured
by a cover pool of mortgage loans (property
as collateral) or public-sector debt to which
investors have a preferentiai claim in the
event of default; and (iii) the bank has a
Act
{Pfandbriefgesetz,
or
PfG),
complemented by a respective ordinance
{Pfandbriefverordnung, or PfV). The PfG
provides for explicit regulations regarding
all key eiements of the Pfandbrief system,
such as the institutions authorised to issue
instruments under the PfG, the structure
and valuation of the cover pool, and certain
insolvency-related issues. Accordingly, the
instruments issued in accordance with the
PfG - the Swiss Pfandbriefe - could be
qualified as statutory covered bonds. The
continuing Obligation to provide a sufficient term Pfandbriefe is, however, widely
amount of assets to the cover pool in order to recognised and protected by law and it is
be able to satisfy the claims of the covered rather unusual to use the term covered
bond investors, and compliance with such bonds when describing the Swiss
Obligation is subject to supervision by a Pfandbriefe.
public authority or independent third party.
On the other hand, the concept of
In Switzerland, there are two different freedom of contract allows an issuer to
legal concepts which correspond to this structure a covered bond programme based
definition.
on contractual agreements with investors
On the one hand, in 1931, the Swiss and other persons or institutions to be
legislator created the Swiss Pfandbrief involved in the transactions. Instruments
System by enacting the Federal Pfandbrief
issued under such contractual agreements
qualify as structured covered bonds. The
avenue of structured covered bonds has
only recentiy been explored in Switzerland,
when first UBS (in 2009) and then Credit
Suisse (in 2010) established their respective
Pfandbrief holder
covered bond programmes.
The co-existence of Pfandbriefe and
A Right of lien on
structured covered bonds is underscored by
loan receivable
the fact that they tend to serve different
investor bases. Pfandbriefe must be
Pfandbrief institutes
denominated in Swiss francs and are
subject to Swiss withholding tax. They
A Right of lien on
therefore mainly attract Swiss retail and
mortgage
institutional
investors.
Meanwhile,
structured covered bonds are issued out of
IViember bank
non-Swiss branches of the two big Swiss
A Right of lien on
banks (UBS and Credit Suisse) and are not
subject to withholding tax. Furthermore,
property
due to the appeal to an institutional
investor
base outside of Switzerland,
Mortgagee
structured covered bonds are denominated
A
predominantly in Euros and US dollars.
Today, Pfandbriefe still dominate the
Property
Swiss (covered) bond market with an
aggregate size of SFr 63.7 billion or 24.5%
com
(end of 2011) of the nominal amount
outstanding of all listed domestic bonds.
The issuing volume for Swiss Pfandbriefe is
somewhat restricted, however, since the
capital adequacy provisions in the PfG
provide that, in addition to the
maintenance of the cover pool, Swiss
Pfandbriefe must be underpinned by equity
of PBB and PBZ in excess of 2% of their
respective total Pfandbrief issuance volume.
Nevertheless, Pfandbriefe are the second-
"Pfandbriefe still
dominate the Swiss
covered bond
maricet"
largest and second-most liquid segment of
the Swiss franc bond market after Swiss
government
bonds
{Eidgenossen).
Structured covered bonds are catching up
quickly in light of the Swiss big banks
having more than SFr 13 billion
outstanding at the end of 2011, mainly in
the form of jumbo issuances into the
European market.
Legal s e t u p of S w i s s
Pfandbriefe
According to the PfG, only two institutions
are authorised to issue Pfandbriefe in
Switzerland, namely the Pfandbriefzentrale
der schweizerischen Kantonalbanken (PBZ),
a vehicle issuing Pfandbriefe for the Swiss
cantonal banks and the Pfandbriefbank
schweizerischer Hypothekarinstitute (PBB),
a vehicle issuing Pfandbriefe for all other
Swiss banks. Both institutions are special
banks and as such supervised by the Swiss
Financial Market Supervisory Authority
FINMA. The issuance of Swiss Pfandbriefe
aims at financing the mortgage business of
the member banks. PBZ and PBB use the
proceeds from the issuance of Pfandbriefe to
grant loans to their member banks which
allow the member banks to enter into longterm mortgage loan agreements with real
estate owners.
