UK: UK Regulated Covered Bond Regulations 2008 - Summary Of The Regulations - Part 2 Of 4

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Keywords: FSA, covered bonds, debt securities, asset pool, UCITs Directive, Capital Requirements Directive, credit institutions, SPV model, eligible property

Originally published March 2008

2.1 Eligible Issuers

Under the Regulations, only a credit institution (the "issuer") that has its registered office in the UK (Regulation 9(a)) may issue "Regulated Covered Bonds" provided that it has been admitted to the "Register of Covered Bond Issuers" maintained by the FSA (regulation 9 - in relation to this Register, please also see section 5 of this part 2 on Special Public Supervision and part 3 of this paper).

For now, the FSA and HM Treasury have rejected requests from market participants to expand the eligible issuers to include UK branches of non-UK credit institutions. However, HM Treasury and the FSA are aware that there may be benefits to extending the regime to UK-branches of EEA credit institutions and will therefore reconsider this position when the Regulations are reviewed one year after implementation.

2.2 The SPV Model

Payments to covered bondholders are secured by a pool of assets which must be ring-fenced from the remaining assets of the issuer.

The Regulations only recognise the SPV model (the "SPV model") which mirrors in broad terms the structure adopted by UK covered bond issuers to date. The SPV model used in UK structured covered bonds can be summarised as follows:

Step 1.

the credit institution issues covered bonds and lends the issue proceeds to an SPV, which in the UK structured bond programmes to date has taken the form of a limited liability partnership (whereby the credit institution is one of its members);

Step 2.

the SPV uses the loan to acquire by way of equitable assignment a beneficial interest in a pool of mortgage loans (and accompanying security) originated by the credit institution. In most cases, the beneficial interest was acquired by way of equitable assignment. In one of the UK structured covered bonds issued to date, due to transfer restrictions in the underlying loan documentation, such beneficial interest was acquired by way of declaration of a bare trust by the credit institution. In another of the existing UK structured covered bonds, the SPV acquired the loans by way of contribution in kind by the originating credit institution;

Step 3.

the SPV guarantees the obligations of the issuer in respect of the covered bonds and will, in the event of the issuer defaulting in its obligations under the covered bonds, be required to pay the amounts due and payable under the covered bonds on a pre-acceleration basis (funded by the proceeds under, and any sale of, the mortgage loans and assets);

Step 4.

the SPV grants security over its assets (which largely consist of the mortgage loans) in respect of its obligations under the covered bond guarantee and, if the SPV defaults in respect of its obligations to pay under the covered bond guarantee, then the bond trustee may accelerate the bonds under the guarantee and the security trustee may enforce the corresponding security; and

Step 5.

during the life of the covered bonds, the SPV is required to ensure that the mortgage assets in the pool are maintained in an amount that will cover the claims of the covered bondholders.

Below is a diagram showing the most commonly used UK covered bond structure (using a sale of the mortgage loans rather than a declaration of trust over such loans):

The structure described above is reflected throughout the Regulations:

  • the issuer must lend sums derived from the issue of a regulated covered bond to the owner of the asset pool (the "owner") (regulation 16);

  • the owner (i.e. the SPV) of the asset pool must use all sums lent to it by the issuer of a Regulated Covered Bond to acquire eligible property (as further described below) and keep such property in the relevant asset pool (regulation 22(1)). Until the eligible property is acquired, the owner must hold the on-lent funds in the asset pool (regulation 22(2));

  • the owner must be a limited liability partnership or a company and must have its registered office and centre of main interests in the UK (regulation 21(1));

  • the issuer must enter into arrangements with the owner of the asset pool, which must provide that there is timely payment under the covered bonds (regulation 17(2)(c)) and that the asset pool, during the life of the covered bonds, is capable of covering all claims attaching to the bonds and the sums required for the maintenance, administration and winding up of the asset pool (regulation 17(2)(b), which imposes an asset coverage requirement).

2.3 Composition Of The Cover Asset Pool

According to regulation 3, the cover asset pool will be comprised of:

  • the proceeds from the regulated covered bonds on-lent by the issuer to the owner and the eligible property acquired with those funds (see below);

  • eligible property transferred to the asset pool by the issuer or by a connected person to the issuer (i) to enable the issuer or the owner to comply with the asset coverage requirement (see above), any direction of the FSA or any court order under the Regulations and (ii) for over collateralisation purposes (see section 2.4 of part 2 on Asset Coverage Requirement for a further description of over collateralisation). A person connected to the issuer may transfer eligible property to the asset pool only if such connected person (i) has its registered office in the UK and (ii) has its centre of main interests in the UK or is authorised to accept deposits in the UK;

  • sums derived from assets (other than any Regulated Covered Bond proceeds) in the asset pool and eligible properties acquired using those sums; and

  • sums lent to the owner by persons other than the issuer to enable the owner, upon insolvency of the issuer, to make timely payments under the regulated covered bonds and to satisfy the asset coverage requirement.

