In countries such as Australia, where sophisticated structured note products are sold to the public, dealmakers have devised techniques to ensure the investments are created and sold in a way that makes them comprehensible while at the same time protecting those with legal responsibility for the offering.
Their experiences are a helpful guide as to how the market might develop in Hong Kong, where the low interest rate environment is forcing the public to look for new investment options. Coupled with the government's recent efforts to encourage a retail bond market, banks and corporate issuers are offering increasingly sophisticated structured notes. Issuance of equity and index linked notes has increased, and banks are also arranging more complex credit linked transactions.
This trend poses several challenges for bankers and their legal advisers. How can they structure a product that the public will understand? How can they present the product in the offering document in a way that is appealing to investors but complies with the law? And how can they sell the product to the public?
Keeping it simple is the answer. Headlines in the Australian press such as Let's hope the punters who put up the money understood what they were buying highlight the importance of making sure retail investors understand what they are buying. A simple product is easier to sell than a complex one.
It is also easier to guide a simple product through complex regulatory rules. Structuring decisions must be made with the retail market in mind.
Consider the following example. Assume that an issuer issues a fixed or floating rate note linked to (in the sense that the amount of principal repaid on the note depends on) a portfolio of loans or other debt obligations.
The high interest rate accounts for the investor taking the credit risk on the portfolio. If one or more of the loans or other debt obligations comprising the portfolio defaults, or a borrower included in the portfolio becomes bankrupt, the amount paid to the investor will be reduced according to a complicated valuation process.
The portfolio's composition and characteristics are often diverse, complex and may change over time, reflecting, for instance, repayments or cancellation of un-drawn amounts. The issuer hedges its exposure under the notes by entering into a portfolio credit default swap (CDS) with a swap counterparty under which the issuer takes on credit exposure to the portfolio identical to that taken on by noteholders under the notes. The issuer receives fixed amounts under the swap as the price of taking on that risk. Assume also that the proceeds from the issuance of the notes are invested in highly rated collateral that can also change over time. Security is granted over this collateral to secure the issuer's performance under the notes.
Such synthetic collateralized debt transactions are common in the wholesale market. But, to sell these products to retail investors, firms must keep it simple.
Simplifying collateral
One way to do so is to deposit the amount raised from the note issue into a bank account instead of a range of collateral.The deposit bank is usually the swap counterparty itself. The deposit, which pays interest, is commonly structured as a flawed asset - the issuer can only withdraw it in limited circumstances, such as at maturity of the notes - and is usually subject to a right of the bank to set off the balance of the deposit against amounts owing to it under the CDS.
Depositing the note proceeds into the bank account removes the complexity of the collateral and also the exposure that investors would otherwise have to the market value of the collateral if it needs to be sold early (following a default of a loan in the portfolio).
For a retail transaction, it is easier to explain to retail investors that losses are deducted from a deposit account rather than from the proceeds of a sale of the securities comprising the collateral (and the timing, pricing and other issues that such a sale involves).
From the bank's perspective, the deposit grants it flexibility in the use of the proceeds from the issue of the notes. It can invest them in highly rated collateral if it chooses. The usual concern in wholesale transactions, which is that such an approach drags the rating of the notes down to that of the bank (as the deposit taker), does not arise because retail investors are generally hungry for the enhanced yield derived under lower rated transactions.
Simplifying credit derivatives
Another way to simplify deals is to change the credit default swap. The terms of most wholesale credit linked notes are based on the swap entered into by the issuer with the swap counterparty, which in turn is based on the market terms of the transaction that the swap counterparty enters into with the street to hedge its exposure under the CDS with the issuer. These market terms are often complicated and difficult to explain to retail investors.
A successful retail product will explain to retail investors the relevant aspects of the swap without simply quoting complex standard swap terms. Indeed, some terms commonly accepted in a wholesale structured note issue are unsuitable for retail products.
The difference between the terms used in the wholesale market and those used in retail products represents basis risk. This is managed as part of the price of a retail offering.
Reduction on cash settlement date: In wholesale CDS transactions, the amount used to calculate the fixed sum paid by the swap counterparty is reduced from the date of notice of the credit event.
This means that interest under the notes is also reduced from this date, even though the cash settlement amount (the amount payable by the issuer on account of the credit event) has not yet been paid. In a retail offering, it is common that no reduction in interest occurs until the cash settlement date.
