Letters of Credit, Generally

November 2, 2012

Document Drafting Matters

  1. Ensure that the reimbursement agreement or letter of credit describes how the letter of credit may be cancelled, and what the process is when an optional redemption pursuant to the terms of the reimbursement agreement coincides with the date on which the letter of credit is cancelled.  Should an optional redemption notice be provided or should the optional redemption be waived?

Other Matters

Payment of letter of credit fees might be considered capital expenditures, especially if paid during the project period.  If the letter of credit fee is amortized beyond the project period, however, portions of the fee could be treated as working capital expenditures.  Therefore, it may make sense to assume that the fee won’t be counted as a capital expenditure to test whether the 95/5 test is met.


Leases and Installment Purchase Agreements

May 8, 2012

Typical Lease Financing Structure

The lease purchase agreement (LPA) is entered into between the municipality, as lessee, and a lender or other lessor.  Under the LPA, the lessor leases the equipment to the lessee, and the lessee rents, leases and hires the equipment from the lessor.  The term of the LPA is for one year and is subject to renewal and appropriation by the lessee.  In some jurisdictions, a built-in evergreen provision might be added to provide for automatic renewals of the IPA unless the lessee takes action to “not” appropriate.

The lessee, on behalf of the lessor, orders the equipment and installs the equipment, and only then leases the equipment.

Under the IPA, the lessee promises to make rental payments only to the extent appropriated therefore.  In the event of a nonappropriation, the IPA is deemed terminated, and the lessee is required to deliver the equipment to the lessor.

Upon acceptance of the equipment by the lessee, title to the equipment and any and all additions, repairs, replacements or modifications will vest in the lessor, subject to the lessee’s rights under the IPA.  The lessee has no right, title or interest in the equipment except its leasehold interest therein.

The lessee commonly has a purchase option under which it may be allowed to purchase the equipment from the lessor.

Typical Installment Purchase Agreement Structure

The installment purchase agreement (IPA) is entered into between the municipality, as borrower, and the lender.  Under the IPA, the lender makes a loan to the municipality.  Usually, the loan proceeds are deposited to an escrow fund.  The municipality, with the consent of the lender, may make a draw from the escrow fund from time to time to use the loan proceeds to purchase the equipment (or energy conservation measures).  The lender does not operate, control or have “possession” of such equipment or measures.  The municipality is responsible for selecting the equipment and using, maintaining, operating and storing the equipment.

In the IPA, the municipality promises to make loan payments to the lender during the loan term, usually based on a payment schedule attached to the IPA.  A portion of the loan payment is separately identified as the interest component, which is eligible for tax-exempt treatment.  The lender may assign the loan payments to another person.

During the loan term, legal title to and “ownership” (vs. possession) of all equipment and any and all repairs, replacements, substitutions and modifications thereto is in the lender, and the municipality must take all actions necessary to vest such title and ownership in the lender.  For instance, the municipality may need to mark or otherwise label the equipment to identify the lender as the owner.  Upon termination of the loan by prepayment in full by the municipality or through payment by the municipality of all loan payments and other amounts relating thereto, the lender must convey its ownership interest in the equipment thereby terminating the lender’s ownership of the equipment.

The municipality may permit the lender to file financing statements and amendments thereto describing the equipment in order to evidence the lender’s ownership interests in the equipment.  Such financing statements should reflect the lender’s legal title to the equipment and be designated as “filed for notice purposes only.”

Upon failure by the municipality to pay, the lender may declare the outstanding balance immediately due and payable and may be able to enter the municipality’s premises to disable the equipment or retrieve the equipment.

In certain states, depending on state law and other pertinent circumstances, it may not be possible to structure an IPA as an annually appropriated financing that would not be considered a multiple fiscal year debt of the municipality.

What’s the Difference Between an LPA and IPA?