"Eligible property" for the purposes of the Regulations will be the following:

  • Exposures to or guaranteed by central governments, central banks, public sector entities, regional governments and local authorities in the EU;

  • Exposures to or guaranteed by non-EU central governments, non-EU central banks, multilateral development banks, international organisations, and exposures to or guaranteed by non-EU public sector entities that qualify for "credit quality step 1" (meaning AAA-rated), and exposures to or guaranteed by non-EU public sector entities, non-EU regional governments and non-EU local authorities that are risk weighted as exposures to institutions or central governments and central banks according to the CRD and that qualify for "credit quality step 1" (meaning AAA);

  • Exposures to "credit quality step 1" (meaning AAA-rated) firms. The total exposure of this kind must not exceed 15% of the nominal amount of the issuer's outstanding covered bonds;

  • Loans secured by residential real estate up to the lesser of the principal amount of the liens that are combined with any prior liens and 80% of the value of the mortgaged properties;

  • Loans secured by commercial real estate up to the lesser of the principal amount of the liens that are combined with any prior liens and 60% of the value of the pledged properties;

  • Senior units issued by French Fonds Communs de Créances or by equivalent securitisation entities governed by the laws of the UK or an EEA state, securitising residential or commercial real estate exposures provided that such exposures were originated or acquired by the covered bond issuer or a connected person and the senior units are rated by an agency with the highest credit rating;

  • Loans secured by ships, up to a maximum LTV of 60%;

  • Loans to a registered social landlord (or registered housing association) secured over housing accommodation or by rental income from housing accommodation;

  • Loans to a person who directly provides the loans set out in paragraph immediately above;

  • Loans to a project company of a project which is a public-private partnership project secured by payments made by a public body with step-in rights;

  • Loans to a person who directly provides the loans set out in paragraph immediately above.

Eligible property (and any relevant security) must be situated in the specific countries or territories mentioned under regulation 2(2), being EEA countries, Switzerland, the US, Japan, Canada, Australia, New Zealand, the Channel Islands or the Isle of Man.

2.4 Asset Coverage Requirement (Over Collateralisation)

As mentioned above, regulation 17(2) and regulation 24(1)(a) determine that the asset pool must, during the life of the regulated covered bond, be capable of "covering claims attaching to the bonds and sums required for the maintenance, administration and winding up of the asset pool". Before the insolvency of the issuer, the issuer must ensure that the necessary arrangements are made with the owner of the asset pool to ensure that the asset coverage requirement is satisfied. Upon insolvency of the issuer, this requirement becomes the direct responsibility of the owner.

This asset coverage requirement amounts to "over collateralisation"1 of the asset pool. In the Regulations, however, the asset coverage requirement goes beyond "over collateralisation" in the traditional sense, which refers to the provision of additional assets in the pool to ensure payment to covered bondholders in the event of the failure by the issuer. In the Regulations, the asset coverage requirement means that there must not only be enough assets to cover the amounts owed to the covered bondholders but also enough assets to cover the other sums required to maintain the asset pool (such as the costs relating to the servicing of the asset pool).

The Regulations do not prescribe the manner to satisfy the asset coverage requirement and to monitor it on an on-going basis. However, this is further detailed in the Sourcebook, a summary of which is set out in part 3 of this paper.

Also, in addition to the asset coverage requirement, the Regulations require the issuer and the owner to make arrangements so that the asset pool in general "is of sufficient quality to give investors confidence that in the event of the failure of the issuer there will be a low risk of default in the timely payment by the owner of the claims attaching to the bond" (regulation 17(2)(d) and regulation 23(2)). The Regulations do not clarify how this requirement must be met and how it will be monitored by the FSA. The Sourcebook provides further guidance in this respect.

2.5 Insolvency Of The Issuer – Transfer Of Title And Priority Of Payments

In the event of insolvency of the credit institution, the regulated covered bondholders will have a priority claim on the asset pool by virtue of the ring-fencing structure.

HM Treasury is satisfied that the structured covered bond model used in previous transactions in the UK provides the necessary ring-fencing of the assets to ensure the priority of the regulated covered bondholders' claims, and therefore the Regulations do not substantially amend the Insolvency Act. The Regulations, however, incorporate the following provisions to strengthen the covered bondholders rights in the event of insolvency/liquidation of the issuer or the owner:

  • Regulation 26 requires the issuer's liquidator to transfer the legal title to the assets in the asset pool to the SPV upon winding up of the issuer.

