SPVs & ISDA Documentation

This article will discuss how to customize standard International Swaps and Derivatives Association documentation for special purpose, bankruptcy remote vehicles (SPVs) that issue rated securities. An SPV is often formed by the entity (the sponsor) structuring a securitization or other structured financing. In a securitization, a pool of assets is transferred to the SPV and the SPV issues rated securities backed by such assets. There are a variety of reasons a sponsor will form an SPV (e.g., off balance sheet financing or regulatory capital relief). Rating agencies often require that assets be transferred into the SPV so that the credit and bankruptcy risk of the assets will be separate from the credit and bankruptcy risk of the sponsor. Often derivatives are used in order to achieve a particular risk profile. These derivatives are typically governed by ISDA documentation.

Rating agencies scrutinize the risks of the securitization to ensure that the probability of default by the SPV on a particular security is aligned with the rating of the security. One rating agency requirement is that the ISDA documentation be customized to conform to the rating agencies' analysis of these risks. The rating agencies' standards vary depending upon the type of transaction, the SPV and the rating, and the following is only a general summary.

 

Events of Default & Termination Events ("Defaults")

Many of the traditional Defaults are not appropriate with an SPV for the reasons specified below.

Breach of Agreement & Misrepresentation

An SPV typically is a newly formed vehicle that is dependent upon third parties (servicers, trustees, and managers) to perform most functions. While the rating agencies review the structure to ensure that the proper parties are in place, the rating agencies do not address the likelihood or ability of these third parties to perform, therefore these defaults are not applicable. In addition, because the rating agencies do not include the risk of non-performance when issuing their ratings of the securities, these defaults are inappropriate. Dealers have the opportunity to review the transaction documents of the SPV and are in a position to assess the likelihood that such third parties will comply with their undertakings.

 

Cross Default and Default under Specified Transaction

Because securitizations rely upon the credit quality of the underlying assets and these risks are incorporated into the structure of the securities, these defaults are removed from ISDA documentation.

 

Merger without Assumption, Credit Event Upon Merger; Tax Event Upon Merger

The SPV's organizational documents prohibit mergers and therefore these Defaults are inapplicable.

 

Credit Support Default

SPVs typically do not have third party credit support providers so this Default is generally inapplicable.

 

Bankruptcy

Bankruptcy of a SPV is considered "remote" because all parties that contract with the SPV agree not to institute a bankruptcy proceeding until the security holders are paid. The transaction documents require the vote of an independent director or trustee (a person not affiliated with the sponsor) who cannot vote for the bankruptcy unless it is in the best interest of the security holders.

Failure to Pay

When an SPV fails to pay a dealer a scheduled payment, it should be regarded as a default because these payments usually are pari passu or senior to the rated securities.

 

Illegality

The affected party has the right to transfer the ISDA document to a party acceptable to the rating agencies in order to eliminate the illegality or if this is not possible, the agreement may terminate.

 

Additional Termination Events

Additional Termination Events may include a default by the SPV under the indenture (or amendment of the indenture without dealer consent) or a ratings downgrade of the dealer.

 

Tax Event

Standard ISDA documentation provides the right of a party affected by a tax event (if it is obligated to gross up or will receive a payment net of taxes) due to a change in tax law to terminate the ISDA agreement. Rating agencies do not address a change in tax law risk, and it is therefore incumbent upon the dealers and the SPV to negotiate this risk in the agreement. There are different ways parties may negotiate this risk. First, the SPV and dealer may agree that the tax risk will be borne by the dealer, such that the dealer is obligated to "gross-up" while the SPV is not. In this scenario, the parties may agree that the dealer may either transfer the agreement to another counterparty to eliminate the tax event or terminate the transaction. Second, the parties may agree to allow standard ISDA terms to apply. The result of the negotiations may affect the ratings of the notes. Whatever option is negotiated, the risks must be properly disclosed to investors.

This week's Learning Curve was written by Kristin Boggiano, associate, and Paul N. Watterson, Jr., partner in the structured products group at Schulte Roth & Zabelin New York.