Symbiotic Markets: Secondary Market Tax-Exempt Asset Securitization and the Primary Municipal Bond Market Darrell R. Buzz Larsen Jeffrey D.

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1 Symbiotic Markets: Secondary Market Tax-Exempt Asset Securitization and the Primary Municipal Bond Market Darrell R. Buzz Larsen Jeffrey D. Berry Secondary market tax-exempt asset (TEA) securitization and the primary municipal bond market enjoy a symbiotic relationship in which each market benefits the other. Secondary market TEA securitization narrows the gap between supply and demand for high-quality, short-term tax-exempt paper and expands the investor base in, and enhances liquidity and competitive pricing to, the municipal bond market. The primary municipal bond market supplies securitizable federally tax-exempt state and local government obligations for secondary market TEA securitization. Another beneficiary of this symbiotic relationship is the market for federally tax-exempt installment sale contracts, installment purchase agreements, lease-purchase agreements, and similar contracts for equipment and other personal property with state and local government obligors (referred to as muni equipment leases). Muni equipment lease pool securitization represents a specialized niche within secondary market TEA securitization, which is itself a niche within the global securitization market. xvii

2 xviii Secondary Market Tax-Exempt Asset Securitization Investor demand for high-quality, short-term variable-rate tax-exempt paper (whether in the form of bonds, notes, or other obligations) has significantly exceeded the supply of that paper issued, sold, and traded in the municipal bond market. The dollar volume of original issuance of such paper in the primary municipal bond market is sensitive to interest rates and other factors. A state or local government obligor is more likely during a period of relatively low interest rates (as has been experienced over at least the past decade) to fix interest rates on its long-term debt rather than issue variable-rate debt. In addition, state and local governments, to a significant extent, have a unique political and financial bias (when viewed from the perspective of the corporate market) in favor of the predictability of fixed-rate debt service rather than face the potential budgetary, political, and other consequences of exposure to variable-rate debt, notwithstanding the increased usage of interest rate swaps and other arrangements to manage and shift interest rate risk primarily for the limited universe of the most sophisticated and creditworthy state and local governments. As a result of these and other factors, the supply of high-quality, short-term variable-rate tax-exempt paper has failed to satisfy the demand of money market fund investors (among others), who must invest within strict legal constraints, as described in Chapter 5 under Considerations for Investors That Are Registered Investment Companies. One of the most significant uses of secondary market TEA securitization is the issuance of securities that synthesize highquality, short-term variable-rate tax-exempt paper (with characteristics that make such securities eligible for investment by money market funds) from relatively long-term fixed-rate tax-exempt state and local government obligations issued, sold, and traded in the municipal bond market. While secondary market TEA securitization and the primary municipal bond market are interrelated and benefit each other, they are also very different markets and are based on separate legal foundations. The original issuance and sale of state and local government obligations are subject to complex state laws that reflect significant variations among the 50 states 1 as those laws are applied to each state, including its universities, colleges, departments and agencies, and a broad range of general and special purpose local government units. 2 Federal tax law as 1. References to states in this book include the District of Columbia, the Commonwealth of Puerto Rico, and the Territory of Guam, except in Chapter 4 in which references to states do not include the Commonwealth of Puerto Rico or the Territory of Guam. 2. The United States Securities and Exchange Commission, Office of Economic Analysis, and Office of Municipal Securities recently estimated that on November 5, 2000, there were about 51,000 state and local government units that had outstanding municipal securities. SEC, Report on Transactions in Municipal Securities, at 2 (July 1,