Swiss Pfandbriefe are largely standardised
debt products. They are a commodity,
denominated only in Swiss francs, normally
I F L R / J u l y / A u g u s t 2012
79
have long-term duration of between three
and 22 years and always have fixed coupon.
Swiss Pfandbriefe are issued either as public
bonds or as private placements. All
publicly-issued Swiss Pfandbriefe are listed
at the SIX Swiss Exchange.
From the beginning, Swiss Pfandbriefe
have obtained a triple A rating. The Swiss
National Bank accepts Pfandbriefe as
collateral for its repo facility.
The key feature of the Swiss Pfandbriefe
is the collateral: The direct and
unconditional Obligation of the Pfandbrief
issuer to pay principal and interest is
coUateralised by a two-tiered system of
security over claims which is ultimately
secured by first ranking mortgage
certificates on Swiss real estate:
Firstly, claims under a Pfandbrief are
directly secured by a statutory lien over the
loans extended by the Pfandbrief issuer to
the member banks out of the proceeds of
the Pfandbrief issuances. The lien will be
created with the entry of the cover assets in
the register of the relevant Pfandbrief
issuer.
Secondly, the claims of the relevant
Pfandbrief issuer against the participating
bank under the relevant loan are secured by
a statutory lien over mortgages granted by
the participating bank. The relevant lien
extends both to the claim of the
participating bank against the relevant
borrower under the relevant mortgage loan
and to the security (normally a mortgage
certificate, Schuldbriefi granted therefor,
and Covers principal and interest. The lien
is created by registering the relevant cover
mortgages in a special register maintained
by the relevant participating bank.
However, both of these liens can only be
enforced in a bankruptcy proceeding of the
Pfandbrief issuer or the relevant member
bank. Effectively, this means that in a
hypothetical insolvency of a Pfandbrief
issuer all claims under all Pfandbriefe
issued benefit from the security provided
by the aggregate cover pool on a pro-rata
basis. In an insolvency of a member bank,
the mortgages encumbered would be
liquidated for the benefit of the Pfandbrief
issuer with a view to cover its claims under
the loans granted to the member bank.
Dieter G r ü n b l a t t
Homburger
Dieter Grünblatt graduated from the University of Basel S c h o o l
of Law in 1 9 8 9 . He holds a doctorate (Dr iur) in law from the
University of Basel (1 9 9 4 ) and an LLM from New York
University, where he c o m p l e t e d postgraduate studies with a
f o c u s on corporate finance and corporate tax law in autumn
1 997. He was admitted t o t h e Baselland Bar in 1 9 9 6 a n d t h e
New York Bar in 1 9 9 8 . H e has been a Certified Tax Expert since
2 0 0 0 . Grünblatt joined Homburger in 1 9 9 7 and has been a
partner since 2 0 0 5 .
Grünblatt f o c u s e s on tax structuring of national and international capital market transactions, collective investment schemes, real estate investments, structured financial
instruments, private equity and fund management structures. He designs acquisitions and
reorganisations, and advises on employee stock option plans, pension plans and social
security taxes and VAT.
He published his doctoral thesis on non-fiscal taxation objectives (Basel 1 9 9 4 ) . H e is
co-author o f t h e Basel Commentary on tax aspects of Corporate Divisions a n d Asset
Transfers u n d e r t h e n e w Swiss Merger Law (Helbling & Lichtenhahn, Basel 2 0 0 4 ) a n d
a u t h o r o f the tax section on Securities Transactions in Europe ( C C H , C h i c a g o 2 0 0 4 ) ,
Getting the Deal Through — Mergers & Acquisitions 2 0 1 1 — Switzerland (Getting the Deal
Through, London 2 0 1 1 ) and the tax section of Corporate Laws o f t h e W o r l d - Swiss
Country Report, 201 1.
