Selecting the Right Counsel in the New Capital Markets Era

01 September 2007

Facundo Gomez Minujin, managing director, JP Morgan Chase (head of legal department for Latin America)

MARKET GLOBALISATION AND INNOVATION

This expansion was fuelled by the economic growth and globalisation of markets. Issuers throughout the world were eager to issue debt or raise capital and investors in many different countries were eager to expand their scope of investment in search of higher yields. Some countries helped motor the expansion of the capital markets by issuing regulations that would bring more transparency for investors or facilitate placements by issuers.

In the US, the creation of shelf registration procedures, integrated disclosure and regular reporting facilitated the interest of issuers and investors. Furthermore, the adoption of book entries instead of physical certificates for securities simplified the administrative work. Another US regulation that helped boost international capital markets in the 1990s was the creation by the US Securities and Exchange Commission of Rule 144A and Regulation S. These regulations permitted the distribution of foreign securities to institutional investors with fewer regulatory requirements. Consequently, regulators expanded the numbers of non-US issuers able to access the institutional markets in the US through global offerings.

Europe was not asleep during this process and also facilitated the expansion of capital markets. The creation of the Euro currency and other joint directives were promulgated during the 1990s to achieve capital formation and generate some regulatory harmonisation among EU member states.

It has been quite difficult to achieve a basic level of standardisation on both sides of the Atlantic. US and European regulators have not been able to advance fast enough in harmonising the two most important capital markets regions. In other regions, such as Latin America, there has been a regulatory effort to increase transparency in the market, but the enforcement of the regulations lacks sufficient impetus to guarantee investors the minimum level of protection.

With the dawning of the new millennium we saw new players entering the capital markets, such as hedge funds (there are currently 9,000 hedge funds with US$1.3 trillion under management, according to Bloomberg). Whereas mutual funds were increasingly tired, heavily regulated players in the capital markets, hedge funds have become relevant participants, helping to increase market efficiency by demanding higher returns and more creativity from issuers.

Investment funds have increasingly sought to diversify their risk by establishing global trading capabilities, often through their banking relations both with the main financial centres and with emerging markets. Today these funds play a major role in international capital markets and are actively looking for better investment opportunities.

On the other hand, scandals such as Enron and WorldCom have pushed legislators and regulators to enact tighter regulations on issuers. The Sarbanes-Oxley Act of 2002 is a milestone for the new capital markets era. Paradigms of the 1990s – transparency and market efficiency principles – were, after these fiascos, considered insufficient to protect investors from abuses of regulations. It was necessary to create a stronger corporate governance model that would guarantee the integrity of issuers.

The creation of more internal corporate controls, specific accounting rules, internal ethics committees and stronger compliance departments were the result of the crisis. The larger compliance burden and increased liability risk has dissuaded many non-US issuers from listing their securities in the US. Furthermore, foreign issuers began to delist their securities from the US to avoid the new regulations burden.

Since then, as other markets have evolved and larger investor bases have appeared in other countries, non-US issuers are considering placing their new securities in non-US markets, attracted by fewer restrictions and the ability to absorb a portion of the issuance. We are seeing a revolution in multi-market listings.

The first half of the year has been very active for capital markets. However, due to the recent market volatility, it is not certain whether the abundance of liquidity in the financial markets will continue facilitating access to new money for issuers. Anyway, since investors are more inclined to diversify as far as possible (in order to limit exposure to a single asset) and because they are searching for higher yields, we will continue seeing more innovation.

Securitisations, where a large amount of debt is combined and then subdivided into more manageable pieces that are widely distributed by financial intermediaries, will continue to grow. Furthermore, derivatives will be used more and more to manage risk and allow investors to assume specific risk from a certain issuer or underlying asset. Many times these derivatives will already be embedded in the security issued.

From a yield standpoint, because emerging economies have shown unprecedented growth for the last four years (fuelled mostly by high commodity prices), issuers from these countries have been able to access money at rates that are marginally higher than those of the issuers of more developed economies. However, since these windows are so rare, issuers should move quickly during 2007 to issue as much as possible to finance their investments and expansions before the next crisis spreads through emerging markets.

