Direct Lending GREG BLONDE, ESQ. ORRICK, HERRINGTON & SUTCLIFFE LLP 1120 NW COUCH STREET, SUITE 200 PORTLAND, OR TEL.

Transcription

1 Direct Lending GREG BLONDE, ESQ. ORRICK, HERRINGTON & SUTCLIFFE LLP 1120 NW COUCH STREET, SUITE 200 PORTLAND, OR TEL. (503) ALISON RADECKI, ESQ. ORRICK, HERRINGTON & SUTCLIFFE LLP 51 WEST 52 ND STREET NEW YORK, NY TEL. (212)

2 Introduction What is a direct purchase transaction? Direct purchase is a generic term used when a bond or other obligation is privately placed with, or directly purchased by, an investor (usually a commercial bank) rather than offered to the investing public. As with publically offered bonds, direct purchases can be tailored to meet the needs of an Issuer (flexibility with respect to use of proceeds, sources of repayment, legal structure, etc.). There is a growing use of direct purchases in the municipal market as an alternative to traditional public offerings of bonds. Direct purchases were roughly $13 billion in 2011 according to estimates reported by The Bond Buyer. Commercial banks now reportedly hold over $327.4 billion of municipal debt 1 1

3 How Did We Get Here? Confluence of bank and issuer events led to "perfect storm" of supply/demand for direct purchases Prior to the economic crisis (2008/2009), there were a limited number of private placements. Issuer factors leading to increased demand for direct purchases: Large number of expiring letters of credit (LOCs) on existing VRDOs with little hope of renewal. Financial instability in public markets led to interest rate volatility. Deterioration of bank credit quality led to investors tendering VRDOs. Issuers recognized that direct purchases have a number of advantages over VRDOs, including less burdensome disclosure and rating processes. Bank factors leading to increased supply of direct purchases: Favorable bank qualified treatment under ARRA. Concerns relating to implementation of Basel III capital and liquidity standards. 2 2

4 Issuer Considerations: Pros and Cons of Direct Purchases Pros: Interest rate may be fixed or variable. Variable rates may be based on a SIFMA rate or a percentage of LIBOR plus a spread. No remarketing agent needed. No risk of rate increase or optional tenders by public bondholders due to market panic or bank specific factors (bank downgrade, bondholders over-exposure to a particular bank, etc.). Usually eliminates the burden of preparing a disclosure document. No 15c2-12 requirement, so it can reduce or eliminate need for ongoing disclosure. Usually does not require ratings. Issuers may be able to avoid termination of swap agreements and resulting termination payments with index rate direct purchases. 3 3

5 Issuer Considerations: Pros and Cons of Direct Purchases Cons: Banks may want to expand their services provided to the Issuer (insurance, payroll, depository bank, investment products, operational accounts, etc.). Amortization potentially shorter than traditional, publically offered tax-exempt debt. Bank generally will not agree to hold the bonds until maturity. Typical initial holding period will usually be 2 to 7 years. Bank has right to tender the bonds back to the Issuer at the end of the initial holding period. If initial bank hold period is not extended, the Issuer must pay the entire principal amount of the bonds (subject to a term out, if any) or restructure the transaction. 4 4

6 Other Issuer Considerations Direct purchase documents are highly negotiated Typical issues: pledges of assets/revenues, financial covenants, right of set off, cross defaults, consent rights, default rates, increased costs, taxable rates and term out provisions. There may be tax issues associated with some covenants, particularly liquidity covenants. As with all borrowings, Issuer must have legal authority to enter into the transaction. Constitutional and statutory debt limits still apply. Disclosure issues Although no offering document is required, many direct purchase transactions are still subject to the anti-fraud provisions of Section 17 of the Securities Act of 1933 which makes it unlawful to obtain money in interstate commerce by means of an untrue statement of a material fact in the offer or sale of securities, or by the omission of material facts. Direct purchasers often require 10b-5 type representations as to information provided to them. 5 5 Direct purchasers conduct due diligence and will require budgets, audits, operating data, projections, etc., sometimes on an ongoing basis. CDIAC filings still required. EMMA filing recommended.