3 Symbiotic Contents Markets xix xix applied to the excludability from gross income of interest on state and local government obligations expanded dramatically (including a vast array of federal tax regulations) from at least 1978 through the mid-1980s, culminating in the Internal Revenue Code of 1986, as amended (the Internal Revenue Code), and continues to expand. Federal tax law pervades the structuring of the original issuance and ongoing administration of state and local government obligations that are designed so that interest is, and will continue to be, federally tax-exempt. Federal securities law as applied to the original sale and trading of state and local government obligations has expanded significantly since at least the mid-1990s to regulate indirectly state and local government obligors in the primary municipal bond market that cannot legally be regulated directly. 3 The bankruptcy of Orange County, Cali- 2004), available at [hereinafter SEC Muni Report 2004]. 3. The Tower Amendment (enacted in 1975) to the Securities Exchange Act of 1934 specifically provides: (d) Issuance of municipal securities. (1) Neither the Commission nor the [Municipal Securities Rulemaking] Board is authorized under this chapter, by rule or regulation, to require any issuer of municipal securities, directly or indirectly through a purchaser or prospective purchaser of securities from the issuer, to file with the Commission or the Board prior to the sale of such securities by the issuer any application, report, or document in connection with the issuance, sale, or distribution of such securities. (2) The Board is not authorized under this chapter to require any issuer of municipal securities, directly or indirectly through a municipal securities broker or municipal securities dealer or otherwise, to furnish to the Board or to a purchaser or a prospective purchaser of such securities any application, report, document, or information with respect to such issuer; Provided, however, That the Board may require municipal securities brokers and municipal securities dealers to furnish to the Board or purchasers or prospective purchasers of municipal securities applications, reports, documents and information with respect to the issuer thereof which is generally available from a source other than such issuer. Nothing in this paragraph shall be construed to impair or limit the power of the Commission under any provision of this chapter. 15 U.S.C.A. 78o-4 (1990). For a discussion of the history of the Tower Amendment, see ROBERT A. FIPPINGER, THE SECURITIES LAW OF PUBLIC FINANCE 6:4.1[B] (Practicing Law Institute, 2d ed. 1993). The Tower Amendment significantly limited the SEC s power to require state and local government issuers to provide secondary market disclosure with respect to their municipal securities, which was in effect implemented indirectly under Rule 15c2-12 through requirements imposed on participating underwriters engaged in primary offerings. See Chapter 5, Anti-fraud and the Securities Exchange Act of 1934 Municipal Securities Market Regulation; Rule 15c2-12 Secondary Market Disclosure for State and Local Government Obligations.

4 xx Secondary Market Tax-Exempt Asset Securitization fornia, in December 1994 focused the municipal bond market on the Alice-in- Wonderland world of bankruptcy as applied to different types of state and local government obligations (e.g., bonds secured by special revenues versus bonds secured by the issuer s full faith and credit). 4 Expertise with the federal and state tax, municipal, securities, bankruptcy, banking, and other laws that govern the municipal bond market and knowledge of the business practices and customs in that market are essential to secondary market securitization of state and local government obligations originated in that market and traded in the secondary market. Such laws, business practices, and customs in the municipal bond market form the foundation for the state and local government obligations that are securitized, but should not be confused with those that exist in the separate, though interrelated, TEA securitization market. Secondary market TEA securitization essentially involves the financial and legal engineering of a separate legal entity or custodial arrangement 5 (referred to as a conduit) to issue synthetic variable or synthetic fixed-rate securities the sale proceeds of which are used to purchase and own primarily fixed-rate state and local government obligations. In many cases, such state and local government obligations have been originated and sold or traded in the primary or secondary municipal bond market and are owned or controlled by a private entity, referred to in this book as a sponsor. A sponsor may be a national or state bank, U.S. branch or agency of a foreign bank, investment banking firm, finance company, captive finance subsidiary, insurance company, or other financial institution which, for any number of business and legal reasons, is the owner of state and local government obligations. There are many incentives for a private entity to become a sponsor. For example, in connection with a change in its business strategy, a sponsor may 4. See Executive Summary of the Report of the Ad Hoc Committee on Municipal Bankruptcy Law Reform (Feb. 1, 1996) (on file with the authors) (proposing modifications to Chapter 9 of the U.S. Bankruptcy Code to address shortcomings that became apparent in the 1994 bankruptcy of Orange County, California). See also Chapter 6 Bankruptcy Risks From Within Bankruptcy Risks of Other Transaction Parties State and Local Government Obligors. 5. A custodial arrangement may be a nonentity that, in substance, represents a contractual arrangement under which the rights and interests of an owner of receipts created under that arrangement so closely mirror the rights and interests of an owner of the underlying asset that the contractual arrangement is treated as not resulting in the creation of a separately identifiable legal entity for certain purposes. Cf. Chapter 5, The Investment Company Act of 1940 The Merrill Lynch Analysis No New Issuer (describing the analysis of an arrangement under which a new issuing entity is not treated as creating an investment company under the Investment Company Act of 1940).

