Credit Suisse released an excellent research paper at Davos this year entitled "How Corporate Governance Matters". Coming at the end of a flurry of corporate governance scandals that were operatic in colour and scale (Volkswagen, FIFA, Toshiba...), this is indeed a topic which seems ripe for discussion. Messrs Keating, Koutsoukis and colleagues make interesting observations which are clearly of relevance to all who dabble in the equity markets.
This article, however, looks at how the concept of good corporate governance applies to corporations that are off Main Street and geographically remote from (but very connected to) Wall Street and the major international financial centres; we are referring to special purpose vehicles ("SPVs") established to participate in securitisation transactions, typically in jurisdictions like the Cayman Islands where the authors practise. The thinking on SPVs and governance has, over the course of the last few years, subtly evolved. Some market participants and users, however, may not have noticed this.
What is "Corporate Governance"
As we are lawyers, tradition requires that we begin with defined terms. By "corporate governance", we mean that internal system of rules, practices and processes by which a company is managed by those to whom its direction is entrusted and controlled by those who are its owners. Shleifer and Vishny, interestingly, define the concept by reference to the investors and how such "suppliers of finance assure themselves a return on investment"1. In a structured finance transaction involving a SPV, how do the suppliers of finance assure themselves of their returns?
The Myth of the Steady State System
In the context of structured finance transactions, governance issues do not traditionally rank high on the investors' list of priorities. In some sense, this is because structured finance transactions are seen almost like "steady state" systems, i.e. systems in which variables remain constant over time despite the ongoing processes that attempt to change them.
Structured finance transactions feel like steady state systems because of the features that make them "structured". Cashflows have been analysed and waterfalls conceived in order to keep the system constant. Factors like overcollateralization or interest coverage ratios are configured to enable transactions to deleverage and maintain their "steady state" without intervention and, when sufficiently serious issues arise, triggers and events of default work to move control over to relevant parties who can then exercise their rights with a view to protecting their own interests. Documentation clearly delineates rights and responsibilities and incorporates covenants which are supposed to prevent risk from outside the system being imported into the system.
At the centre of this steady state system is the issuing entity. The SPV does not look like a real company: it has no physical office, no employees and, in most cases, no shareholder with a meaningful economic stake in the transaction or in the SPV's financial performance. It is there essentially as a legal device to enable investors to gain exposure to a portfolio of assets. Given the nature of the issuer and the engineering which holds the transaction together, participants may well feel that they need not worry about "corporate governance" and the ills it seeks to address. If, in the structured finance world, you just set your transaction like the cruise control in your car, why should transaction participants focus on anything other than the checks and balances engineered into the transaction's structure and documentation? Put simply, corporate governance is displaced by transactional governance.
The Reality of the Steady State System
All this holds true so long as the assumptions hold true and the steady state remains steady. When, as in 2008, the assumptions prove false, the steady state system begins to look like a fiction.
Over the crisis, that fiction began to unravel in the Cayman Islands courts in the context of collapsed hedge funds, where much judicial consideration was given to the position and role of independent directors and other governance issues. While the entities before the courts were funds (i.e. legal devices enabling collective investment), the judges of the Cayman Islands courts affirmed loud and clear that these were companies nonetheless. In turn, this led to the affirmation that directors of hedge funds have the same core duties as directors of any other company and that just because a company has financial or investment objectives and has contracted out some functions to third parties does not mean that its directors are exempted from their usual responsibilities. The same judicial consideration has not been given (yet) to SPVs in the Cayman Islands courts but those practitioners who have advised on workouts and restructurings of distressed structured finance transactions reached the same conclusions about directors' fiduciary duties and the correct internal management of companies which happen to be SPVs.
So, where transactional governance turns out to be insufficient, for whatever reason, good corporate governance is what transaction parties may have to fall back on.
The Connection Between Structured Finance and Good Corporate Governance
In actual fact, good corporate governance is not a fall back at all but is firmly embedded in structured finance transactions; a little excavation is required to unearth it.
Structured finance transactions, in essence, allow investors to gain exposure to the performance of a portfolio of assets, excluding the "noise" that is associated with certain parties who have been or are connected with those assets. Typically, assets are isolated in an SPV, removing them from the bankruptcy risk of the person who originated them or who services them. In addition to "true sale" another key concept is "non-consolidation": the absolute independence of the SPV, such that it (and its assets) will not be drawn into the bankruptcy of another person and its assets made available to discharge that person's liabilities. Various measures are typically taken to establish and ensure the "separateness" of the SPV at the heart of a structured finance transaction. These include requiring the SPV to:
- conduct business and hold assets in its own name
- maintain books and records separate from any other person or entity
- at all times, hold itself out to the public as an entity separate and distinct from any other person or entity and correct any known misunderstanding
- not guarantee or secure the obligations of any other person or entity
Such requirements are built into transaction documents and constitutional documents too, and are fundamentally related to governance: they are all about the rules, practices and processes that are in place within a company and regulate its proper "behaviour" so that its corporate integrity is not called into question. However, it is not enough merely to introduce provisions into the documentation – what is key is how these requirements are implemented and how the entity actually functions in practice.
Separateness, which is essential to the performance of a structured finance transaction, can only really be guaranteed if an entity has good corporate governance: it must be clear as to its obligations, have proper processes internally to enable it to discharge them and appropriate systems to monitor and remediate any lapses swiftly. If the SPV fails to have sufficient systems and processes in its own right, then other transaction parties will have to "fill in" for it or "prompt" it or initiate processes on its behalf. The more this happens, surely, the more its "separateness" becomes questionable.
At some point, "separateness" (the quality of being separate from something else) develops into a slightly different concept, that of "independence" or "integrity" (having substance in one's own right). If substance is the gold standard, the most robust argument for separateness, it is interesting that we now see questions of "substance" being explored more and more.
Changing Views of the SPV Device
While structured finance is often about performance under stress (rating agencies, after all, perform the role of conducting stress tests), we note increasing interest in considering performance at rest.
CLO managers are increasingly looking at the vehicles whose assets they manage with increased interest and asking questions that were never fielded pre-2007: what sort of governance systems does the SPV have in place; what competencies do the directors actually have to assess matters; what oversight does the entity have over the persons to whom it has delegated functions and how is this managed; when a trustee report is signed off by the Issuer, what process has been followed to enable that to happen?
In the same way that managers are, perhaps by virtue of regulatory pressure, seeking to assess the substance of the orphan SPVs they face, so too have investors in certain structured finance transactions begun to wise up to the issue. Sometimes, as the global financial crisis demonstrated, the issuer team is the last man standing, the fiduciary upon whom all depends. One had better be sure that the last man standing does not wobble and fall. Whether that happens depends on how he has been performing while at rest. If there has been good corporate governance – a steady state of good practices - this will likely determine how effective he is when suddenly he is placed under stress. This is what the smart "suppliers of finance" are looking at now.
This article was originally published by Law360 in November 2016.
1 Shleifer, A., & Vishny, R.W. (1997), "A survey of corporate governance," Journal of Finance
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