Practical guides on orphan SPV repackaging transactions for Hong Kong SAR and Mainland China clients

This is the first article in a series of articles on orphan SPV repackaging transactions[1] for Hong Kong SAR and Mainland China[2] clients.

Introduction

We observe growing interest from Chinese financial institutions in the use of orphan special purpose vehicles (“SPVs”) in repackaging structures for financing deals. Chinese clients do not just include traditional sell-side clients like investment banks and authorised institutions, but also securities houses and many buy-side clients such as fund managers and asset managers.

The key advantages in the use of repackaging structures include their off-balance sheet treatment, and reduced credit risks to the arranger’s corporate group.

This series of articles will provide an in-depth understanding of repackaging transactions, and promote the use of the repackaging structures.

This first article provides an introduction to the background, basic features and commercial uses of repackaging transactions, and answers to some of our clients’ frequently asked questions.

1. How long have repackaging structures been around?

Repackaging structures are not a recent invention. The earliest repackaging transaction is thought to have been conceived as early as the 1980s in the UK. Since then there has been explosive growth in the scale and variety of repackaging transactions across multiple asset classes, including bond-linked, equity-linked, credit-linked, commodity-linked and other structures linked to bespoke products.

The following key features of repackaging transactions are all well-established in global markets:

• orphan nature of the SPV;
• insolvency remoteness and ring-fencing through limited recourse and non-petition;
• security over the underlying collateral assets;
• use of derivatives to manage cashflows discrepancies between the note level and the collateral asset pool level; and
• use of pre-enforcement liquidation by a disposal agent and trustee enforcement.

The volume and complexity of repackaging transactions fell after the global financial crisis in 2008, but have resumed in recent years. There have been various initiatives in recent years to develop multi-dealer repackaging programmes in Europe and the US, where multiple financial institutions accede to a common programme to offer products on more standardised terms.

The use of repackaging transactions is relatively novel to mainland China clients. Instead of using the repackaging structure in traditional methods such as large volume “flow” transactions that are linked to safe and liquid assets, Chinese financial institutions have successfully and creatively leveraged repackaging structures to fit their own unique business and capital needs. We will share our observations on some of these interesting and bespoke transactions in part two of our series of articles.

 2. What is the basic structure of a repackaging transaction?

Traditionally, many of the simpler repackaging transactions are structured with the following features:

• An orphan SPV issuer issues notes (“Notes”) and uses the issuance proceeds to purchase underlying assets, such as a portfolio of bonds (“Collateral Assets”).
• In repackaging transactions arranged by Chinese financial institutions, these structures are often “pass-through”, under which the cashflows under the Notes will match the cashflows under the Collateral Assets precisely without the need for a swap in managing cashflow discrepancies.
• If it is necessary to modify the cashflows under the Collateral Assets for any reason (e.g. changing the interest rate or currency), the SPV issuer enters into a swap transaction with the Swap Counterparty (usually the arranger or one of its affiliates), under which the SPV issuer pays to the Swap Counterparty cashflows it receives from the Collateral Assets, and the Swap Counterparty pays to the SPV issuer cashflows which match payments under the Notes.
• The SPV issuer grants security over the Collateral Assets it holds as well as all of its rights, title and interest under the swap transaction (if any) and other related transaction documents in favour of the Trustee.
• The Trustee holds the benefit of the security on trust for the secured creditors, which include the Noteholders and the Swap Counterparty.

To increase cost-efficiency, arrangers will typically arrange for note programmes to be established by the SPV issuers. The programme documentation will set out the framework for the basic structure above, which allow the SPV to enter into repackaging transactions using shorter form issuance documentation. Such programmes are commonly known as “repackaging programmes”.

3. What is an orphan SPV?

A fundamental feature of repackaging structures is the use of an insolvency remote “orphan” SPV as the issuer. The SPV is typically a company established in a tax neutral or tax favourable jurisdiction (such as the Cayman Islands or Ireland), and is independently owned and controlled by independent directors.

When establishing a repackaging programme, a professional corporate services provider is usually appointed to assist with incorporating and managing the SPV. The professional corporate services provider’s core business activities include holding the shares of the SPV on trust for a charitable purpose, as well as providing independent directors for the SPV. The SPV and the professional corporate services provider will enter into an administration agreement appointing the professional corporate services provider as the administrator of the SPV and setting out the scope of its services. Any fees, costs and expenses payable to the administrator will usually be borne by the arranger.

