Ares Notes Essay

ALBA LEGAL ASPECTS OF INTERNATIONAL FINANCE
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Aries, so much more than god of war | stefanos likkas | 1/10/2010

ALBA, Law 10 Stefanos Likkas
Rodrigo Olivares Caminal

In the few pages that follow we will attempt to present a concise and succinct
outline of the Credit-linked Notes issued by the Federal Republic of Germany
through SPV Aries Vermögensverwaltungs GmbH in 2004. Emphasis will be put on
the political environment which underscored the particular and exceptional risk
structure of these bonds.

1. Introduction

The history of Russian sovereign debt is very distinct for its political origins and
implications. As the Russian Federation emerged after the break-up of the Soviet
Union, it unwillingly reached an agreement with the rest of the successor republics
(“Treaty on the legal succession in respect of the external public debt and assets of
the USSR” UN Registration Number I-42935), whereby it effectively assumed the
outstanding Soviet external debt in its entirety. Most of the Soviet debt itself was
accumulated in the few years of Soviet life left in 1985 during the financial instability
which accompanied perestroika and the glasnost. In the first years of existence of
the Russian Federation, the reluctance of private creditors to extend further credit
to the young Russian State led to an increased dependency on formal creditors such
as the U.S. and Germany. Owed to a considerable 12 billion DM debt of the Soviet
Union to its satellite DDR (the communist German Democratic Republic), Russia’s
single greatest Creditor became the by then unified Germany.

Throughout the 90’s the Russian Federation tried to juggle the impossible task of
both servicing its debt and keeping its economy afloat and found itself frustrated
several times trying to rid itself of the burden of the Soviet debt, which it
unsuccessfully tried to contest as odious 1. A few times it defaulted on the part of its

1
‘Odious debts are those contracted against the interests of the population of a state, without its consent
and with the full awareness of the creditor.’ CISDL WORKING PAPER: ADVANCING THE ODIOUS DEBT
DOCTRINE 2003, p.1 retrieved on 1/05/2010 from http://www.cisdl.org/pdf/debtentire.pdf.

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debt that it had inherited from its Soviet past in an attempt to impose on
recalcitrant debtors favorable further restructuring of such debt. It then resumed
however servicing after limited alleviation by its creditors as they and particularly
Germany vehemently opposed the possibility of either scrapping part of such debt
or even further restructuring, on the grounds of strong Russian growth and
accumulation of foreign currency reserves on the back of high oil and other raw
commodity prices. As it turned out Germany was right and by 2000 the Russian
economy was growing by 6.5% running a whopping 19.2% annual surplus and held
already a strong US$25,960 million in international reserves (according to the World
Bank World Development Indicators 2001). And despite it being seen as too oil-
dependent, the Russian economy was already considered a strong one (the Russian
Federation officially joined the G7 block in 1997 which has been dubbed G8 since)
and the country wasn’t realistically expected to default again, at least on economic
terms.

By 2004 the total external Russian dept stood at US$197,335 million of which its
total debt to Germany stood at around US$11.3 billion (or €14 billion at July 2004
rates). Germany conversely has gained world prominence in the post WWII years for
its renowned strict budgetary policies enshrined in its Constitution (art. 115 as it
stood before the 29.07.2009 amendment) during boom and bust periods alike. In
2004 as the Economist put it “Hans Eichel, Germany's finance minister, has a hole in
his budget. His plans to raise euro10 billion ($12 billion) through privatisation this
year have come to naught. Yet budget law forbids him to borrow more than he
invests. So wizards at Deutsche Bank and Goldman Sachs have offered him a
solution: monetise some of the official debt owed to Germany by Russia.” 2 The way
Germany did that was through Aries Vermögensverwaltungs GmbH, a special
purpose vehicle through which it issued credit-linked bonds.

2
"Soviet solution; Germany and Russian debt. (A novel way of raising money)." The Economist (US).
Economist Newspaper Ltd. 2004. HighBeam Research. Accessed on 1/05/2010 at
http://www.highbeam.com.

2


2. The Structure of the Aries Bond

In a nutshell Germany sells to a bank the credit risk of sovereign loans to Russia. The
bank passes that on to Aries, which issues bonds. Aries in addition to issuing bonds
agrees to pass predefined payments made by Germany to a third party in order to
reinvest that sum and use the proceeds to pay for interest and principal on the
bonds. Finally, Aries deposits its rights and obligations with a trustee, in order to
offer additional safety to investors. Through this structure Germany pockets the full
sum of the nominal value of the three bond issues, Note-holders hope to get the
yield that they are promised on their investment and all the other parties get their
hefty fees and commissions.