5 Symbiotic Contents Markets xxi desire to liquidate its position in one or a pool of those obligations. A sponsor may also be seeking a programmatic solution to its purchase and holding of state and local government obligations with a view to securitizing those obligations periodically to enable it to purchase and hold additional state and local government obligations and continue to provide funding to its state and local government customers. For example, a sponsor may acquire over time a portfolio of state and local government obligations up to its de minimis capacity and may want to establish a program to securitize the portfolio from time to time to free up its de minimis capacity. A bank may want to service its state and local government customers who issue obligations that are not eligible to be designated as bank-qualified under Section 265(b)(3) of the Internal Revenue Code by acquiring those obligations with liquidity provided through securitization as well as syndication, other institutional placement, or other means. See Chapter 7, Limitation on Ability of Banks to Deduct Interest on Indebtedness Relating to the Purchase of Tax-Exempt Obligations. Whatever may be the motivation for a sponsor s interest in undertaking a secondary market TEA securitization program, a sponsor would arrange for the creation of the conduit and arrange for other participants (including affiliates who may perform many of the following services) to provide placement and remarketing, servicing, trustee, credit enhancement, and liquidity services depending upon the structure of the particular program. The securitization of state and local government obligations does not (in fact, cannot) vary in any respect the terms that the state or local government obligor has bid or negotiated in its original issuance and sale of its obligations. 6 The terms of the securitized assets (including interest rate, redemption or prepayment rights, interest payment dates, and maturity dates) have been agreed to by the state or local government obligor and the original owner or owners of those assets. The state and local government obligors and any bond trustee are not parties to, or otherwise involved in, the securitization transactions that are the subject of this book. See What This Book Is Not About below. Nevertheless, state and local government obligors have legitimate interests to be protected in connection with securitization transactions (as described in Chapter 4 under State Law Considerations at the Conduit Level State Law Restrictions on Fractionalizing Interests ) that sponsors 6. Nevertheless, securitization may indirectly benefit the sponsor and obligors by encouraging obligors use of financing provided by sponsors of securitization programs as an alternative to the municipal bond market generally to achieve pricing and cost efficiencies in the securitization market when compared to the primary municipal bond market or financing provided by lenders that do not participate in the securitization market.

6 xxii Secondary Market Tax-Exempt Asset Securitization and their investment banking and legal advisors must take into account in structuring a secondary market TEA securitization program. In substance, secondary market TEA securitization represents the exercise by the owner of state and local government obligations of its right to sell its assets as the owner determines, subject to compliance with applicable legal requirements and any contractual constraints that may be embedded in the terms of the obligations being securitized (such as limitations on transferability or securitization). See Chapter 4, State Law Considerations at the Conduit Level State Law Restrictions on Fractionalizing Interests and Provisions Under Article 9 of the Uniform Commercial Code Favoring, and Overriding Contractual and Statutory Restrictions on, Assignability of Chattel Paper. In some cases, a private entity owning state and local government obligations may want to engage in a securitization transaction without creating its own program. Therefore, it may arrange with a sponsor of an existing securitization program for the owner to sell its obligations (or, in some cases, its rights to receive payments) to a conduit in exchange for cash and residual certificates representing an interest in the conduit. In these cases, the sponsor may not actually own the obligations at any point in time but may serve a managerial role with respect to the conduit and, to permit it to act as tax matters partner (if necessary), as discussed in Chapter 2, Unique Characteristics of a Securitization Program Minimum Residual Interest; Tax Matters Partner, may own a small portion of the securities issued by the conduit. The legal requirements that govern secondary market TEA securitization are largely unrelated to those that govern the issuance and sale of state and local government obligations. The state law complexities that abound in the original issuance and sale of state and local government obligations do not apply to secondary market TEA securitization. Other state law requirements do, however, apply to secondary market TEA securitization, as described in Chapter 4. The federal tax law that relates to the establishment and maintenance of federal tax exemption for interest on state and local government obligations is largely irrelevant to a conduit. In secondary market TEA securitization, federal tax exemption of interest on the securitized assets is assumed based upon: (a) the presence, in a single-asset securitization or in a pool securitization that includes or consists of relatively large dollar value assets, of an opinion of nationally recognized bond counsel or special tax counsel to the effect that interest on the particular state and local government obligation is federally tax-exempt, or (b) the underwriting criteria, documentation, and diligence procedures for relatively smaller dollar value assets (including small ticket muni equipment leases) representing the securitized assets in a pool securitization in the absence gener-