At KWM, we have strong relationships with the most well-established corporate services providers that have a long track record in incorporating and managing orphan SPVs. While fraud risk cannot be completely eliminated, appointing a reputable corporate services provider will help to minimise this risk. Arrangers and investors can also take comfort that the Collateral Assets for any series of Notes is secured in favour of the Trustee, who holds the security on trust for the secured creditors. The orphan SPV and its directors are usually subject to restrictions from dealing with Collateral Assets under the repackaging programme documents.

Such arrangements ensure that the SPV will not be regarded as a subsidiary of the arranger or the originator, or indeed of any corporate group. It will be for all intents and purposes an “orphan” with no affiliates.

4. What are the pros and cons of repackaging transactions?

A common question that many Chinese clients ask is whether they should set up a repackaging programme, or a more traditional structured notes programme with a corporate group entity as the issuer. Some of the pros and cons of setting up a repackaging programme are set out below.

Pros

• Off-balance sheet treatment in respect of Collateral Assets – Perhaps the most important advantage that a repackaging structure gives is off-balance sheet treatment in respect of the Collateral Assets. The SPV is an “orphan” that is not an affiliate or subsidiary of the arranger group. This means that any Collateral Assets that the SPV purchases for any repackaging transaction will not form part of the balance sheet of the arranger group, including any assets that the SPV purchases from the arranger group. When the arranger group sells assets to the SPV, this accelerates cash receipts on the sale of the assets while removing the assets from the balance sheet of the arranger group. In doing so the debt-to-equity ratio of the arranger group is reduced, and the financial ratios are improved so as to enable it to borrow more on-balance sheet.

• Off-balance sheet treatment in respect of Notes – For similar reasons as described above, any Notes issued by the orphan SPV will not form part of the balance sheet of the arranger group. This has a number of advantages – for example, that the arranger group will not need to hold capital under the Financial Resources Rules (“FRR”) for notes issued by the orphan SPV issuer. In addition, for Chinese financial institutions, Notes issued by the orphan SPV should not constitute foreign debt of the Chinese financial institutions and therefore should not require NDRC filings.

Although there have been instances where issuances by a corporate group issuer under a structured notes programme have achieved off-balance sheet treatment, this often requires discussions with accountants and specific structuring features (such as holding and granting security over the reference assets). Using a repackaging programme is arguably a more established and reliable method of achieving this outcome.

• Reduced credit risk to the arranger group – Another important advantage of repackaging transactions is reduced credit risk to the arranger group. Investors in structured notes issued by a corporate group issuer are exposed to the credit risk of both the arranger group (via the issuer) and reference assets that underlie the structured notes. However, in a repackaging transaction, investors are only exposed to the credit risk of the Collateral Assets. The SPV issuer is not part of the arranger group and is structured to be “insolvency remote”.

• Tackle investment restrictions – Repackaging structures may also help tackle investment restrictions imposed on the investors. Financial institutions or funds may be subject to investment restrictions, such as restrictions from making loans or investments in equity or fund products. Often they are not restricted from investing in fixed income products. Repackaging notes issued by an orphan SPV are often regarded as fixed income products falling within their investment scope.

• Others – Other key benefits of using repackaging transactions include obtaining a favourable tax treatment and avoiding conflicts of interest with an independent board in place at the SPV level.

Cons

• Costs – The main drawback of establishing a repackaging programme is cost. As it is a more complex structure than a traditional structured notes programme, there are more parties and documents involved, which will involve a substantially higher establishment and on-going maintenance cost. The list of the key parties and documents involved in a repackaging programme are described below.

• Time – It also generally takes longer to establish the repackaging programme than a traditional structured notes programme. A typical timeline for establishing a repackaging programme is described below.

We observe a trend amongst Chinese financial institutions in Hong Kong to maintain both a repackaging programme and a traditional structured notes programme, which provides the greatest flexibility to meet client and business demands.

5. How to achieve “insolvency remoteness” in repackaging transactions?

An SPV is structurally independent of the arranger group, and will not be affected by the insolvency of the arranger group.