Stefan Kramer
Homburger
Stefan Kramer advises clients in matters involving capital
markets, structured finance and banking law. In structured
finance he focuses on covered bonds and securitisatiön transactions. In addition, he advises c o m p a n i e s with r e s p e c t t o stock
exchange laws and corporate matters. H e has published various
books and articles on financial services regulation and is a c o editor o f t h e Commentary on the Swiss Banking A c t .
Stefan Kramer is admitted to the Swiss bar, holds a doctorate
from the University of Zurich ( 2 0 0 5 ) and an LLM from Harvard Law S c h o o l ( 2 0 1 0).
B e n e d i k t IVI a u r e n b reell er
Homburger
Benedikt Maurenbrecher's practice f o c u s e s on banking,
finance and capital markets. He is experienced in a broad range
of transactions, notably in the areas of equity capital markets,
secured and unsecured lending, covered bonds, securitisatiön
and derivatives. He is an Authorised Issuers' Representative at
the SIX Swiss Exchange.
Maurenbrecher also advises on domestic and cross-border
aspects of banking, securities and investment fund regulation,
and regularly represents market participants in related regulatory p r ö c e e d i n g s and civil
litigation.
He is a member o f t h e Banking Committee and the Securities C o m m i t t e e o f t h e
S w i s s structured covered bonds
International Bar Association, and currently heads the Banking Committee's s u b c o m -
Due to the aforementioned limitations
applicable to the Swiss Pfandbrief market,
and in response to the tightening of the
market for liquidity during the financial
crisis, the two Swiss big banks developed
structured covered bond programmes which
fall outside the scope of the PfG. The
contractual structure of these programmes
mittee on innovations in legal transactions.
allowed UBS and Credit Suisse to include a
number of structuring features which aim to
improve investor protection and enabied the
covered bonds to be allocated an AAA/Aaa
rating.
Under Swiss covered bond issuance
programmes, covered bonds are issued into
the international market by the UK or other
non-Swiss branch of a Swiss bank as issuer.
Initially, issuances were predominantly made
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structure of the mortgages in the cover pool,
as well as the currency risk between Swiss
franc mortgages in the cover pool and
uarantee deed
foreign currency obligations under the
Go/r-r
Trustee
Guarantor
covered bonds. Also, the covered bonds and
the relevant documentation (trust deed
Guarantee payments
agency agreement, and so on) are governed
© m •
by English law.
B c:
Conversely, the agreements governing the
c: CD '
establishment of the cover pool and the
2 E:
CO
relationship between the issuer and the
guarantor are governed by Swiss law.
Relevant agreements include the agreement
under which the mortgage loans and the
related mortgage certificates are transferred
to the guarantor and into the cover pool.
The
same applies for the guarantee mandate
Mortg
agreement
pursuant to which the issuer
ciain
instructs the guarantor to issue a guarantee
for the payment obligations of the issuer
under the covered bonds.
The arrangement of structured covered
Mortgage debtor
bonds mainly depends on the structure of
the cover pool, and, in case of a cover pool
containing claims secured by residential
mortgages, in particular on the
in reliance on Regulation S under the US enforce in the cover pool and to use the documentation and the structure of the
Securities Act of 1933 into the European proceeds to satisfy its payment obligations mortgage business of the issuer. Therefore,
market. More recentiy, both issuers followed under the guarantee.
the following description focuses on the two
Up with 144A offerings into the United
The cover assets mainly consist of Swiss programmes established by the two Swiss big
States.
mortgage loans granted by the issuing bank banks, UBS and Credit Suisse.
to Swiss domestic individuals and the
Key eiements
respective mortgage certificates securing Role of issuer
There are a number of key eiements of this such loans. Additionally, cash and other The issuers of Swiss structured covered bond
structure:
qualifying Substitute assets may be part of programmes, currently UBS and Credit
1. The Swiss bank, acting through a non- the cover pool.
Suisse, are large financial institutions subject
Swiss branch, issues covered bonds as direct,
To a considerable extent, Swiss structured to regulation, supervision and examination
unconditional
and
unsubordinated covered bonds build on features developed by FINMA and certain systemic oversight
obligations of the issuer.
in the context of English structured covered powers of the Swiss National Bank.