  • Regulation 28 provides for a priority of payments in case of a winding up of the owner.

    Under many of the existing UK covered bond programmes, payments will be made pursuant to the post-enforcement priority of payments upon the trigger of a default by the SPV and enforcement of the security. Generally, such post-enforcement priority of payments will provide for payments of all amounts received by the security trustee (or the receiver) to the following parties in the following order:

    1. bond trustee and security trustee;

    2. agent banks and paying agents;

    3. servicer, cash manager, account bank and corporate services provider;

    4. swap providers (in relation to included swap amounts);

    5. covered bondholders;

    6. swap providers (in relation to excluded swap amounts), (vii) issuer (under intercompany loan); and

    7. members of the SPV.

    Regulation 28 requires that, in the case of the winding up of the owner, the claims of the following entities (the "relevant persons") are paid from the asset pool in priority to all other creditors:

    1. the regulated covered bondholders;

    2. "persons providing services or securities for the benefit of the covered bondholders" (e.g. bond trustee and security trustee);

    3. hedge counterparties who provide hedging in relation to the asset pool or the regulated covered bonds (and its guarantee); and

    4. providers of liquidity (other than the issuer) for payment of the claims of the persons in paragraphs (i), (ii) and (iii) above.

    The claims of the persons referred to in paragraphs (ii), (iii) and (iv) above, may rank pari passu with, but not in priority to, the claims of the covered bondholders. The example post-enforcement priority of payments set out above in relation to existing UK covered bonds would therefore need to be changed in order for such covered bonds to be able to qualify as Regulated Covered Bonds going forward (because in the example, the covered bondholders are ranked lower than the other relevant persons).

    Regulation 28 applies only in case of a winding up of the owner. In case the security provided by the owner is enforced in a non-winding up scenario, the proceeds of realisation will first be paid to the relevant persons. However, in such case, the Regulations do not provide a restriction on the ranking amongst the relevant persons (similar to the one provided in case of a winding up of the owner).

  • Regulation 29 confirms the general rule that expenses incurred by any liquidator, administrator, receiver or manager of the owner in relation to the relevant persons (other than the covered bondholders) will be paid in priority to all other expenses and amounts due and will therefore be paid before any payments are made to the relevant persons. Such super-priority expenses will rank pari passu amongst themselves.

2.6 Special Public Supervision

The special public supervision is designed to protect covered bondholders' interests and, as such, it is intended to ensure that the requirements for Regulated Covered Bonds are observed at inception of the issue and on an ongoing basis (Part 3 of the Regulations).

The key element of the system is the FSA's "Register of Issuers" and "Register of Regulated Covered Bonds", which UK credit institutions must apply to for each of their covered bond issuing programmes. The FSA will review the applications and grant access to the relevant Register(s) within six months from receipt of the issuer's application. However, the FSA may refuse any application for registration on a Register if it considers that granting it would be detrimental to the interests of the investors in Regulated Covered Bonds or to the maintenance of the good reputation of the Regulated Covered Bond sector in the UK.

Any change of ownership over the asset pool must also be notified to the FSA and no owner may transfer the asset pool to a proposed new owner before it has received a written notice from the FSA approving the change.

The credit institution, the owner of the assets (the SPV), the administrators and the liquidators will be subject to an on-going obligation to notify the FSA of certain mandatory events under the Regulations. The main mandatory event is the satisfaction of the asset coverage requirement. In particular, it is anticipated that these parties must confirm to the FSA through an annual notification (which must be verified by the credit institution's senior management and by a suitable third party professional advisor) that the asset coverage requirement continues to be met.

Where any of the parties fails to comply with any of such mandatory requirements, the FSA will be entitled with certain enforcement powers by Part 7 of the Regulations, which may result in financial penalties or the removal of an issuer from the Register.

The special public supervision described in this section 2.6 is further detailed in the Sourcebook, a summary of which is set out in part 3 of this paper.


1. In UK covered bond structures with SPVs done to date, over-collateralisation was achieved by issuing covered bonds with principal outstanding smaller than the aggregate principal balance of the assets in the pool sold to the SPV; in some cases, pools of assets with aggregate cover for all projected issuances for a year (or more) have been transferred to the SPV.

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Mayer Brown is a global legal services organization comprising legal practices that are separate entities ("Mayer Brown Practices"). The Mayer Brown Practices are: Mayer Brown LLP, a limited liability partnership established in the United States; Mayer Brown International LLP, a limited liability partnership incorporated in England and Wales; and JSM, a Hong Kong partnership, and its associated entities in Asia. The Mayer Brown Practices are known as Mayer Brown JSM in Asia.

This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.

Copyright 2008. Mayer Brown LLP, Mayer Brown International LLP, and/or JSM. All rights reserved.

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