In a nutshell
Capital markets lawyers feel all the highs and lows of market forces more than any other practitioner, and when the Great Recession hit the practice took a hit too. The vast sums exchanged and the technicality of the transactions mean that it will always remain an important area for BigLaw firms. Essentially, the world's capital markets are trading floors (either real or virtual) on which cash-hungry businesses obtain funding by selling a share of their business (equity) or receiving a loan (debt) from lenders.
These 'markets' are used by companies with unique financing needs which traditional bank loans cannot satisfy. They offer more freedom to companies than obtaining cash via bank loans which tie both parties into the term of the loan. Capital markets allow for companies to obtain massive sums with more flexibility; they also offer up limitless investment opportunities. Large financial institutions offer customized services to companies seeking funding on the capital markets. These services include advice on debt and equity offerings, on securitization and on the creation of derivatives. Debt (bonds), equity (stocks) and derivatives are all types of security, and capital markets law is sometimes referred to as 'securities law'.
“The range of capital raising companies pursue is almost endless, and is limited only by human creativity.”
Attorneys advise companies ('issuers') and investment banks ('underwriters') on these complex capital markets transactions. Issuer and underwriter will both engage a separate law firm. The issuer's attorneys will sometimes help their client analyze which type of security to issue. This decision depends on the nature of the company, the desired duration of the loan, who the buyers are likely to be, and market demand. If an issuer is new to the market, they may begin by seeking their lawyers' advice on the processes involved, before approaching an underwriter.
Equity capital markets
Within equity, there are initial public offerings (IPOs) and follow-on offerings of common and preferred stock. An IPO is a transformational event for a company. “The IPO is the ‘ne plus ultra’ of capital markets work,” says Josh Bonnie, co-managing partner of the DC office at Simpson Thacher. “The decision of whether or not to become a public company is incredibly commercial and requires a great deal of strategy. It’s unlikely the client will have IPO experience, so they will be reliant on their attorneys.” The New York Stock Exchange and Nasdaq are the major exchanges in the US and most American public companies will be listed on one of them. Companies can list on multiple exchanges around the world.
Debt capital markets
This covers many types of debt instrument, but generally speaking it deals with a borrower raising capital by selling tradable bonds to investors, who expect the full amount lent to be paid back to them with interest. Bonds (also called 'notes') come in all shapes and sizes, from investment grade to high-yield ('junk') bonds. The terms of the bond – including the interest rate (or 'coupon') and maturity date – are decided by the underwriter and issuer.
Why would a company issue bonds rather than take out a bank loan? As mentioned above, the terms of a bank loan can be restrictive to both parties: bank debt can prevent companies from making equity or debt issuances or from acquiring other companies until the loan is paid off. The terms of a bilateral loan tie both parties in, so a bank can't transfer risk or sell this debt with the same flexibility that the bonds market allows. Bonds are tradable; risk and its rewards can be sold on and spread across numerous lenders (bondholders), meaning that a company can raise much larger sums that can only be matched by arranging a syndicated loan (a group of banks chipping in on the principal), but without the same bank loan obligations that syndications entail. Plus, bondholders can be anyone, not just a bank.
Structured finance and securitization
This can get gloriously complex, but its aims are simple: to increase liquidity and structure risk, which in turn offers up extra funding for borrowers. Securitization is the core of the process, which takes a lowly untradeable piece of debt, such as a mortgage, vehicle loan or a credit card receivable, bundles it together with debt of the same class, and sells the bundle of debt on to investors, such as pension funds, hungry for the cash flows that come with the debt.
To securitize debt a bank will first set up a special-purpose entity (SPE) to isolate the debt risk from the bank's main operations, and separate the legal rights to the debt, enabling it to be transferred to new holders. Within the SPE are the bundled loans which enable the SPE to issue bonds, where the interest on the bundled debt forms the cash flows or bond yields. Mortgage securities like residential mortgage-backed securities (RMBS) and commercial mortgage-backed securities (CMBS) are among the most common in the market, but “the range of capital raising companies pursue is almost endless, and is limited only by human creativity,” says Josh Bonnie. Collateralized debt obligations (CDOs) are a unique structure in that they group a variety of types of debt and credit risk, where different classes are called 'tranches'. The higher the tranche's risk, the greater the yield.
Securitization shouldered much of the blame for the credit crunch and the ensuing global economic havoc. Complicated structures led to a murky tangle of debt obligations, grouping different debt classes and exploiting credit enhancement. All was rosy until the housing bubble burst, mortgages defaulted and the ugly truth emerged. Don't let this put you off; there still is and will be demand for structured finance lawyers, but the order of the day is caution. For a leisurely introduction to the topic, watch 'docudrama' The Big Short.