Of course, the actual structure of the bonds is far more complex than what is alluded
above. In order to keep track of that complex structure we have no better way at
hand other than simply follow the money. The cash-flows which can help us unveil
the underlying structure of the bonds are those of the amortization payments.

On the predefined amortization payment dates, the Federal Republic of Germany
will authorize specific amortization payments made out to Aries. However, Aries is
never to get hold of that money. Instead the money is deposited with a Trustee,
Deutsche Bank AG, which holds it in its name on behalf of Aries (and arguably to the
benefit of the Note-holders) for a certain fee. That money is then paid out to KfW. In
return for this money, the amount of which is agreed on in a schedule to the PCD
Participation Agreement, KfW is under the obligation to procure amounts to cover
interest payments to Note-holders, one business day prior to the interest payment
date (or principal payments one business day prior to principal payment dates). This
is the scope of the Reinvestment Agreement which presents notable affinity to an

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asset swap, with the reservation that it remains undisclosed whether the
amortization payments will be flat predefined amounts or otherwise construed.

The interests and principal procured by KfW pursuant to Clause 4 of the Trust
Agreement are channeled through Deutsche Bank AG (as fiscal agent) to Deutsche
Bank Trust Company Americas and possible further paying agents to CBF
(Clearstream Banking Frankfurt) and to the registered holder of the DTC (Depository
Trust Company 3) Global Note (no individual bond tenders or actual coupons are to
be printed). It is through these channels that Note-holders can get hold of their
interest and principal on interest and principal payment dates.

The default mechanism on the Notes is of paramount importance as it underscores
their risk structure. The event of default in the Aries Bond is called a sovereign
event which is satisfied when Russia misses a single debt payment to Germany of
€50 million (after the expiry of a grace period) or the aggregate amount of missed
payments is equal or in excess of €250 million. In that case Germany has the
prerogative to notify to Aries a sovereign event certificate and a copy of the public
information. This will bring about Sovereign Event Redemption under which Note-
holders are entitled to the sovereign event redemption amount, equal to 20% of the
nominal value of the Notes. What is central in this default mechanism is the sway of
Germany over the Sovereign Event, since there is no way for Note-holders to be
informed of its occurrence, unless Germany decides to notify.

In addition to the event of default two instances of termination events are provided
for, which can bring about an Early Redemption; issuer events and discretionary

3
DTC is the world's largest central securities depository. It accepts deposits of over 2 million equity and
debt securities issues (valued at $23 trillion) from over 65 countries for custody, executesbook-
entrydeliveries (valued at over $116 trillion in 2000) records book-entry pledges of those securities, and
processes related income distributions.. DTC is a member of the Federal Reserve System and is owned by
The Depository Trust and Clearing Corporation (DTCC), which is in turn owned primarily by most of the
major banks, broker-dealers, and exchanges on Wall Street (Definition by Campbell R. Harvey accessed on
04/01/2010 at http://www.bloomberg.com/invest/glossary/bfglosd.htm).

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enforcement events. In both cases it is the Trustee that triggers the Early
Redemption on the occurrence of a number of breaches under the underlying
instruments (most notably perhaps a breach by Germany of its obligation to make
amortization payments). In the Early Redemption the Note-holders will receive an
amount that Deutsche Bank and possibly other KFW hedging providers can more or
less freely calculate according to their estimates on the profits earned on previous
payments made by Germany.

We must finally note that there is no connection whatsoever between the Russian
Federation and these Notes. The Russian Federation is not a party in any of the
executed instruments, and its behavior alone cannot determine the life of the Notes.

3. Parties Involved and Risks-Benefits

The Federal Republic of Germany. Germany is first of all the party which
takes the formal initiative for the entire transaction to begin. It is Germany
that decides to securitize the Russian debt that it held, to set up Aries
Vermögensverwaltungs GmbH and in addition to manage the reinvestment
and the hedging of risk through KfW, an entirely state-owned company (and
for the debts of which it is a full guarantor by law!). Germany is the party that
pockets in the proceeds from the three Note issues. It is Germany that will
procure the amortization funds which will finance the interest and principal
payments to Note-holders (and which as we will examine further later are
not linked to payments made directly from the Russian federation to the
Federal Republic of Germany).

Most importantly, Germany is king of when, if and under what conditions the
Sovereign Event Redemption Conditions are met. There is of course the
objective condition of Sovereign Event, set out in advance, which can kick off
the Sovereign Event Redemption, but the fact of the matter is that no one
will even know unless Germany herself lets everyone know. As a result
Germany could go as far as clause picking to terminate the bonds
prematurely on the most favorable terms if Russia failed to meet its Paris
Debt obligations, and choose between Sovereign Event Redemption and
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Early Redemption. This could make sense financially to Germany, since by
law it is fully liable for any debt of KfW, which is the party that will be called
to reimburse Note-holders with 20% of the Notes’ nominal value in case of
Sovereign Event Redemption.