There isn’t really a difference.  The LPA may be more acceptable in certain jurisdictions in which there is an express prohibition of multiple fiscal year obligations.  The lease, as such, is more easily understood as a structure that provides for annual renewals.  Unlike the IPA structure where the municipality is considered the borrower of the loan, the LPA refers to the municipality merely as lessee, and there is no “loan” – instead, the lessee purchases the equipment on behalf of the lessor, and then leases the equipment.  In some jurisdictions, these distinctions may not matter. In others, they are significant reasons for why the lease structure is preferred.

Other Matters

It is questionable whether a “true lease” can be structured as a tax-exempt obligation given the federal tax law requirement that the lessee build up equity in the leased property. See Rev. Rul. 55-540 and PLRs 8235056 and 8347058.  See discussion in Bond Attorneys Workshop materials from 2008.

True lease vs. financing lease?  See “When Is a Lease Not a Lease? Seventh Circuit Adopts ‘Substance Over’ Form Test for True Lease Determination,” David A. Hatch and Mark G. Douglas, Jones Day, available online.

 


Basic Terminology

November 29, 2009

Some of the matters discussed herein are excerpted from TVMCalcs.com.

Time Value of Money:  A dollar today is worth more than a dollar tomorrow.

Revenue Bond Index: Index computed by the Bond Buyer every Thursday and published every Friday. Index is based on the average rates of 25 selected revenue bonds with 30 year maturities.

Standard Measure of Risk Premium:  The different between interest rates on tax-exempt debt and those on short-term Treasury bonds is a standard measure of the risk premium that investors require in order to hold bonds.

Current Yield: Annual interest payment ÷ current market price of the bond.

Day Count Basis: The method of counting the number of days between two dates.  See the Wikipedia entry for additional information.

  • Banker’s Year/US: 30/360 convention (Excel = 0);
  • Actual/360: Counts actual number of days but assumes a year of 360 days (Excel = 2);
  • Actual/365: Counts actual number of days but assumes a year of 365 days (i.e., it ignores leap years) (Excel = 3);
  • Actual/Actual: Counts actual number of days and uses actual number of days in the year (Excel = 1); and
  • European 30/360: (Excel = 4).

Settlement Date:  This is the date the bond formally changes hands, and is usually several days after the trade date.  In the U.S., the settlement date is usually three days after the trade date.  Interest begins to accrue on the settlement date.

Discount Rate: This is the rate that is used to convert between future values and present values. The process of calculating present values is often referred to as “discounting” because present values are generally less than future values.

Internal Rate of Return:  This is the compound average annual rate of return that is expected to be earned on an investment held to maturity in which all cash flows are reinvested at the same rate as the IRR.  Investments that have an IRR of greater than the weighted average cost of capital should be accepted.  The Modified IRR is the same as the IRR, except that it is assumed that the reinvestment occurs at some other rate – usually at the cost of capital rate.

Municipal Market Advisors and Municipal Market Data:  Municipal Market Advisors and Municipal Market Data (a Thompson service) each provide a service that in the afternoon of each trading day makes available generic pricing scales for different bond maturities and different credit ratings.

Net Present Value:  This is the present value of a cash flow less the cost of the investment.  It is a measure of cost versus benefit.  If an investment has a negative net present value, this means the cost of the investment is greater than the present value of the expected cash flow. Think twice before investing in a net present value investment.

Rule of 72:  Rule of thumb for determining how long it takes for an amount to double at a given interest rate.  Of course, it can also be used to determine the interest rate required in order to double the amount during a given time period.  To determine how long it will take to double the amount for a given rate, simply divide 72 by the rate.  E.g., it will take 7.2 years to double the amount if the rate is 10%.  To determine the required rate to double an amount, simply rearrange the formula.  E.g., to double the amount within 5 years, divide 72 by 5, which equals 14.4%.