At its most basic, a derivative is a financial instrument used by banks and businesses to hedge risks to which they are exposed due to factors outside of their control. They can also be used for speculative purposes by betting on the fluctuation of just about anything, from currency exchange rates to the number of sunny days in a particular region. The value of a derivative at any given time is derived from the value of an underlying asset, security or index. Futures, forwards, options and swaps are the most common types of derivatives. Forwards are agreements between two parties that one will buy a certain product from the other for a fixed price at a fixed date in the future. Hedging against future price risks and speculation over the price movement of the underlying assets are the big attractions. Futures are standardized forwards, which can be traded on the futures market. Options are optional futures, where a buyer has the right but not the obligation to purchase or sell a product at a certain date in the future for a certain price. Swaps are agreements between two parties to exchange assets at a fixed rate, for example to protect against fluctuations in currency exchange rates.
What lawyers do
IPO or other equity offering
- Work with the client and its accounting firm to prepare and file a registration statement with the Securities and Exchange Commission (SEC).
- Do due diligence on the issuer company and draft a prospectus (as part of the registration statement) that provides a welter of information about the company and its finances, as well as past financial statements.
- Help the accountants draft a comfort letter, assuring the financial soundness of the issuer.
- File with the SEC and wait 30 days before getting initial comments from them.
- Undergo multiple rounds of commentary back and forth with the SEC. This can take one or two months.
- Negotiate approval of a listing on the stock exchange. This involves the submission of documentation, certifications and letters that prove the client satisfies the listing requirements.
- Finalize the underwriting agreement and other documentation.
- Plan out the deal with issuer and underwriter. A timeline is drawn up and tasks are allocated between the different parties.
- Draft a prospectus for SEC registration or a Rule 144A offering memorandum.
- Conduct due diligence on the issuer to examine its creditworthiness, make the disclosure accurate and highlight any associated risks.
- Deliver to the underwriters at closing a legal opinion and a disclosure letter on the offering based on due diligence.
- Draft the indenture: a document describing the bond's interest rate, maturity date, convertibility and so on.
- Draft the purchase (or 'underwriting') agreement.
- Work with the underwriter and issuer to draw up the structure of a security, and help the parties negotiate the terms of that structure. “We will literally sit down with all the parties and draw boxes, charts and arrows on a whiteboard in order to come up with new ideas,” explains John Arnholz, structured finance transactions partner at Morgan, Lewis & Bockius.
- Draft the disclosure document and the prospectus or private placement memorandum. “It is a descriptive piece – almost like a magazine article,” says Arnholz. “It covers all the risks and other characteristics of owning a security.”
- Draft the purchase agreement documenting the transaction. “This involves a lot of negotiation back and forth between issuer, underwriter, trustees, service providers and insurers,” Arnholz tells us.
- Be approached by a financial institution client (e.g. a hedge fund) with an idea to create a new derivatives product.
- Communicate back and forth with the client discussing legal issues and risks related to various possible structures for the product.
- Home in on a specific structure for the product.
- Prepare a memo explaining the problems, issues and legal risks associated with the derivative's agreed-upon structure, as well as suggesting ways to resolve or mitigate those problems and issues.
- If all has gone well, and if the new structure has sufficient prospects for legal and commercial success, lawyers will draft new documentation describing the make-up of the derivative.
Realities of the job
Notwithstanding the differences mentioned in the descriptions above, there are big similarities between the work of lawyers on debt, equity and other securities transactions.
- The nature of lawyers' involvement in a capital markets transaction depends on its novelty. “If someone is doing a securitization or designing a derivatives product they must address those issues which are novel,” says Josh Cohn, former head of US derivatives and structured products at Mayer Brown. “If you are working on a product based on a preexisting structure, you may be asked to look at certain details like new swaps arrangements.”
- Junior lawyers usually practice in all areas of capital markets law, sometimes combining this with other corporate work too. Some top firms have specialist departments for each capital markets subgroup. Partners often specialize in debt, equity, securitization or derivatives work, but they may continue to dabble in other areas too. “I would advise junior associates to get involved with as many different types of transactions as possible,” says Robert Gross, former capital markets partner at Clifford Chance. “You'll end up getting more to do that way, and it will be more burdensome, but you will get a ton of experience.”
•Clients in the world of finance are incredibly demanding and attorneys usually work very long hours. On the plus side, clients are also smart, sophisticated and dynamic. Large law firms usually have strong and close relationships with investment bank clients, meaning that juniors can get frequent client contact. “I love working with companies' management teams and with bankers,” says Arthur Robinson, head of the capital markets practice at Simpson Thacher. “On each deal I do I 'meet' a new company and learn about the business from the inside from the CEO and CFO. It may sound odd, but companies do have their own personality, so it's akin to meeting a new person each time.”
