Relevant Documents:
The Regents of the University of California 2010 Series F (Taxable - Build America Bonds)
The Regents of the University of California 2009 Series R (Taxable - Build America Bonds)
Conditional Notice of Redemption 2010 Series F (EMMA notice)
Conditional Notice of Redemption 2009 Series R (EMMA notice)
Purdue University and the state of Washington will issue an aggregate $1.2 billion of tax-exempt bonds this week to redeem outstanding taxable Build America Bonds, or BABs, in a rising wave of extraordinary BAB redemptions, according to market sources. As much as $80 billion of primary supply this year could be in the pipeline from BAB redemptions, according to market sources.
While the municipal bond market might welcome the supply, existing BAB holders have begun to challenge the provisions through which issuers are calling their BABs. In recent weeks, municipal bond investors have challenged the Regents of the University of California’s proposal to redeem $1.2 billion of BABs, split between $759 million of 2009 Series R BABs and roughly $456 million of 2010 Series F BABs. The two BAB issues are scheduled for extraordinary redemption on March 27.
Sources say there is a “compelling” financial case to refinance BABs with tax-exempt debt because the refinancing “could generate considerable savings, even at current elevated interest rates.” Greater liquidity in the tax-exempt market will also work to hold down the costs of the new debt, according to sources.
A research note from JPMorgan identified 15 unique issuers with an aggregate $9.2 billion of debt that have either called BABs, posted conditional calls for BABs or are considering plans to redeem BABs. While redeeming bonds issued from 2009 to 2011 is not unusual, the disclosures all point toward the terms of an extraordinary redemption provision, or ERP, in the bond documents that would pay BAB bondholders less than a make whole provision subject to the optional redemption provision, or ORP, said market sources.
The refinancing of the outstanding BABs based on the ERP has prompted pushback from investors. Issuers are exercising the ERP with smaller payouts to bondholders based on a decade-old cut to the federal government 35% federal interest payment subsidy, positing that it qualifies as an “extraordinary event.”
BABs were introduced by the American Recovery and Reinvestment Act of 2009, or ARRA, as taxable bonds with a subsidy from the federal government in the form of “a direct cash payment to issuers to refund 35% of each interest payment made to bondholders.” The subsidy was reduced via the 2011 enactment of the Budget Control Act though a “sequestration” process, which reduced government spending across federal government programs.
The high taxable rates, coupled with the diminishing subsidy, are providing incentives for issuers to “lean into the legal language” in an attempt to refinance the outstanding BABs, according to sources. This week, the Trustees of Purdue University are looking to issue a
$72.4 million Series 2024 GG student fee bond that will pay for the extraordinary redemption of the
$65 million of Series Z-2 Build America Bonds issued in 2010. The ORP for Purdue’s BABs includes a T+25 bps discount rate and a T+100 bps discount rate under the ERP, according to the
2010 bond statement.
Meanwhile, the state of Washington is pricing a $1 billion refunding issue today to refund the
Series 2010D and
Series 2010F BABs pursuant to the ERP with a similar discount. The Regents of the University of California have scheduled a redemption of $1.1 billion of outstanding BABs on or around tomorrow, Wednesday, March 27, for its
2009 Series R BABs and
2010 Series F BABs. Norfolk is also evaluating a new general obligation issuance to refund the Series 2010B BABs, pursuant to the ERP,
according to an EMMA notice from Friday, March 22.
Extraordinary Provisions Receive Extraordinary Challenges
Parties on both sides of the question of whether the reduced federal subsidy can trigger the ERP provisions are looking for guidance from the recent
Indiana Municipal Power Agency v. U.S. case, in which a group of municipal power utilities sued the federal government over the reduced interest subsidy payments. The U.S. Court of Federal Claims found that the sequestration statutes mandated the reduction because the BAB payment obligation “constituted direct spending subject to sequestration, rather than appropriation under an ‘appropriation Act’ exempt from sequestration.” The court also held that the petitioners’ complaint did not establish a government “intent to contract” and that the ARRA “provides no basis on which to demonstrate congressional intent to create a contract by law.” The U.S. Court of Appeals for the Federal Circuit affirmed the ruling on appeal, and the U.S. Supreme Court denied a petition for a writ of
certiorari by the utilities.