Aries Vermögensverwaltungs GmbH. Aries is an SPV 4. It is the Bond issuer
and the only party liable for interest and principal payments to Note-holders.
In order to remain solvent on its obligations it depends entirely on the
payments made by Germany and subsequently by KfW and as a special
purpose vehicle it is void of any assets, other than the rights stemming from
the Notes’ underlying instruments. As an SPV it is lacks interests and does
not seek any benefits.

KfW. KfW is a German state-owned development bank. It will receive
amortization payments by the Federal Republic of Germany to Aries in full
and in return it will pay Aries the Notes’ interest and principal on specified
dates. Its relation with Aries is prescribed by the scope of the reinvestment
agreement to which they are both parties as well as by the PCD pledge
agreement (under which Aries pledges to KfW a first rank claim status with
respect to rights and claims of Aries from the Federal Republic of Germany)
and which is reinforced by a separate pledge of Aries to KfW under the PCD
fiduciary transfer agreement.

An important part of KfW’s obligations under the reinvestment agreement is
its role in case of “Sovereign Event Redemption”. When the specific Sovereign
Event Redemption Conditions are satisfied, KfW will be liable to pay Aries the
Sovereign Event Redemption Amounts instead of the ordinary interest and
principal payments. These amounts are as high as 20% of the nominal value

4
An SPV, or a special purpose entity (SPE), is a legal entity created by a firm (known as the sponsor or
originator) by transferring assets to the SPV, to carry out some specific purpose or circumscribed activity,
or a series of such transactions. SPVs have no purpose other than the transaction(s) for which they were
created, and they can make no substantive decisions; the rules governing them are set down in advance
and carefully circumscribe their activities. Indeed, no one works at an SPV and it has no physical location.
*…+In short, SPVs are essentially robot firms that have no employees, make no substantive economic
decisions, have no physical location, and cannot go bankrupt. Gorton, Gary B. and Souleles, Nicholas S.,
Special Purpose Vehicles and Securitization (September 2005). FRB Philadelphia Working Paper No. 05-21,
pp. 1-2, accessed on 1/05/2010 at SSRN: http://ssrn.com/abstract=713782.

6


of the Notes and constitute the greatest risk assumed by KfW with respect to
the transaction. Of course KfW is to hedge against such risk with (as
expected) the Lead Managers.

In practice KfW is the party in the transaction which through a series of
financial investments and swaps should guarantee the three issues’ interest
and principal payments as well as the Sovereign Event Redemption Amount
in case the Sovereign Event Redemption Conditions are met, all with the
money that the Federal republic will procure in amounts and dates provided
for in the Schedule of the PCD participation agreement. KfW will receive fees
for these transactions and does not invest own funds in the bond and
therefore assumes only very limited risk, hedging its obligations under the
reinvestment agreement.

The Trustee. Deutsche Bank Aktiengesellschaft (AG) is the Trustee.
Incidentally and thanks to its institutional nature, it is also the Initial
Purchaser, the party that is with which the official German State agrees to
execute the Paris Club Debt Participation Agreement, before that is passed
on to Aries, as well as one of the two Lead Managers for the Notes and a
hedge provider for KfW.

The Trustee has a very mundane but at the same time crucial function in the
transaction. The Trust Agreement, under which Deutsche Bank AG is vested
with the role of trustee, is according to applicable German law (Section 328
of the German Civil Code) a contract for the benefit of third parties (Clause
2.3 of the Trust Agreement), whereby third parties are intended to be the
Note-holders. The role of the trustee is to keep track of cash-flows, hold on
to funds, as these are transferred from one party to the other and ultimately
made payable to Note-holders in the form of interest and principal
payments. Its most important role however is manifest in the case of Early
Redemption. This is because it is the role of the trustee to monitor the
transaction and the implementation of all underlying instruments to the
effect that the trustee holds the initiative to force Early Redemption in case
of an Issuer Event or a Discretionary Enforcement Event.