2. The obligations of the issuer under the bonds. But the resulting structure is unique,
Following the issuance, the main duty of
covered bonds benefit from a guarantee driven by Swiss legal, regulatory, tax and the issuer in relation to the covered bonds is
issued by a subsidiary of the issuer under a insolvency law considerations. Furthermore, to always maintain an appropriate level of
so-called guarantee mandate agreement in combining the requirements of issuing into eiigible mortgage assets or Substitute assets
favour of the holders of covered bonds, the international market with the in the cover pool.
represented by the bond trustee.
particularities of a cover pool consisting of
The cover pool assets are legally owned
3. Under the guarantee mandate Swiss mortgage assets has led to a bifurcation and held by the guarantor rather than by the
agreement, all liabilities, costs and expenses of the governing law:
issuer. The mortgages are, however, only
incurred by the guarantor under or in
Certain agreements essential for the transferred to the guarantor for security
connection with the guarantee will have to functioning of the covered bond purposes and therefore remain on the issuer's
be reimbursed (or pre-funded accordingly), Programme, such as the intercreditor deed balance sheet (as further explained below).
by the issuer.
governing the priority of payments in
4. As security for the relevant relation to the proceeds of the cover pool, Guarantor and guarantee
reimbursement and pre-funding claims of the cash management agreement regulating The guarantor is a Swiss corporation, which
the guarantor, the Swiss bank transfers a related aspects of managing the cash in the is majority-owned by the relevant issuer with
pool of mortgage loans, together with the cover pool and the guarantee deed pursuant two independent board members which are
related mortgage security, to the guarantor.
to which the guarantor guarantees the also minority shareholders. Under the
Accordingly, if the issuer defaulted under payment of principal and interest under the constitutional document of the guarantor,
the covered bonds and the guarantee was to covered bonds are governed by English law. the
two
independent
board
be drawn, the guarantor could claim for English law also applies to the swap members/shareholders are granted a veto
coverage by the issuer under the guarantee agreement needed for purposes of mitigating right in respect of all relevant decisions on
mandate agreement. Failure by issuer to pre- the interest rate risk resulting from the the shareholders and the board level. This
fund the payments lowered under the discrepancy between fixed coupons under corporate governance setup is designed to
guarantee would allow the guarantor to the covered bonds and the interest rate enhance the protection of the interests of the
8 2 I F L R / J u l y / A u g u s t 2012
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covered bond investors and the stability of
the guarantor in case of an insolvency of the
issuer.
The guarantor is structured as a
bankruptcy remote special purpose vehicle
with a limited corporate purpose. In essence,
this purpose consists in holding and, if
necessary enforcing the assets in the cover
pool. Therefore, the guarantor may only
enter into such agreements and transactions
as are necessary to effectively perform its
function under the covered bond
programme. Moreover, it benefits from nonpetition and limited recourse provisions, to
which substantially all parties to the
transactions have acceded with view to
reinforce the bankruptcy remoteness of the
guarantor.
There are a number of trigger events as
described in guarantee deed following which
the guarantee is activated. Such trigger
events include: (i) Failure by the issuer to
pay any interest or principal amount when
due; (ii) bankruptcy or insolvency
pröceedings being ordered by a court or
authority against the issuer; and (iii) failure
to rectify any shortfall in the cover pool, as
established by the asset coverage or interest
coverage test.
While an issuer event of default
accelerates the payment obligations of the
issuer, it will not change the payment
schedule under the guarantee. Accordingly,
amounts of principal and interest will be
payable by the guarantor as originally
stipulated in the terms of the bonds as long
as no guarantor event of default occurs. Such
event would occur i f a guarantor failed to
make any payments when originally due, an
amortisation test failed or if the guarantor
itself became insolvent.