Local time zone only: It is common for a wholesale CDS to refer to a range of time zones relating to notifications, payments and calculations, depending on the location of the reference entities.
In retail transactions offered in one or two jurisdictions, this can be confusing for the investor, or simply impracticable. Therefore the local time zone is often the benchmark.
Local currency: Wholesale CDSs are often denominated in US dollars. Where this is not the local currency, this can create the perception of foreign exchange risk even though this does not automatically follow. A retail structured note is often re-denominated in the local currency.
Fixed recovery: One of the most complex parts of a CDS is the valuation methodology. To avoid the need to explain this process to retail investors, the latest transactions have adopted a fixed recovery approach (meaning that the amounts payable when a credit event occurs are fixed in advance). This simplifies the transaction, but can give rise to hedging concerns for the swap counterparty.
Plain-language prospectuses
By contrast with some jurisdictions, prospectuses in Hong Kong for structured note issues are seldom used as marketing documents. The documents often comprise dense (but legally accurate) information, the majority of which would be difficult for retail investors to understand.
The prospectuses also take a fairly standard form both in terms of content and layout. Recent improvements have been made as plain language summaries have been included. However, further refinement and tailoring to a retail audience is needed.
Certain techniques have proven successful at getting complex messages across to retail investors in other countries. First, the terms used in the transactions are simplified to more accurately reflect what they mean to the general public.
For example, the term credit default swap has been replaced with portfolio agreement or credit transfer agreement. Similarly, reference entity may become portfolio company and credit event could become company event.
Alongside the simplified terms,
basic diagrams can be used to explain the cash flows in a simple way and there should be more use of charts and tables.
Summaries are also a key way to sell the story. It is common to find one-page abstracts at the beginning of the prospectus to cover key aspects of the transaction. Common sections include information describing the issuer, key offer details and the fundamental terms of the notes.
An investment summary containing a review of the terms then follows. This section is not intended to repeat every precise detail but rather to help investors understand the elements of the terms that are material to assessing the risks of investing in the notes.
Some prospectuses have used the effective technique of including a section entitled Answers to key questions, providing simple responses to questions such as: Where does my money go? How is the issuer able to generate my return? What is the portfolio agreement? What is the key risk in investing in the notes? What is a company event? How can I assess the likelihood of a company event occurring? What happens if a company event occurs? Who is Standard & Poor's? and what is a Standard & Poor's rating?
The ordering of information is important for the prospectus to tell its story. This should not just follow the order of the transaction documentation.
The initial summaries and answers to key questions provide an overview of the structure and context. More detailed sections should follow in a way to logically build on the previous section.
The amount of information included should be kept to the minimum necessary to meet the disclosure standard. Some jurisdictions allow documents to be incorporated by reference so that lengthy financial statements and detailed terms and conditions do not need to be set out in full.
This puts a lot of responsibility on the participants involved in preparing the prospectus to ensure the information accurately reflects the terms of the deal.
For example, it is common to include a material contracts summary where the terms of the transaction documents material to investors are described in more detail. The intention is not to set out all the terms in full. Value judgments need to be made as to which terms are material and how they may be described.
Preventing liability
Those responsible for preparing a prospectus must ensure the relevant disclosure standards are met and that there are no false, misleading or deceptive statements that could result in liability for third party losses. Some jurisdictions expressly provide for a due diligence defence to any such claim.
This typically provides that an offence is not committed if a person proves they made all reasonable enquiries, and after doing so, believed on reasonable grounds that there were no misleading or deceptive statements or omissions.
A tension in retail debt deals exists where, on the one hand there is a need to seize the moment and close the deal when credit pricing is right, and on the other hand there is a need to take the time to ensure the due diligence is carried out to the required standard to prevent liability.
This problem is exacerbated in any jurisdiction where there are mandated delays built into the offer process. Highly efficient and refined due diligence committee processes have been developed by which risks are identified, the prospectus drafted and statements verified before they are filed, all within a tight timeframe.
While there is no express due diligence defence under Hong Kong law, the relevant liability provisions under the Companies Ordinance and the Securities and Futures Ordinance incorporate concepts of negligence and reasonableness. Adequate due diligence processes are an important in ensuring that these provisions are not breached.
Richard Mazzochi is a partner and Abigail Rath is a senior associate of Mallesons Stephen Jaques in Hong Kong. Scott Farrell is a partner of Mallesons in Sydney.
This article first appeared in IFLR, May 2004