7 Bank Considerations Recap: Market grew out of bank qualified debt exceptions. Some banks have reduced/insufficient ratings and cannot issue letters/lines of credit. Reduction of contingent liquidity risk created by letters and lines of credit for demand bonds. Basel III regulatory changes led banks to pursue loans instead of contingent liabilities in order to limit exposure to possible negative efforts of Basel III. Banks have increased capital to lend. Documentation Issues: Need to negotiate covenants to reduce risk and possibility of being in a subordinate position to other debt owners. Investor/Purchaser Letter will sometimes be required by Issuer. Letter may include transfer restrictions and representations that: bank is an "accredited investor or a qualified institutional buyer bank is purchasing for its own account and not with a view to resell 6 6 bank has done its own due diligence and has not been provided with a formal disclosure document

8 Bank Considerations Remedies may be limited by rating agencies that require extension of cure periods for certain defaults. Disclosure issues and pricing information (Not subject to Rule G-34 or Rule 15c-2-12). How will direct purchases be treated internally on bank's books? Is bank purchasing a security or making a loan? How do securities laws and MSRB rules affect those decisions or analyses? 7 7

9 MSRB Notice : Direct Purchases and Bank Loans MSRB Notice (September 12, 2011): Alerted municipal market participants that, under existing legal principles, certain direct purchases that are called bank loans may in fact be municipal securities. Reviewed Reves v. Ernst & Young, Inc. (1990), the principal U.S. Supreme Court case on whether a note constitutes a security and therefore is subject to federal securities laws. If a direct purchase involves municipal securities and if parties regulated by the MSRB play a role in such financing, those parties may inadvertently violate MSRB Rules as well as other federal securities laws Purchasers are not subject to the MSRB Rules unless they are acting as Brokers or Dealers. 8 8

10 Reves Analysis Rebuttable Presumption Reves v. Ernst & Young, Inc. Rebuttable Presumption: Every note is presumed to be a security, except for a judicially created list of instruments commonly called notes that nonetheless fall outside of the security category. The types of notes that are not securities include: Note delivered in a consumer financing Note secured by a mortgage on a home Short-term note secured by a lien on a small business or some of its assets Note evidencing a character loan to a bank customer Short-term notes secured by an assignment of accounts receivable Note which simply formalizes an open-account debt incurred in the ordinary course of business Note evidencing a loan from a commercial bank for current operations 9 9

11 Reves Analysis Family Resemblance Test The presumption can be rebutted only if it can be shown that the note in question bears a strong family resemblance to one of the judicially enumerated non-security notes (listed on slide 9) by applying four factors: 1. Examine the transaction to assess the motivations that would prompt a reasonable buyer and seller to enter into it. 2. Examine the plan of distribution to determine whether the note is an instrument in which there is common trading for speculation or investment. 3. Examine the reasonable expectations of the investing public. 4. Examine the existence of an alternate regulatory scheme. There is no guidance on the relative weighting of the four factors or on whether any particular factor is controlling. Possibility that other instruments fall outside the security category: If an instrument is not sufficiently similar to an item on the list, the decision whether another category should be added is to be made by examining the same factors

12 Application of Reves to Direct Purchases The determination of whether a transaction involves a security or a nonsecurity is very fact driven and must be done on a case-by-case basis. Task is left to SEC and federal courts to determine which financial transactions involve securities and fall within the coverage of the federal securities laws. Conservative Approach: If you have something evidenced by a bond or a note in your transaction with CUSIP numbers, an indenture/resolution and/or the use of DTC (more form driven), the most conservative approach will be to assume that your transaction involves a security because of the presumption under Reves. Another Approach: Look at substance and how bank is treating the transaction. Factors to consider are: Limited intent to distribute (where the bank intends to hold until maturity), where the business terms resemble commercial lending terms (price based on spread to LIBOR, covenants, prepayment features) and when bank attempts to document transaction as such. The MSRB has asked the SEC for guidance on determining whether something is a loan or a security. Banks should establish policies and procedures to support their analyses as to whether or not they are buying a security or making a loan or acting as a broker-dealer