Apart from the SPV corporate ownership independence, the programme documents will also adopt contractual “insolvency remoteness”. Common contractual provisions include:

• Restrictions on the SPV against engaging in any business (other than the issuance of notes under the repackaging programme), the disposal of assets, declaration of dividends, owning of any subsidiary or incurring of liabilities except for those contemplated by the repackaging transactions.
• “Limited recourse” language – i.e. noteholders and other secured creditors in respect of a repackaging transaction only have recourse to Collateral Assets which are subject to security for that transaction.
• “Non-petition” language – i.e. noteholders and other secured creditors agree not to take any legal proceedings or file any winding-up petition against the SPV. 

6. How to achieve “ring-fencing” in repackaging transactions?

It is typical for arrangers to establish repackaging programmes such that a single SPV can enter into multiple series of repackaging transactions. It is important that each series of repackaging transaction is “ring-fenced” from all other series, such that the collateral assets held by the SPV for a particular series are only available to the noteholders and other secured creditors for that series, and not to any other creditor of the SPV.

This is achieved by:

• “Limited recourse” language – i.e. noteholders and other secured creditors for a particular series will only have recourse to Collateral Assets which are subject to security for that series only, and not to the Collateral Assets for any other series.
• Security – i.e. security over Collateral Assets for a particular series is created in favour of the trustee, which holds it on trust for the noteholders and other secured creditors for that series only.

It is also important that the SPV is “insolvency remote” (as discussed in Section 5 above) from a ring-fencing perspective, as these ring-fencing mechanisms may not always survive in an insolvency scenario.

7. How are repackaging transactions operated in practice?

As discussed in Section 3 above, arrangers typically appoint professional corporate services providers when establishing repackaging programmes, who appoint independent directors for the SPV. The directors will be involved in signing transaction documents and holding board meetings, but will not be typically involved in running the transactions. This means that other parties will be responsible for all structural and operational aspects of repackaging transactions, including making all determination and decisions and taking actions.

We list out some of the most common roles in a typical repackaging transaction:

Arrangers	Managing and overseeing the setting up of programme and structuring each note issuance
Dealer	Initial purchaser of notes for on-sale to investors Usually a Type 1 licensed entity
Calculation Agent	Making certain calculations and determinations in connection with the Notes
Originator	The arranger (or one of its affiliates) usually holds (or acts as the dealer in respect of) the Collateral Assets that are sold to the SPV The originator can also be a buy-side client of the arranger which holds the underlying asset and is looking to accelerate cash receipts and remove assets from its balance sheet
Disposal Agent	Pre-enforcement liquidation of the Collateral Assets before redemption
Swap Counterparty	Taking on certain risks in a repackaging, e.g. interest rate and currency mismatches between the receivables and the Notes, or providing leverage on the return of the Notes

Arrangers will usually also appoint a professional trustee and agency services provider to perform the following roles:

Account Bank	Maintaining an account into which proceeds of the underlying assets are deposited
Custodian	Safekeeping of the underlying assets (usually for securities cleared through external clearing systems)
Paying Agent	Making payments to the noteholders as they fall due
Note Trustee/ Security Agent	Acting on behalf of the noteholders as an intermediary between them and the Issuer, representing the noteholders’ interests throughout the life of the notes Also holding the benefit of the security on behalf of the investors and other parties whose interests are secured
Settlement Agent	Assisting with the initial settlement of the Notes Usually be appointed if the arranger does not have an account with clearing systems

A key consideration for arrangers is that, while they will necessarily be heavily involved in structuring and running repackaging transactions, there are certain limits in order to retain off-balance sheet accounting treatment. For example, arrangers should not have any control over the orphan SPV’s board of directors. The directors need to be genuinely independent directors that act in the best interests of the orphan SPV.

Voting rights in respect of the Collateral Assets should be held solely by the orphan SPV and not the arranger. As security interest over the Collateral Assets is created in favour of the trustee, the SPV usually covenants not to exercise voting rights unless it receives a direction from the noteholders by way of extraordinary resolution.

8. What documents are required to establish a repackaging programme?

Arrangers will need to appoint a local counsel to incorporate the SPV in their jurisdiction of choice (e.g. for a Cayman SPV, Cayman counsel is required). Many such local counsel have a professional corporate services provider arm, and it is common to appoint both of them together.

