Bank Loan Structures Risks Remain, But GASB 88 Is A Positive Step Toward Transparency In Financial Reporting

Transcription

1 Bank Loan Structures Risks Remain, But GASB 88 Is A Positive Step Toward Transparency In Financial Reporting Primary Credit Analyst: Geoffrey E Buswick, Boston (1) ; geoffrey.buswick@spglobal.com Secondary Contacts: David N Bodek, New York (1) ; david.bodek@spglobal.com Beatriz Peguero, New York (1) ; beatriz.peguero@spglobal.com Media Contact: April T Kabahar, New York (1) ; april.kabahar@spglobal.com BOSTON (S&P Global Ratings) May 2, In March 2018, the Government Accounting Standards Board (GASB) released Statement No. 88, new accounting guidelines that detail disclosure requirements for a variety of financial instruments. S&P Global Ratings believes GASB 88 will help improve disclosure for direct purchase transactions, private placements, and bank loans (hereafter, bank loan structures), as well as other transactions that could present contingent demands on issuers' liquidity or alter the relative rights of lenders to public finance borrowers. The document's introduction cites "improve[d] financial reporting," as GASB's purpose for introducing the disclosure guidelines. Similarly, S&P Global Ratings has viewed inconsistent disclosure and the asymmetric information associated with many bank loan structures as being detrimental to the market, and have called for improved disclosure requirements for years. As such, we view the GASB 88 release as an important and favorable development that facilitates transparency. Markets function most efficiently when all stakeholders have symmetrical or equal access to material information. Although the release speaks to required disclosures, not all public finance issuers comply with GAAP standards or MAY 2,

2 adopt all GASB statements. Consequently, we believe the municipal market is not functioning as effectively as it could around a bank loan structure. Nevertheless, this release is a significant positive development that signals even to those who have not adopted GASB statements that the marketplace is developing higher expectations about disclosures. Adopting the statement could also have credit implications for our view of management teams, which is a component of our credit analysis and which we have found often have misunderstanding about these concepts. GASB 88 Released in March 2018, GASB 88, "Certain Disclosures Related to Debt including Direct Borrowings and Direct Placements," cites improved information disclosure as the primary objective. GASB states that there is "essential information" that should be disclosed to all of an issuer's stakeholders when entering into bank loan structures due to "significant events of default and termination event with finance-related consequences " S&P Global Ratings agrees that these structures have financial implications that could affect credit quality and encourage all obligors to disclose these items, in addition to the audited statements, when entering these structures. Statement 88 will be effective for reporting periods beginning after June 15, 2018, so it is unlikely that we will see the associated improved reporting in audits until fall The statement, however, "encourage[s]" earlier application of the new standards. Although the improved disclosure might not be evident until late next year, we continue to ask about and assess all bank loan structures. Historically, the question of, or perhaps the aversion to, whether to disclose these bank loan structures has centered on two points: whether there is a regulatory obligation to do so, and whether these bilateral financing arrangements constitute debt. To the first point, the Municipal Securities Rulemaking Board and SEC are still considering whether they need to clarify regulations regarding bank loans. But Statement 88 directly addresses the status of these financings as debt. Paragraph number 4 of the statement explicitly says: "For purposes of disclosures in notes to financial statements, debt is defined as a liability that arises from a contractual obligation to pay cash (or other assets that may be used in lieu of cash) in one or more payments to settle an amount that is fixed at the date the contractual obligation is established. For disclosure purposes, debt does not include leases, except for contracts reported as a financed purchase of the underlying asset, or accounts payable." Paragraphs no. 5 and 6 outline the specific information to be included in the notes to the financial statements with respect to these instruments. They include "significant (1) events of default with finance-related consequences, (2) termination events with finance related consequences, and (3) subjective acceleration clauses." The statement further specifies that notes to financial statements address these matters in a separate section to promote clarity or, MAY 2,