In a research
note published in February, Orrick, Herrington & Sutcliffe said the ruling “supports the conclusion that sequestration resulted in a materially adverse change to the cash subsidy payment obligation. … Although the specific language must be reviewed in each case, we believe extraordinary optional redemption is available for issuers of BABs in most cases,” the report states. The research note was penned by tax partner Charles C. Cardall and public finance partner Barbara Jane League, who could not be immediately reached for comment today and did not immediately respond to requests for comment.
Attorneys for holders of BABs are taking the opposite view, however. In a Wednesday, March 20, letter reviewed by Reorg to officials at the Regents of the University of California, or UC, a group of investors, represented by Kramer Levin, expressed its opposition to university plans for the proposed BABs extraordinary redemption based on a decade-old adjustment to federal appropriation levels. The letter states that under the budget sequestration imposed by Congress in 2013, the effective BABs subsidy to the Regents decreased by 5.7% to 33% instead of 35%, which resulted in an increase in the Regents’ effective interest rate on the BABs of “around one-eighth of one percent.”
The letter contends that UC is not entitled to undertake this extraordinary redemption and should cancel the proposed transaction. If the university nevertheless proceeds, it must pay bondholders a make whole redemption amount, which Kravin Levin estimates to be at least $120 million greater than the currently proposed extraordinary redemption amount, according to the letter.
“Should the Regents fail to cancel the redemption or pay the make-whole redemption amount, the holders we represent reserve their right to pursue an action for breach of contract, breach of the implied duty of good faith and fair dealing, and unjust enrichment, at a minimum. Damages in any lawsuit will include the make-whole redemption amount, consequential damages, what we imagine will be substantial legal fees, and any other relief to which bondholders are legally entitled,” states the letter, which was signed by Kramer Levin partners Amy Caton and Matthew Madden.
“These damages and fees are likely to be far in excess of any savings that the Regents anticipate through moving forward with the extraordinary redemption,” the letter adds.
The letter was addressed to UC Regions CFO Nathan Brostrom and General Counsel Charles Robinson, and written on behalf of holders of “hundreds of millions of dollars” of UC Regents 2009 Series R GRB and 2010 Series F LPRB Taxable BABs, which include some of the largest financial institutions in the country, according to the letter.
The “insignificant adjustment to federal appropriations levels” has not spurred the regents for nearly 11 years to try to undertake an extraordinary optional redemption, according to the letter, which asserts that the regents and their advisors “must have concluded” that current market conditions are favorable to attempt an early redemption of the BABs without paying holders the make whole premium required by the governing indentures. Caton and Madden also say that the regents apparently received legal advice that an extraordinary redemption could potentially pass legal scrutiny but warn “such advice is mistaken, and acting on it would be subject to straightforward legal challenge.”
The proposed ERP lacks a basis in the governing indentures because no adverse change to sections 54AA or 6431 of the Internal Revenue Code has occurred, there has been no material reduction to the regents’ cash subsidy payment, and the regents cannot “plausibly invoke” a decade-old sequestration statute as a “supposed extraordinary event,” according to the letter.
In asking for the regents to either cancel the proposed redemption or pay the holders the make whole premium to which any current redemption entitles them, the letter outlines a legal argument as to why the reduced federal subsidy does not meet the legal standard that would allow for an extraordinary redemption.
The UC Regents BABs indentures define an “Extraordinary Event” as when “a material adverse change has occurred” to section 54AA or 6431 of the Internal Revenue Code, or IRC, “pursuant to which The Regents’ 35% cash subsidy payment from the United States Treasury is reduced or eliminated,” according to the letter. Because the indentures require the occurrence of an adverse change to section 54AA and the plain language governs, an extraordinary redemption is unavailable, according to the letter.
The Kramer Levin attorneys say they are aware of
contrary analysis that Orrick has provided to BABs issuers, which contends that budget sequestration “implicitly altered” sections 54AA and 6431 and therefore was an adverse change to them.
Caton and Madden, however, call Orrick’s analysis “unsound,” noting that nothing in the sequestration statutes reference “directly or indirectly” the BABs legislation. Further, when Congress repealed these two tax provisions, sections 54AA and 6431 of the IRC, in 2017, it did so only prospectively and expressly stated that those provisions continued to apply to existing bonds, thus confirming Congress’ understanding and intent that they continued to apply as written and unmodified by sequestration, according to the letter.
