The Total Return Swap Business Expands to Bank Loans

More documents

Recommendations

Info

I. Operation of a Typical TRS on a Bank LoanMany of the hedge funds engaged in these types of arbitrage strategies will not acquire a bank loan directly.Instead, the hedge fund will acquire a synthetic exposure to the loan through derivatives. Bank A and theHedge Fund enter into a two-year TRS regarding 80 percent of the funded and unfunded amounts of thebank loan. 9 During the term of the TRS, Bank A pays 80 percent of the interest and commitment fees that itreceives on the loan to the Hedge Fund. In exchange, the Hedge Fund agrees to pay the product of (x)LIBOR plus a spread and (y) 80 percent of the outstanding drawn amount by XYZ, on the loan made byBank A. Also, the Hedge Fund would either make an upfront swap payment to Bank A or place collateralwith Bank A, equal to a percentage of the amounts drawn on the loan, to secure its obligations. 10 Thecollateral requirements will change over time as the amounts drawn on the loan change as well for changesin the value of the loan itself. Under the TRS, at the end of two years, Bank A will pay an amount equal tothe appreciation in 80 percent of the bank loan to the Hedge Fund. The loan could appreciate if, forexample, the credit quality of XYZ improves during this period. Conversely, if the value of the bank loan atthe end of the term of the TRS is less than its initial value, the Hedge Fund will pay that diminution in valueto Bank A. Thus, the Hedge Fund is economically exposed to 80 percent of the risk and reward on the loan.At least two independent companies provide pricing for bank loans and quotes from those companies arecommonly used to ascertain the value of bank loans. 11The bank loan TRS does not provide the Hedge Fund with any direct rights against XYZ regarding any ofthe covenants and representations made by XYZ nor does it require Bank A to actually hold the loan. Forexample, if the bank loan contains coverage tests (asset to liabilities or income to expenses), the HedgeFund would not be entitled to send out any notices of default or otherwise deal directly with the borrower.Those rights are left with Bank A. If XYZ is placed into bankruptcy receivership, the Hedge Fund would not,by virtue of the TRS transaction, be entitled to receive reports from XYZ or otherwise exercise any rights of adebt holder in the bankruptcy. In general, any of those events would trigger an acceleration and, therefore,settlement of the TRS or a mark-to- market of relative obligations. Also, the obligations of Bank A to theHedge Fund are not secured by the underlying bank loan. It is common for the swap confirmation to containan indemnity provision under which the Hedge Fund is required to indemnify Bank A against any costs orexpenses incurred regarding the underlying loan.It is also worth noting that recent innovations in this market have included the development of portfolioswaps. In those swaps, the financial institution, Bank A, will enter into a supplement under which it willprovide the Hedge Fund with derivative exposure to a number of loans that it has made to corporateborrowers. The supplement may relate to loans to be made as well as loans already held by Bank A (andmight provide Bank A with discretion, within predetermined guidelines, to add loans meeting certain criteriato the swap with the Hedge Fund).Greenberg Traurig, LLP
II.The TRS as an NPC for Federal Tax PurposesSeveral U.S. tax regulations contain a definition of a swap or notional principal contract (also known as aswap). The general definition (and the definition in the source rules, which is, for purposes of this article,identical) reads:A notional principal contract is a financial instrument that provides for the payment of amounts by oneparty to another at specified intervals calculated by reference to a specified index upon a notionalprincipal amount in exchange for specified consideration or a promise to pay similar amounts. 12Objective financial information is defined as objectively determinable financial information that is not withinthe control of any of the parties to the swap. 13 Objective financial information does not include the value ofthe stock of one of the parties to the swap or its dividends, profits, and so forth.An issue exists whether a bank loan that is extended by one of the parties to the swap (Bank A in ourexample) is objective financial information. That issue is posed because Bank A negotiated the loan, has theright to accept or reject requests for draw-downs, and is otherwise servicing the loan. The performance ofthe loan, however, is not within the control of Bank A; its value will totally depend on the performance of theborrower — something not within the control of Bank A. Accordingly, a strong argument exists that the loanperformance should be considered objective financial information within the meaning of the regulationdefining swaps.The TRS between the Hedge Fund and Bank A appears to meet the literal definition of a swap. Although thenotional amount will vary over the life of the swap with draws on the loan itself, that changing notionalamount affects both parties equally. Specifically, as the loan amount fluctuates, the notional amount onwhich the payments made by Hedge Fund are calculated likewise fluctuates. Conversely, because Bank A isrequired to pay an amount equal to all interest and fees received on the underlying bank loan, the notionalamount applicable to Bank A’s payments fluctuates in a like manner. Both parties are making payments atspecified intervals. Applicable regulations specifically permit a contract with a notional amount that variesover the life of the contract to be taxed as a swap, provided that the variance is based on objective financialinformation. 14 Since any variance will relate to actions by a third-party borrower, that requirement should besatisfied. 15 The loan itself is “notional” inasmuch as the swap does not convey any direct ownership rightsregarding the loan. As noted above, the swap does not allow the Hedge Fund to vote on matters submittedto creditors nor does it require a collateral deposit equal to the full amount loaned by Bank A.A. Issues as to NPC QualificationEven assuming the form of the swap meets the criteria for a “notional principal contract,” the question ariseswhether a “total return” derivative regarding an asset could constitute a transfer of tax ownership of the assetto the “long” counterparty. 16 Most practitioners view that issue as particularly acute when the underlyingasset is nonfungible property, which might include a privately originated bank loan. As long as thereferenced asset does not secure the swap, substantial arguments can be made that a total return swapregarding a nonfungible asset can be structured in such a manner as to avoid a transfer of tax ownership.The major feature of a bank loan TRS that raises an issue to whether that contract should be a taxed as aswap is whether it would be considered to have a different notional amount for Bank A (which includespayments on unfunded amounts) and for the Hedge Fund (whose notional is only the drawn amounts). Evenif unused commitment fees are not interest for tax purposes, 17 they are earned in connection with the loanGreenberg Traurig, LLP
Page 1: When the Exotic Embraces the Mundan
Page 6 and 7: analyzed above the swap should not
Page 8 and 9: 1. The general securities trading s
Page 11: Footnotes1Remarks attributed to Ste

The Total Return Swap Business Expands to Bank Loans

Create successful ePaper yourself

Delete template?

Save as template?