The curious structure of an MTN
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The Law and Lore of Repackaging
“bond” as explained to my neighbor Phil
Financial concepts my neighbour Phil was asking about when I borrowed his mower. Index: Click ᐅ to expand:
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You will know old Grandpa Contrarian’s story of the farmer and the sheep. It is illustrated richly in every cove, inlet and waterway of the financial markets, but is no better exemplified than in the genetic structure of a medium term note programme.
These, for the fortunately uninitiated, are architectural structures by which corporations raise funds in the international debt capital markets. Their history is long and mildly diverting at best — the type who naturally deals in debt instruments is not really given to intrigue — but for our purposes it is important.
Conceptual underpinnings
Now: as per the panel summary, a bond of any kind is an IOU, in that it represents an entitlement to be repaid a loan. In earlier epochs one would borrow against a “note” — literally, a signed piece of paper indicating your preparedness to pay a sum to whoever presented it, in exchange for its surrender.
The neat thing about this kind of note is its transferability: the original lender can “negotiate” it — sell it[1] without the issuer’s permission, or even knowledge — and its value will be the present value of the issuer’s promise to pay. A note is a unilateral contract, therefore. A conventional loan is a bilateral contract, and the job of transferring ones rights and liabilities under it is more involved, and often requires the cooperation of the borrower.
The other neat thing about notes compared to loans is that you can easily divide a big borrowing into lots of little notes, rather than a single big one. Thus, you can access a wider pool of lenders — including Belgian dentists, as we will see — each of whom can manage its own exposure without reference to the others, by buying or selling bonds in the secondary market.
Notes therefore are more liquid, transferable things, and while they are outstanding the issuer need not even know who its creditors are: they hove into view only upon payment of principal or interest, when they would show up at the issuer’s office with their instrument in hand.
Industrialisation of debt securities
This all being the case, notes quickly became popular, and the process of issuing, selling and maintaining them industrialised. Notes were “security printed”, like banknotes. Interest payments were represented by perforated coupons that could be detached and presented (or “stripped” and separately traded): for a long-dated bond, where there wasn’t room for all the coupons, there would be “talons” attached entitling the bearer to a fresh strip of coupons. Issuers appointed banks as “paying agents” to handle the mechanics of dealing with holders, paying out on presentation and so on. In some jurisdictions[2] issuers needed to maintain a record of noteholders, so created “registered” notes which were profoundly different in legal concept — title transferred by entry in the register, whereas with a bearer instrument the security itself was the debt and title passed by delivery — and there needed to be terms to deal with certain unwanted contingencies: replacing lost or mutilated notes; provisions for noteholder meetings to consider amendments to terms and so on.
Now an IOU is a simple enough thing: the legal architecture making it all possible was another thing altogether: trust deeds, paying agency agreements, dealer agreements, prospectuses and so on, and the up-front cost of a “stand-alone” debt issuance was formidable. Thus emerged the medium term note programme — a pre-crafted architecture containing all the standard terms, appointments and so on, which an issuer could quickly “tap” when it needed to, in a fraction of the time and cost.
In parallel the information revolution arrived and notes started to trade electronically, in a clearing system[3]. Here noteholders’ interests were represented as electronic entries in their clearing system accounts there was no need for security printing, perforated coupons, a wide network of paying agents, and the identity for the time being of the holders was ascertainable, at least by the clearing system, which had to maintain the records on order to ensure everyone got paid. At the very heart there was still a physically printed note: just one: a “global note”, representing all the nominally issued notes, held by a “common depositary” — a custodian for the electronic clearing systems in which the notes are traded.
Residual DNA
By the 1990s, all notes, bonds and other securities were electronically cleared, and none has been security printed since. Nonetheless, the MTN terms and structure still bear traces of their physical biology, a bit like tailbones, appendixes and male nipples. The basic rationale is “well, the clearing systems might not work one day — you know, there could be some kind of post-apocalyptic, Mad Max-style future with everyone driving round in battle trucks and drinking their own urine — so I might need to change these into security-printed definitive notes, so we better leave these terms in just in case”.
Now the JC would be the last one to pooh-pooh the idea of a dystopian future — given the last few years he rather expects it at some stage, in fact — but, really: if you are eating caterpillars, presenting your coupons to the Luxembourg paying agent is going to be a long way down your list of priorities.
For reasons we can only put down to entropy, international bond terms and conditions are all shot through with laborious mechanical conditions that deal with how payments are made, where, by whom, on what conditions, to whom, should the notes be held outside a clearing system — a circumstance which, in the year of our Lord 2022, categorically will not happen — but which, thanks to the vagaries of historical appetite, meant might happen in a number of ways.
The logical structure of legal documents
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On what kind of ball may be used with what kind of game
Two branching propositions where the subject is the ball:
Three non-branching propositions where the subject is the game.
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Now that being the case there are design principles that apply to how you articulate those alternatives. Any legal statement, however Fishily articulated, boils down to a logical proposition, rather like software code, with propositions, conditions, logic gates, if/then statements, and so on, only lawyers call them obligations, rights, discretions, provisos, inclusos, options, definitions and so on.
Most legal propositions have some formal logical content: an obligation is an if-then statement; condition precedent is an either-or gate. Some operators do not constrain or expand the propositions they act on — expressions like “(whether or not...)”, “(including without limitation...)”, “(for the avoidance of doubt...)”, “(may, but need not...)” — and so can be omitted from a logic map (just as they should be omitted from the draft), but how they are organised can make a difference to the formal complicatedness of the draft.
This leads us on to one of our pet interests: why are legal documents so convoluted, and what can we do to correct it? For this we need to delve into the underlying logical structure of a contract.
Any “logic gate” that splits a proposition into alternatives increases the inherent complicatedness of a proposition.
Take the alternative statements about cricket and rugby balls in the panel at right. The variables at play are:
- round or oval ball (relevant to all games)
- red or white ball (relevant to all cricket games)
- rugby or cricket, (relevant to all games) which in turn breaks into
- test or one-day (relevant to cricket)
- union or league (relevant to rugby
How you structure these variables can great more or less complicatedness. If we try to create a single proposition that covers all eventualities, we commit ourselves to a lot downstream branching, because that our single logical structure must accommodate all the permutations.
The subject of the sentence and sequence of the branches makes a difference. For example, focussing on the ball first then its colour then its shape, and articulating these by reference to the games, commits to sixteen branches. If we break the proposition into two and focus first on shape, we can reduce this to five. if we reframe the proposition to focus on the game, we can get it down to the three, which is the minimum.
There is doubtless some information theory that optimises the logical structure, but intuitively it seems to us common options should be delayed as far as possible, and where games are largely common, separating out the points where they differ into a separate set of propositions may help.
Back to our medium term notes: base terms and conditions are designed to set out options — allow registered or bearer form, for example, and listed or unlisted notes, or interest bearing, fixed or floating. The majority of the conditions will apply to all, but with variations. The art — it’s probably a science of information theory, but for legal eagles it is a lost art — is working out when to embed that variability in the body of your conditions, and when to set it out as a separate proposition.
Still thinking about it.
See also
References
- ↑ Or pledge, or lend it.
- ↑ America being a prime example, thanks to the glorious strictures of the Tax Equity and Fiscal Responsibility Act (TEFRA) of 1982, which introduced punitive tax treatment for bearer bonds, on the grounds that they were inherently fishy, income-sheltering things — a quality that never bothered the Belgian dental profession in the same way.
- ↑ In the European markets, there are two major clearing systems: Euroclear and Clearstream.