The letter also says “statutory repeals by implication” are “not favored … and are a rarity” and require that a statute completely revokes or suspends the underlying obligation before the government began incurring it, or alters the statutory payment formulas “in ways ‘irreconcilable’ with the original methods.”
In this case, sequestration has merely directed the U.S. Office of Management and Budget to take regulatory action limiting the government’s ability to pay the full subsidy, which the letter says is not legislative action to alter the statutory obligation to pay the 35% subsidy or any other parts of sections 54AA and 6431 of the IRC The letter also states if the government were to terminate sequestration, sections 54AA and 6431 would require no legislative modification in order for the government’s continuing obligation to pay the full BABs subsidy to remain effective.
Caton and Madden say their view is not contrary to the recent Court of Federal Claims decision in
Indiana Municipal Power Agency, which they say rejected the issuers’ argument that sequestration did not apply to appropriations made to pay BABs subsidies and instead held that BABs subsidy payments stem from a “direct appropriation” statute that is subject to sequestration. That holding “has nothing to do with” whether an adverse change to sections 54AA and 6431 of the IRC have occurred, according to the letter.
Further, any provision of the
Indiana Municipal Power ruling indicating that the two sections were changed by the sequestration statutes “would be dicta, wrong, and not precedential outside the Federal Circuit,” the letter states, noting that the regents continued to describe the subsidy as 35% until at least 2020.
The letter also asserts that the reduced federal subsidy is “immaterial” and cannot meet the indentures’ materiality’ requirement, noting that courts impose a “heavy burden” on parties attempting to invoke a material adverse event clause. In an interview with
Reorg on March 11, John Miller of First Eagle Investments noted that the ERP debate centers on whether a 5.7% cut to the subsidy can be considered an extraordinary event.
The sequestration reduction accounts for 2% of the interest payment, which in the case of the Series R bonds, amounts to about $872,000 annually, which is 0.002% of the regents’ annual budget and far below expected redemption issuance and refunding costs of $3.5 million, according to the letter. “The impact of the subsidy reduction is miniscule by any metric, and could in no way be considered material in the context of the bond payments or to the Regents. … It falls far short of the standard set in the few cases that have found a material adverse event to have occurred, which typically have required a double-digit percentage impact,” the letter states.
The Kramer Levin attorneys also assert that the redemption is untimely and that even if UC had an extraordinary redemption right available, they elected not to invoke it and did not inform bondholders of this supposed right in its public filings. The regents’ decade-long delay should preclude them from acting on the redemption provision now.
“This delayed action and lack of disclosure have misled holders - ranging from large financial institutions to individual investors - that bought and sold these bonds over the past eleven years into believing, reasonably, that their bonds would only be redeemed at maturity or at the make-whole price, with no reason to think otherwise,” the letter states. Further, the bonds have traded at a premium to par at time, and buyers may have paid far more and may have held the bonds far longer than they would have had they known the regents would take the view that the bonds were callable under the extraordinary optional redemption provisions at any time after 2013, according to the letter.
The letter says the indentures’ plain text provides that redemption will occur “upon the occurrence of an Extraordinary Event” and that “no one drafting this agreement, or buying and selling bonds, could have contemplated that it granted the Regents an indefinite call right to be exercised whenever the market conditions were favorable, even many years after the supposed adverse change occurred.”
The Kramer Levin attorneys also say they expect a court would treat the belated exercise of this extraordinary redemption “as estopped by principles of equity and an act of unjust enrichment” by the regents, arguing that they have “quietly sat on their hands for far too long to now suddenly spring this redemption on holders of publicly issued bonds.”
Favorable Market Conditions
Market sources say current market conditions favoring tax-exempt rates over taxable rates could boost new tax-exempt debt issuances by $80 billion as issuers look to replace the taxable BABs with new tax-exempt debt. The high taxable rates, coupled with the diminishing subsidy, are providing incentives for issuers to “lean into the legal language” in an attempt to refinance the outstanding BABs. There is also much more liquidity in the tax-exempt market, which helps keep spreads to Treasurys or AAA munis compressed, according to one source.
California issuers represent the dominant share of future ERPs being exercised such as Los Angeles United School District, Bay Area Toll Authority, Los Angeles Department of Water and Power and Sacramento Municipal Utility District, said an investor source. There is also a select group of issuers throughout the country where meaningful savings could be achieved like in Maryland, North Carolina and Ohio, the source added.