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The Note-holders. The Aries Notes Prospectus goes in great depth in
analyzing the various risk factors related with these securities. In trying to
avoid a sterile repetition of said factors, we will briefly touch upon a couple
of points that warrant in our opinion special consideration. The first one is
also something which sets these Notes apart from government bonds.
Governments routinely issue bonds to fund big and important investments
and in the case of many governments simply to meet current obligations and
cover their gaping deficits. In issuing bonds, they assume debt. The
relationship between these sovereigns and their respective creditors is an
issue of private law, governed by the specified applicable law. Conversely
when two (or more) sovereign states enter under their sovereign capacity to
a loan agreement, such agreement and any relevant disputes are a matter of
Public International Law. There is no rule of thumb on which of the two
kinds of obligations carries greater leverage on a sovereign, but the
underlying fact is that the two are distinct and deserve different evaluation.
In this case, as we already explained in the introduction, Russia has some
incentive to treat its sovereign debt differently from its privately held debt.
This qualifies to a great extent the risk evaluation of a security built on top of
Russian sovereign debt.

The second point is that the Aries bond as any credit-linked Note bears the
cumulative risk factor of both the issuer’s and the reference entity’s default
risk.

The Russian Federation. The Russian Federation is the most interesting non-
party in these transactions. As we have already noted the Russian Federation
is not a party in any of the underlying instruments of the Aries Notes.
However there are opportunities and risks for Russia which spring out of
Germany’s initiative and which Russia must grudgingly or happily live with.
On one hand and given that Russia was at that time in a healthy financial
state, it is presented with an opportunity to buy back part of its debt to
Germany at a discounted price thanks to the advantageous return rates of
the Aries Notes. On the other hand Russia, as every sovereign, issues bonds
of its own. Germany’s initiative to issue bonds which are linked to Russia’s,
i.e. another sovereign’s debt, creates perhaps unwarranted market
saturation for Russian debt. This means that any further Russian attempt to
raise money in the international markets through Notes of its own becomes

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more expensive. This is because the Aries bonds with a risk factor not
particularly different than that of the rest of Russian debt, offers markets a
significantly higher return (and this holds true in spite of what we have
already discussed on the risk factors of the Aries Notes for Note-holders).

4. Purpose of the Transaction

The party which had the initiative for the bond issues is the German Federal State. It
is only natural that these bonds were issued to serve Germany’s purposes. In short
Germany needed to level out its budget under the double constrains of its
constitution (which forbade financing the budget through credit for reasons other
than investments) and the Maastricht Treaty (which sets a 3% cap on budget
deficits). So the main purpose of the bond issues is to get Germany revenues
without reverting to a straight forward issue of debt, and thus keep debt and deficit
in check. This is possible only because Germany held a considerable portfolio of
official Paris Club Russian debt. These loans would arguably bring Germany some
positive cash-flows, which would constitute a cash transfusion to its budgets for a
foreseeable number of years. But that, simply put, would be too little too late. These
bonds were Germany’s way of cashing in on that Russian debt.

The complexity of the Notes’ structure reveals additional purposes to their issuing.
Germany in this transaction didn’t only seek to receive whatever discounted value of
future payments by Russia under her Paris Club debt; she also hoped to rid herself of
the credit default risk. Russia was at the time booming and there was little fear that
she would default, under the burden of economic adversity. But the kind of Russian
debt that Germany held was more sensitive to the political context of international
relations, global power games, and the whimsical attitude of the Russian political
elite of the day. In other words there was some likelihood that Russia could cease or
hold back on its Paris Club debt payments, simply because she felt like it, as she had
threatened before. By means of the Aries bonds Germany practically eliminates to
her benefit the default risk on that Russian debt. In more practical terms the default
risk is now divided between the investors who assume no less than 80% of that and
KfW (which would further hedge against such risk) on 20% (which is the sovereign
event redemption amount).

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5. The Documents Executed

We have already mentioned most of the underlying instruments of the structure of
the Aries Bond. In reviewing the documentation we will simply provide some
information on those documents that haven’t adequately been covered thus far.

i. PCD Participation Agreement: The initial Agreement between the Federal
Republic of Germany and Deutsche Bank AG as the initial purchaser. It is the
only Agreement under which Germany assumes obligations.
ii. PCD Transfer Agreement: The Agreement under which Deutsche Bank AG as
the initial purchaser, Aries Vermögensverwaltungs GmbH and the Federal
Republic of Germany agree to transfer Deutsche Bank’s rights and obligations
under the PCD Participation Agreement to Aries.
iii. Bank Account Agreement: Aries and Deutsche Bank as the initial Issuer
Account Bank agree on issues relating to the Issuer Accounts.
iv. Reinvestment Agreement: The Agreement between Aries
Vermögensverwaltungs GmbH and KfW, pursuant which Aries will pass on to
KfW amortization payments made to it by Germany under the PCD
Participation Agreement and KfW will produce the amounts necessary for
interest and principal payments on the interest and principal payment dates
respectively.
v. PCD Pledge Agreement: Aries Vermögensverwaltungs GmbH assumes the
obligation to award KfW a first-ranking pledge as security for any claims that
KfW may have against Aries under the reinvestment Agreement.
vi. Trust Agreement: The Agreement between Aries Vermögensverwaltungs
GmbH and Deutsche Bank AG, under which the latter assumes a formal role
for the benefit of the Note-holders to monitor other parties’ compliance with