3 dare we say, avoid confusion. The word significant leaves open the potential that covenants and remedies some investors or rating agencies deem meaningful could be left undisclosed. As such, S&P Global Ratings encourages a liberal interpretation of significant and believes that improved transparency better serves the market. Furthermore, we agree with the GASB, as they state in the Appendix B of Statement 88, that the overall public benefit in implementing this change outweighs the costs to the individual issuers. FEDERAL TAX CHANGE IMPACT Our focus on the provisions of bank loan structures calls to mind some of their hidden hazards. As we did in the summer of 2017, we continue to bring to light the issue of the margin rate factor clause, or "gross-up covenant." The clause was included in bank loans to municipalities in the 1980s, leading up to the 1986 federal tax reform, but has been less consistently included since. It allows the bank the right to increase the interest rate the borrower pays if there are tax law changes that reduce the lender's tax rate or remove the municipal interest income tax exemption. These clauses hedge lenders' exposure to potential erosion of the value of the loan's stated interest rate. Since December 2017's tax reform, the clause has been triggered regularly in first-quarter The adjusted rate is not stressing ratings because the nominal value of affected loans tends to be small relative to issuers' overall debt portfolios. However, the clause is raising credit risks. First, we have heard from bond counsel that issuers have been surprised that the margin rate factor clause was in the documents. Whereas the lawyers believe that the clause is typically discussed with clients before document execution, many issuers had not fully understood the potential costs associate with that language. This continued lack of complete understating of the provisions in these documents by the obligors augments the risk to the market. We assess management as part of our analysis, and have repeatedly found that many teams have misunderstandings about provisions such as the margin rate factor and other provisions of bilateral loan agreements, which reflects negatively on them and the issuer's credit quality. Only a rating committee may determine a rating action and this report does not constitute a rating action. S&P Global Ratings, part of S&P Global Inc. (NYSE: SPGI), is the world's leading provider of independent credit risk research. We publish more than a million credit ratings on debt issued by sovereign, municipal, corporate and financial sector entities. With over 1,400 credit analysts in 26 countries, and more than 150 years' experience of assessing credit risk, we offer a MAY 2,

4 unique combination of global coverage and local insight. Our research and opinions about relative credit risk provide market participants with information that helps to support the growth of transparent, liquid debt markets worldwide. MAY 2,

5 Copyright 2018 by Standard & Poor s Financial Services LLC. All rights reserved. No content (including ratings, credit-related analyses and data, valuations, model, software or other application or output therefrom) or any part thereof (Content) may be modified, reverse engineered, reproduced or distributed in any form by any means, or stored in a database or retrieval system, without the prior written permission of Standard & Poor s Financial Services LLC or its affiliates (collectively, S&P). The Content shall not be used for any unlawful or unauthorized purposes. S&P and any third-party providers, as well as their directors, officers, shareholders, employees or agents (collectively S&P Parties) do not guarantee the accuracy, completeness, timeliness or availability of the Content. S&P Parties are not responsible for any errors or omissions (negligent or otherwise), regardless of the cause, for the results obtained from the use of the Content, or for the security or maintenance of any data input by the user. The Content is provided on an as is basis. S&P PARTIES DISCLAIM ANY AND ALL EXPRESS OR IMPLIED WARRANTIES, INCLUDING, BUT NOT LIMITED TO, ANY WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE, FREEDOM FROM BUGS, SOFTWARE ERRORS OR DEFECTS, THAT THE CONTENT S FUNCTIONING WILL BE UNINTERRUPTED OR THAT THE CONTENT WILL OPERATE WITH ANY SOFTWARE OR HARDWARE CONFIGURATION. In no event shall S&P Parties be liable to any party for any direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs, expenses, legal fees, or losses (including, without limitation, lost income or lost profits and opportunity costs or losses caused by negligence) in connection with any use of the Content even if advised of the possibility of such damages. Credit-related and other analyses, including ratings, and statements in the Content are statements of opinion as of the date they are expressed and not statements of fact. S&P s opinions, analyses and rating acknowledgment decisions (described below) are not recommendations to purchase, hold, or sell any securities or to make any investment decisions, and do not address the suitability of any security. S&P assumes no obligation to update the Content following publication in any form or format. The Content should not be relied on and is not a substitute for the skill, judgment and experience of the user, its management, employees, advisors and/or clients when making investment and other business decisions. S&P does not act as a fiduciary or an investment advisor except where registered as such. While S&P has obtained information from sources it believes to be reliable, S&P does not perform an audit and undertakes no duty of due diligence or independent verification of any information it receives. To the extent that regulatory authorities allow a rating agency to acknowledge in one jurisdiction a rating issued in another jurisdiction for certain regulatory purposes, S&P reserves the right to assign, withdraw or suspend such acknowledgment at any time and in its sole discretion. S&P Parties disclaim any duty whatsoever arising out of the assignment, withdrawal or suspension of an acknowledgment as well as any liability for any damage alleged to have been suffered on account thereof. S&P keeps certain activities of its business units separate from each other in order to preserve the independence and objectivity of their respective activities. As a result, certain business units of S&P may have information that is not available to other S&P business units. S&P has established policies and procedures to maintain the confidentiality of certain non-public information received in connection with each analytical process. S&P may receive compensation for its ratings and certain analyses, normally from issuers or underwriters of securities or from obligors. S&P reserves the right to disseminate its opinions and analyses. S&P's public ratings and analyses are made available on its Web sites, (free of charge), and and (subscription), and may be distributed through other means, including via S&P publications and third-party redistributors. Additional information about our ratings fees is available at STANDARD & POOR S, S&P and RATINGSDIRECT are registered trademarks of Standard & Poor s Financial Services LLC. MAY 2,