Local counsel will typically prepare the following documents:

SPV incorporation documents	To incorporate the SPV
Declaration of Trust	For the share trustee to declare a charitable trust over the shares of the SPV
Administration Agreement	To appoint the professional corporate services provider as the administrator of the SPV Arranger usually also signs up to bear the fees, costs and expenses on behalf of the SPV

As your arranger and trustee counsel, we will prepare the following programme documents:

Offering Circular	Disclosure document for the repackaging programme Will contain risk factors, terms and conditions, selling restrictions and any other disclosure that may be required
Principal Trust Deed	Appoints the trustee and sets up the framework for creating the notes and security for any series
Agency Agreement	Appoints the agents of the SPV as listed in Section 7 above
Dealer Agreement	Agreement to sell notes to the Dealer for distribution to investors
Swap Schedule	Form of Schedule to an ISDA Master Agreement between the Swap Counterparty and SPV Sets up the framework for confirmations to be entered into for any issuance Not always necessary to be drafted at programme establishment

9. What licences may be required for repackaging transactions?

The following licences may be relevant to repackaging transactions under the Securities and Futures Ordinance (Cap. 571) (SFO):

Type 1 (Dealing in securities)	Repackaging notes are typically sold to professional investors Type 1 licence always required when selling to corporate or individual professional investors The Dealer must be a Type 1 licensed entity for the SPV to rely on an exemption under the SFO
Type 3 (Leveraged foreign exchange trading)	Potentially relevant if an FX swap is required
Type 8  (Securities margin financing)	Needs to be considered for leveraged transactions This will be described in our next article of this series
Type 9 (Asset management)	This may be relevant in “managed” repackaging transactions, where notes issuance proceeds are deposited with an investment or asset manager Not required for most repackaging transactions
Type 11 (Dealing in or advising on OTC derivative products)	When it comes into force, the arranger group entity that acts as the swap counterparty will need to be Type 11 licensed

There are many other regulatory considerations that may be relevant to repackaging transactions, including:

• suitability requirements when marketing to investors;

• arrangers’ liability for market misconduct and misrepresentation;

• SFC Code of Conduct requirements for complex products and derivative products; and

• regulations in relation to OTC derivatives, including reporting, margining, clearing and potential licensing issues.

This is a big topic which needs to be considered on a case-by-case basis for each transaction. We are happy to discuss further with any client on potential regulatory considerations relating to any repackaging transaction.

10. What is a typical timeline for establishing a repackaging programme?

Depending on the corporate approval process of the arranger institution (which may range from one month to up to six months or more), the set up of a repackaging programme itself can be completed within six to ten weeks. Timeline for a note issuance drawdown under the programme varies from case to case depending on the complexity and novelty of the structure.

The programme establishment process is summarised in the chart below.

The King & Wood Mallesons’ Derivatives and Structured Finance Team advises across the full spectrum of derivatives and structured products. Our team has deep experience in establishing repackaging programmes, structuring bespoke and complex repackaging transactions involving all types of asset classes (including bonds, equities, funds, loans and other types of assets) and innovative pay-off profiles, as well as advising on relevant regulatory issues. We have worked with a large number of Chinese financial institution clients as arrangers on repackaging transactions and are very familiar with their commercial aims and legal needs.

We also have substantial experience in acting for the most active trustees in this market. We are able to offer a full one-stop shop service in acting as arranger and trustee counsel, thereby providing greater cost-efficiencies to clients.

For clients that are interested in PRC cross-border repackaging structures, we work very closely with our colleagues in the Mainland Chinese offices, and we have substantial experience advising in some of the most complex cross-border structured finance transactions in the market. We will cover PRC cross-border issues in a later article of this series.

Please do not hesitate to contact us if you have any enquiries about this article or any aspect of repackaging transactions.

[1] References to “repackaging transactions” and “repackaging programmes” in this article refer to orphan SPV repackaging transactions and programmes respectively, which are distinguished from references to “structured notes” and “structured note programmes” issued or established by a financial institution group.

[2] References to “Hong Kong” shall mean the Hong Kong Special Administrative Region of the People’s Republic of China.