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their obligations and to serve as a unitary depository for all the funds which
would be transferred from one party to the other.
vii. PCD Fiduciary Transfer Agreement: Aries Vermögensverwaltungs GmbH,
Deutsche Bank AG as the trustee, and the Federal Republic of Germany agree
that the former passes on its rights and obligations under the PCD
Participation Agreement to Deutsche Bank, in order to secure its covenants
in the Trust Agreement. Additionally and in compliance with the PCD Pledge
Agreement, Deutsche Bank grants a pledge to KfW.
viii. Account Pledge Agreement: Aries grants a pledge to Deutsche Bank as
trustee on all its present and future rights deriving from the Issuer Accounts.
ix. Agency Agreement: The Agreement executed by Aries and Deutsche Bank
giving the latter various functional agency responsibilities necessary for the
smooth execution of all the operations in the transaction (and imaginably on
the grounds that Deutsche Bank is the Trustee and only has the Note-
holders’ interest at heart).

6. Novel Aspects

The Aries Bond is an innovative way that Germany employed to raise funds without
reverting to debt. At a first glance one could argue that these Notes create debt for
Germany, the trick however is that Germany has secured itself the funding of the
debt for the Aries Notes without any burden to its budget (or more precisely, the
debt burden of servicing the amortization payments is offset off-the-balance sheet
with payments made to Germany by Russia). The surprising thing is that Germany
created a security on the risk of the sovereign debt of another country.

The Aries Bond is further a structured bond inasmuch as the yield on these Notes is
designed to cover the default risk of a referenced asset, i.e. a specific tranche of
Russian sovereign debt. However, it is not a vanilla credit-linked note. This is

11


because amortization payments paid by Germany are not conditional on payments
effected by Russia (other than the eventuality of an outright default or shortfall
which could trigger the Sovereign Event). Otherwise, Germany does not forward
such payments as amortization payments under the Aries Bond and therefore no
party other than Germany has any claim on the Russian payments. In addition,
rescheduling of the debt servicing or early pay-off of said debt does not affect the
bond in any way. If anything, an early pay-off or even rescheduling of the Russian
Paris Club debt would eliminate or considerably lower the risk of a Sovereign Event.

7. Conclusion

The Aries Bonds were designed to be a structured financial instrument which could
meet some very demanding goals. This structure was indeed very complex,
underlying different risk factors; we have only begun to scratch the surface of such
complexity in this paper and it was never our ambition to achieve anything more
than that. We are content if a mere clear picture of their structure, their risks and
the parties involved was drawn here.

There can be little doubt that these securities were a very smart way to achieve
these goals and one which at the time left little room for criticism. In a booming
financial market environment and at a time when the derivative market was near its
peak, there was so much optimism that investors all but saw the high yield of
derivatives as a free lunch. It was as if these high returns were gratuitous and no one
could really default since everyone has hedged all imaginable risk against everyone
else. We now know what happens when things go wrong and we could say as a final
note that markets, which expect that governments be and are the lowest risk
debtors, have a great muted invested interest that governments refrain from issuing
high-risk structured securities.

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These securities are not intended for small or medium investors; however the
repercussions in the confidence of such investors in government bonds could be at
stake, if government-issued structured securities were to default. This is why,
tempting as it may be, high-rating sovereigns should stick to their role of financial
and economic anchors and keep their distances from the realm of financial
speculation.

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References
Brauer, Jane, and Ralph Sueppel. Russia's New Aries Bond. London: Merrill Lynch, Pierce, Fenner
& Smith ltd., 2004.

Brigham, Eugene F, and Michael C Erhardt. Financial Management: Theory and Practice. Mason,
Ohio: Thomson South-Western, 2005.

Flammier, Herve-Pierre, and Kristel Richard. Repackaging of Sovereign Debt Presale Report. New
York: Standard & Poor's, 2004.

Ross, Carl W. Russia: Repackaging of Paris Club Debt to Germany. New York: Bear, Stearns & co.
inc., 2004.

Wood, Philip. Law and Practice of Intternational Finance. London: Thomson Reuters, 2008.

World Bank. World Bank World Development Indicators 2001. Washington, DC: World Bank,
2002.

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