By Antonio Farina, Senior Director & Roberto Paciotti, Managing Director – Analytical Manager Covered Bonds, S&P Global Ratings
In October 2014, Brazil enacted Provisional Measure No 656, which outlined the framework for Brazilian covered bonds (letra imobiliária garantida; LIGs). This measure became Law No. 13,097 in January 2015.
S&P Global Ratings has reviewed this legislation. From the standpoint of the legal protection afforded to covered bondholders by the Brazilian framework in the event of the issuer’s insolvency, we conclude that the new regime could allow a covered bond programme to be rated above the issuer credit rating (ICR). However, we also see several aspects that the law leaves unclear. We expect that secondary legislation, which the Brazilian Monetary National Council (CMN) should approve in 2017, will address these loose ends.
When assessing the underlying legal framework of a covered bond issuance, we focus primarily on the degree to which the cover pool assets are isolated from the risk of issuer bankruptcy and whether a bankruptcy is likely to have other detrimental effects on the timely and full satisfaction of the covered bondholders’ claims.
We have reviewed five key aspects of Brazil’s covered bond legislation:
1) Segregation of the cover pool assets and cash flows
We examine whether or not the cover pool assets are fully available to meet the obligations under the covered bonds. Law No. 13,097 qualifies the cover pool as a segregated portfolio subject to a fiduciary regime. This means that the cover pool assets are deemed legally separate and independent from the issuer’s own assets. In particular, the cover pool and its underlying assets will not be available to any of the issuer’s creditors other than the bondholders, except if the issuer commits fraud or illegal activities when it creates the cover pool.
Third-party execution risk. An LIG’s cover pool is earmarked for the settlement of payment obligations of the issuer under the corresponding LIG. It cannot be seized, attached, or otherwise affected in case of default, intervention, extrajudicial liquidation, or bankruptcy of the issuer or because of any judicial lien resulting from the issuer’s other obligations. The issuer is legally prevented from using, disposing, or encumbering any assets backing a cover pool. Therefore, such underlying credit rights and remaining assets cannot be subject to any lien, burden, or encumbrance other than those related to the rights of LIG holders, and they shall only be released from the fiduciary regime upon the full payment of principal, interest, and other charges related to the LIGs.
Commingling risk. This refers to the possibility that collections received on the cover pool assets from the debtors fall into the general estate of the bankrupt issuer and are thereby either lost or frozen for the covered bondholders.
Since the cover pool assets are deemed legally separate and independent from the issuer’s own assets, we understand that collection cannot be released from the cover pool until the issuer’s obligations under the LIG are fulfilled. Thus, if the issuer defaults on its obligations under the LIG, any amounts arising from the collection of the assets – either under a pre-insolvency or a post-insolvency scenario – would belong to the bondholders.
Set-off risk. We consider the extent to which borrowers are entitled to set-off amounts owed to them by the issuer against their repayment obligations under the loans, in particular deposits that the borrowers may have with the issuer.
The amounts owed by the borrowers to the issuing bank are part of the segregated portfolio, specially created for the LIG’s bondholders. Therefore, we understand that such assets should not be deemed as being part of the issuing bank’s assets and should not qualify for set-off risk.
Eligibility criteria and replacement of ineligible assets.
The issuer is authorised to replace the assets backing a cover pool on a revolving basis upon fulfilment of certain replacement criteria that are yet to be promulgated by the CMN. The CMN has yet to implement a rule on eligibility criteria, portfolio composition, sufficiency, term, cover pool liquidity requirements, and the conditions for the replacement of assets that become ineligible.
The law does not clarify whether or not an asset that becomes ineligible should be maintained, excluded, or replaced from the pool of assets, under either a pre-insolvency or a post-insolvency scenario. We expect future regulations to address these issues.
2) The risk of acceleration of payments to bondholders, a payment moratorium, or forced restructuring
Acceleration of payments. Notwithstanding the issuer’s default, intervention, extrajudicial liquidation, bankruptcy, or the acknowledgement of the issuer’s insolvency by the Brazilian Central Bank, acceleration of the LIGs is forbidden as long as the cover pool is “solvent,” as defined according to the criteria to be implemented by the CMN. Consequently, it is still not possible to determine how and when the cover pool shall be deemed “solvent” or “insolvent” and who should do so and if the acceleration risk is effectively mitigated.
Moratorium and forced restructuring. The pool will not be directly or indirectly available to satisfy any other issuer obligations, no matter how privileged they might be, until the full payment of the amounts due for the LIG holders. Therefore a moratorium or forces restructuring would not be imposed upon the cash flows from the cover pool assets.
3) Limits to the amount of overcollateralisation
Law 13,097 provides for minimum overcollateralisation thresholds for the cover pool and related credit enhancement mechanisms. However, the law does not regulate how any overcollateralisation – above the minimum threshold – should be treated in terms of replacement. Third parties may question this overcollateralisation, especially if, for any reason, the parties are not able to prove that the overcollateralisation ratio chosen is reasonable for the relevant programme. We expect future regulations will clarify the treatment of overcollateralisation over the legal minimum.
4) Treatment of hedging arrangements
The cover pool may contain derivatives contracted through a central counterparty acting as guarantor (for example, stock exchanges or clearing houses), while over-the-counter derivatives are not eligible for the cover pool. Swaps contracted through a central counterparty acting as guarantor are subject to the specific rules issued by the respective stock exchange or any other central counterparty acting as guarantor, especially for insolvency and termination-related issues. Such roles might not follow our criteria and could limit our ability to give credit to derivative agreements included in the cover pool. Notwithstanding the above, the CMN could authorise over-the-counter derivatives to be eligible for the cover pool pursuant to Article 66, Item IV, of Law No. 13,097.
5 ) Access to funding after the issuer’s bankruptcy
Law 13,097 establishes that in case of default, intervention, extrajudicial liquidation, or bankruptcy of the issuer, the trustee shall be vested with powers to manage the cover pool assets, pursuant to the conditions and duties to be further regulated by the CMN. The cover pool assets cannot be subject to any lien, burden, or encumbrance other than those related to the LIG holders’ rights, so they would be freely transferable. In this sense, the trustee is empowered to raise liquidity. Upon the adjudication of an insolvency estate, the trustee shall convene a general bondholders meeting, with the authority to take any appropriate measure regarding the management of the asset pool.
Any and all actions taken by the trustee require prior approval by the committee of general bondholders in order for the trustee to call upon the issuer’s insolvency and decide how the pool of assets should be managed. However, this may cause liquidity issues if a bondholders’ meeting cannot be held before the maturity date of the covered bonds. We will consider if this risk is mitigated in the secondary legislation.
A Preliminary Assessment
At this stage, the views we’ve outlined remain preliminary, particularly because we have not yet seen the secondary legislation.
We believe that new legislation could allow a covered bond programme to be rated above the issuer’s ICR, but we also note several aspects that the law still leaves unclear. Among other things, we look forward to seeing if and how secondary legislation will:
- Further clarify the concept of cover pool solvency and mitigate acceleration risk;
- Define the eligibility criteria for the cover pool assets and their inclusion in the cover pool once those criteria are not met;
- Clarify the treatment of voluntary overcollateralisation; and
- Mitigate the liquidity risk arising from the fact that the trustee must call an investors’ meeting before managing the cover pool.
We also note that the current definition of eligible derivative agreements may prevent S&P Global Ratings from giving credit to swap agreements in our analysis.
This article was originally published in the December 2016 edition of Market Insights & Updates – EMF-ECBC Monthly Newsletter.