We all know that a crisis will eventually hit the capital markets. It is only a matter of following trends to anticipate the near future with a certain degree of likelihood. In the last 20 years the world has faced the external debt default of the emerging markets, the US banking crisis of the early 1990s, the Mexican ‘tequila’ crisis of 1995, the Asian crisis of 1997, the Long Term Capital Management bankruptcy of 1998, the Nasdaq’s abrupt decline of 2000, the September 11, 2001 panic and the largest emerging markets sovereign issuer default (Argentina) in 2002. Since then we have had no financial crisis affecting the market and have enjoyed four years of prosperity. Although the recent US subprime market crisis is creating concern as to whether we are at the door of a next world financial crisis. Will the huge growth of derivatives help to stabilise the and reduce volatility of financial assets during a crisis (as sustained by the previous US Federal Reserve Board Administration)? Or, on the contrary, will derivatives facilitate the crisis –by exploiting hedge funds and other financial intermediaries that have used derivatives for speculative purposes or for wrong hedging models for their true hedges?

Skills Required for Counsel

As yet, we have no answer to our questions of the preceding paragraph; but what is certain is that for the current capital markets transactions we need to pick the lawyer most capable of anticipating potential problems for issuers in the documentation.

The need to serve clients on a global basis has become increasingly important for law firms wishing to remain active in the capital markets arena. In the same way that investment banks are expanding globally, law firms that expect to serve these clients need to be physically present in the world’s financial markets, and they need to be able to manage transactions that are executed under different legal systems. This global expansion can take place either by opening offices in different countries, creating strong alliances with other firms or by simply having a fluid and trustworthy relationship with firms in the different countries. Clients will not demand a particular style, but will demand a close relationship between the different legal players in one same deal.

Another important aspect is the level of experience of the law firm. It is usually better if the firm regularly represents US and non- US issuers, underwriters, initial purchasers and placement agents – not just one side of the transaction. When measuring experience, product knowledge is relevant. Being able to handle equity, debt and hybrid offerings and the full range of securities exchange registered deals, Rule 144A and Regulation S offerings as well as private placements and structured products, adds to a firm’s selection credentials. Furthermore, having worked in the most recent deals is also a plus, since capital market transactions are always subject to changing regulations or innovations in the structure.

On the reporting side, having represented officers, directors and shareholders with respect to the reporting obligations under US and other locations where the listing takes place is valuable.

Another factor is the stability of the law firm. Clients usually prefer firms in which the partners can offer many years of memory and experience. If there is a need to interpret a particular covenant, it is more efficient to go back to the partner that wrote it. Long-standing partnerships allow for better perspective on matters, gained through years of similar work.

Having particular industry knowledge is valuable at the time of performing the due diligence – a key step of any capital markets transactions. Lawyers who know how to ask the right question of a certain industry add tremendous value in the disclosure process. Industry-focused lawyers can advise on specific issues related to securities offerings by issuers in industries such as energy, chemicals, telecoms, biotechnology, financial services and new media.

A close working relationship with regulators will allow the lawyer to obtain quick resolution of difficult regulatory questions, usually at key moments during the filing process. This quality adds speed and certainty to the transaction and often allows the good regulatory lawyer to anticipate comments based on a fluid relationship with reviewers.

Finally, having a lawyer who will favour a long-term relationship with the client and will make every possible effort to bring new transactions or ideas to the client (particularly when the client is a financial house) will be a positive factor.

In summary, the capital markets industry is evolving fast through product sophistication, moving from plain vanilla issuances to structured products and securities embedded with derivatives components. At the same time, markets have grown exponentially, are more technology-driven in the distribution of products and more liquid because of the abundance of resources. External lawyers will have to keep pace with these innovations, push harder to achieve faster results without using a ‘cutand- paste’ approach, and build international relationships that will allow them to be seen as a single team for their clients.

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