As indicated, the guarantee is issued
pursuant to a Swiss law guarantee mandate
agreement entered into between the issuer
and the guarantor. Under this agreement,
the issuer instructs the guarantor to issue a
guarantee for the benefit of the holders of
covered bonds, on the account and risk of
the issuer. As consideration for the issuance
of the guarantee by the guarantor, the issuer
pays to the guarantor an annual guarantee
fee. As mentioned earlier, the issuer also
undertakes to indemnify and pre-fund the
guarantor for any outstanding and future
amounts payable by the guarantor under or
in connection with the guarantee and to
reimburse any such payments made by the
guarantor which have not been pre-funded.
Extension of the guarantee to a new
issuance is subject to the security assignment
of an adequate amount of additional eiigible
mortgage claims and the passing on of legal
title in the related mortgage certificates to the
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guarantor by the issuer, as well as to the
fulfilment of certain other conditions. For
Swiss regulatory and tax reasons, however, the
mortgage claims in the cover pool only secure
the indemnification and pre-funding
obligations of the issuer towards the
guarantor under the guarantee mandate
agreement, but not the claims of the holders
of covered bonds under the guarantee.
Technically speaking, the obligations of the
issuer under the covered bonds are, therefore,
(aside from the guarantee) unsecured
obligations of the issuer. Moreover, as
opposed to English covered bonds, the issuer
does not seil the mortgages in the cover pool.
Rather, for Swiss insolvency law and other
reasons they are only transferred to the
guarantor for security purposes.
The cover pool
As indicated, the cover pool consists of
residential mortgage loans which are
transferred for a security purpose to
guarantor together with the related
mortgage certificates. Accordingly, the
guarantor will acquire legal title in the
mortgage certificates, which represent the
lien on the residential real estate
encumbered. In addition, certain Substitutes
such as cash or governed bonds may form
part of the cover pool.
Each mortgage certificate transferred will
continue to secure only the related mortgage
loan(s) and can not be enforced unless a
relevant mortgage loan is in default.
Together with a number of other
precautions, this helps to ensure that the
interests of the mortgage debtors are not
unfairly prejudiced by virtue of the
transaction.
The mortgage loans in the cover pool have
to meet certain eligibility criteria including a
certain maximum loan-to-value ratio (LTV).
Moreover, the composition of the cover pool
has to meet additional criteria under an asset
coverage test and an interest coverage test,
including a minimum amount of overcoUateralisation acceptable to the rating
agencies from time to time. Accordingly, the
mortgages in the cover pool are subject to
regulär replenishment and Substitution in
order to ensure ongoing compliance with
the relevant tests and eligibility criteria.
Compliance with the eligibility criteria
and the relevant tests are monitored by an
independent asset monitor on a pre-defined
random basis.
In case o f insolvency o f the issuer, the
bondholders benefit, in addition to their
direct recourse to the issuer, from the
guarantee issued by the guarantor which is
backed by the assets in the cover pool. 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 an
insolvency of the issuer, 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.
^^Mo^afes In the
c©wer pool are onlf
transferred to t i e
guarantor for
securitf parposes^'
An enforcement event in respect of the
cover pool assets event will occur upon the
earlier of (i) breach of certain pre-maturity
tests aiming at creating a sufficient amount
of liquidity in the cover pool in respect of
certain payments under designated series of
so-called hard bullet covered bonds; (ii) any
failure by the issuer to pay an amount due
under the indemnity and pre-funding
Obligation in relation to the guarantee or
certain other obligations; and (iii) in case of
a bankruptcy or equivalent pröceedings in
relation to the issuer, completion of the
relevant insolvency pröceedings. Upon the
occurrence of an enforcement event, the
guarantor is entitied to liquidate a sufficient
part of the cover pool assets to 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
eiigible investor.
Condusion
Recent developments have not only
highlighted the importance and versatility of
the Swiss Pfandbrief, but have also increased
the options available to Swiss mortgage
institutions. The development of a
transaction structure compatible with the
Swiss legal environment, the prevailing
practice in the Swiss mortgage business and
the requirements of issuances into
international markets offers Swiss mortgage
lenders flexibility and an improved access to
international institutional investors.
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