- The content and organization of prospectuses tends to be fairly standard, but lawyers consider working on them a rewarding exercise because a good deal of creative writing is required to communicate a company’s narrative.
- The purchase agreement is a lengthy contract in which the underwriter agrees to buy the securities and resell them to investors.
- As soon as a company undergoes an IPO, it will be subject to all the rules and requirements of a public company, so the necessary organizational structure must be in place before the IPO.
- Follow-on offerings of common equity are much simpler than an IPO because most of the basic disclosure has already been drafted and will only need to be updated.
- Underwriter’s counsel drafts most documents related to a bond issue. An issuer's lawyers will comment on them and negotiate changes.
- Due diligence is conducted by both underwriter's and issuer's counsel, but is most important to the underwriter. A due diligence investigation may help in establishing a 'due diligence defense' in any future investor lawsuits claiming a violation of securities laws.
- A debt offering can be registered with the SEC or unregistered under Rule 144A of the 1933 Securities Act. In the latter case bonds can only be bought by certain large registered institutional buyers.
- Issuer's and underwriter's counsel work together with a team of bankers, accountants, insurers and an issuer's management to get securities issued. “There is a very collaborative atmosphere,” says Bill Whelan, corporate partner at Cravath, Swaine & Moore. “The team has the common goal of getting the deal done. There are moments when we have disagreements, but rarely does it get acrimonious.” If teams get on particularly well, deals may end with a closing dinner or drinks event.
- The bond market is huge and influential. It is generally considered to have a large influence on the health of the US and global economy.
- Market conditions are very important to the success of capital market deals – more important even than the willingness of the parties to get the deal done. “The one negative in this area of practice is that the markets are always unpredictable,” says Whelan. “You can invest a lot of time in getting a deal organized, but market conditions can mean it falls through.”
- Practitioners recommend that those interested in the field should take law school classes in securities regulation, corporate finance and the Uniform Commercial Code (UCC). Knowledge of bankruptcy, property and tax law is useful too, as is gaining an understanding of the basic principles of accounting. Reading the financial press – starting with The Wall Street Journal – is a must.
- In an effort to combat adverse effects of the coronavirus on the global economy, in March 2020, the US Federal Reserve slashed interest rates to a range of 1% to 1.25% - a move unprecedented since the financial crash in '08. Rates changes can have a ripple effect on capital markets, as borrowing money becomes more expensive.
- While the pandemic continues to disrupt many sectors of the economy, in the world of capital markets, things are booming. 2020 was one of the best years on record for global IPO activity, with $331 billion raised across 1,591 listings.
- Research from EY shows that a total of 1,322 companies went public in 2020 - 15 percent more than in 2019. The total issue volume of global IPOs also rose by 26 percent to USD 263 billion – the highest amount since 2010.
- 2021 looks set to maintain this momentum. For example, the London market had its busiest January in 15 years, raising $33.1 billion from 126 floats worldwide.
- As it does in the worlds of M&A and private equity, the tech sector continues to dominate the scene, making up 35% of global IPO proceeds last year. This is followed by the health sector, which made up 15% of the total transactions according to research by EY.
- Snowflake and Airbnb both went public in 2020. Each raised around $3.5 billion, positioning them among the two largest tech IPOs recorded over the past decade. However, they remain dwarfed by Facebook’s IPO, which raised $16 billion when it went public in 2012.
- "Securities law is changing dramatically,” John Arnholz comments. “In the old days, rules about securities weren't written down. They were based on lore. Many regulations in the industry are new. That means old hands like me have a smaller advantage over new people entering the field than we used to. Industrious young associates can learn about new regulations and outsmart the partners!”
- According to a report by PwC, London and New York remain the world’s two epicenters of capital market activity, accounting for nearly 45% of activity. However, 76% of surveyed capital markets executives also expected a rival center to emerge in the Asia-Pacific region in the years through 2020. Hong Kong was flagged as the most likely destination, followed by Shanghai and Tokyo.
- According to a report by SIMFA (Securities Industry and Financial Markets Association), the US equity markets account for roughly 40% of the $97 trillion in the global equity market – that’s nearly four times the amount recorded by China, the next biggest market.
- AI continues to disrupt the market, as companies increasingly harness technology to optimize trade processes and reduce operating costs.
- A big development in Europe, meanwhile, is the European Commission's proposed 'Capital Markets Union' (CMU) – which aims to remove barriers to investment in Europe. The UK's Brexit has put a spanner in the works somewhat, although the CMU appears to be moving forward regardless.
- The popularity of using the SPAC (Special Purpose Acquisition Company) framework as an alternative to traditional IPOs continues to rise. The number of SPACs as a share of IPOs rose from 3% in 2014 to 30% in 2019; the total issue volume of SPACs increased from $13.7 billion in 2019 to $75.8 billion in 2020.