Rating Agency Criteria and Other Information

November 10, 2009

Fitch Ratings:

  • Rating Guidelines for Special Tax Bonds: Provides useful insight into various factors contributing to the ratings assignment by Fitch to bonds supported by special tax revenue sources. (Fitch Site | View)

Standard & Poor’s Ratings Services:

  • General Criteria: Methodology and Assumptions: Approach to Evaluating Letter of Credit-Supported Debt, July 6, 2009 (General S&P Criteria)
    • Goal: Clarifies when ratings on LOC-supported debt may be different from rating on the LOC provider, discusses S&P (a) assumptions regarding preference risk in a number of different contexts, (b) assumptions relating to LOC enforceability, (c) assumptions regarding operational risks that relate to debt administrator preference
    • Common Risks in LOC-Supported Structures:
      • Recapture risk related to obligor bankruptcy: Assumption is that obligor becomes bankrupt immediately after making a payment to investors. Are those payments safe from “recapture” under bankruptcy filings?
        • Under section 547 of the Code, a bankrupt debtor’s estate may void and recapture certain property transfers.
        • Transferred funds may be subject to recapture if they were made during the 90 days that preceded the debtor’s bankruptcy filing.
        • Payments by a municipality are not subject to recapture according to section 926 of the Code.
        • Various payment structures affect recapture differently: (a) Direct-pay is most common – here payments are made to investors from the bank directly, so a bankruptcy of the obligor does not give rise to any recapture. (b) Prioritized direct-pay provides LOC funds on a secondary basis where obligor’s funds are not sufficient to pay debt service – documents usually provide that obligor funds must “age” for the appropriate preference period with the trustee before they can be used to pay investors. (c) Standby LOC is also common – here, the LOC funds are used only to cover payment shortfalls (what is the difference to prioritized direct-pay LOCs?). Documents usually provide that standby LOC will cover moneys that are recaptured from investors, and that standby LOC remains in effect until the longest applicable preference period has expired and the trustee has received a certificate of “no bankruptcy filing” from an authorized officer of the obligor.
        • S&P also looks at how the purchase price is paid in remarketings. Documents usually prohibit the obligor from purchasing the Bonds, thus preventing the obligor’s moneys, which may not be preference proof, from reaching investors.
        • Certain sources of funds mitigate obligor-related recapture risk, including initial debt sale proceeds, LOC draws, remarketing proceeds, funds held by the trustee for at least 90 days (or the applicable preference period, if longer), insurance proceeds paid directly to the trustee, proceeds from a refunding debt issue.
        • Recapture risk also arises where an LOC provider is granted new or additional collateral for agreeing to support previously issued debt. See In re Air Conditioning and In re Compton Corp.
      • Risk of insufficient LOC coverage
      • Enforceability risk
      • Risk of credit event
      • Risk of put termination
      • Document-related timing risk
      • Commingling risk and eligible accounts
      • Investment risk
      • Operational risks relating to debt administrator performance
      • Legal defeasance
    • Background on Confirming LOCs: [to come]
    • Joint Support Methodology: [to come]
    • LOCs and Liquidity Facilities Contrasted:
      • LOCs support debt issues, and the LOC provider bears liquidity risk and obligor credit risk.
      • Liquidity facility providers are purchasers of last resort and usually only cover liquidity risk, which is the risk that bond principal cannot be paid.

Document Basics

October 15, 2009

DOCUMENT BASICS

Pledge and Security Agreement: Pursuant to a Pledge and Security Agreement, the Credit Bank, the Obligor (the party to the Reimbursement/Credit Agreement) and the Bond Trustee agree that the Bond Trustee is to hold any bonds not remarketed by the Remarketing Agent and paid for with a draw on the Credit Facility as agent for the Credit Bank.  Such bonds will be registered in the name of the Obligor, but held by the Bond Trustee to secure repayment of moneys thus paid by the Credit Bank.  Upon receipt of moneys sufficient to pay in full the amount of such Credit Facility payment, the bonds thus pledged are released and the Credit Facility is reinstated as therein provided.