7 Symbiotic Contents Markets xxiii ally of an opinion of bond or special tax counsel with respect to federal tax exemption. Significant federal tax law issues in secondary market TEA securitization relate to the transfer of ownership of the state and local government obligations to the conduit (particularly in synthetic variable securitizations) and the ability of the conduit to pass-through federally tax-exempt interest to owners of securities issued by the conduit without changing the character of the income for federal income tax purposes. See the discussion in Chapter 3 under Introduction. Unlike state and local government obligations, which are exempt from registration under the Securities Act of 1933, 7 certificates of beneficial interest or COBIs issued by a conduit may be separate securities for which a private placement exemption from registration must be structured and maintained for the initial placement and successive transfers. See Chapter 5, The Securities Act of 1933 Private Placements. In addition, a conduit may constitute an investment company under the Investment Company Act of 1940 and must be registered as such, unless an exception applies. See Chapter 5, The Investment Company Act of 1940 Exceptions Under the Investment Company Act and Its Rules. Other legal requirements that govern a conduit do not apply to the issuance, sale, and trading of state and local government obligations in the municipal bond market. See Chapter 4, State Law Considerations at the Conduit Level. In summary, secondary market TEA securitization relates to, and benefits from, the municipal bond market and vice versa. However, the legal requirements and business practices and customs that govern secondary market TEA securitization are separate from, although related to, the applicable legal requirements and business practices and customs that govern the municipal bond market. What This Book Is Not About This book is not about the complex state and federal laws that relate to the issuance, sale (including primary and secondary market disclosure requirements), 7. Section 3(a)(2) of the Securities Act of 1933, 15 U.S.C.A 77c(a)(2), exempts from registration [a]ny security issued or guaranteed by the United States or any territory thereof, or by the District of Columbia, or by any State of the United States, or by any political subdivision of a State or territory, or by any public instrumentality of one or more States or territories. Section 3(a)(2) of the Securities Act of 1933 also exempts from registration any security issued or guaranteed by any bank, which is the basis on which state and local government obligations for which a bank has issued its credit facility (for example, in the form of a letter of credit) may also be exempt from registration, unlike such obligations insured under a municipal bond insurance policy.

8 xxiv Secondary Market Tax-Exempt Asset Securitization and trading of federally tax-exempt state and local government obligations. Secondary market TEA securitization generally, and this book describing that market, both assume that the state and local government obligations to be securitized are legal, valid, binding, and enforceable obligations of the respective state and local government obligors under applicable state law and that interest on those obligations is federally tax-exempt. Nevertheless, a thorough examination and understanding of the legal (including disclosure and security) and financial structure of the state and local government obligations to be securitized are essential to the securitization process. State and local government obligors participate significantly in certain primary market transactions that may be viewed, in effect, as securitizations. For example, to finance building construction or equipment acquisition, and depending upon applicable state law, (a) certificates of participation may be issued or created at the direction and with the active participation of a state or local government obligor that simultaneously enters into a real property or equipment lease that is securitized through a trust agreement or similar document with a trustee; 8 (b) a conduit healthcare authority may issue bonds that are secured solely by a pledge of Medicare, Medicaid, and other receivables; or (c) a public building commission or building authority may issue lease revenue bonds that are payable solely from, and secured by, a facility lease with a state or local government obligor. Similarly, subject to applicable state law, delinquent tax receipts (including related tax liens), tobacco settlement receipts, and other municipal cash flows may be securitized either through the creation of a conduit or the issuance of bonds, in either case by a state or local government obligor, and be payable from, and secured solely by, the related cash flows. All such securitizations essentially represent the primary market issuance and sale of municipal bonds in different forms by or on behalf of a state or local government obligor and are not the subject of this book. What This Book Is About Securitizations that are the subject of this book are those that involve the sale to a conduit of issued and outstanding state and local government obligations that 8. See I.R.S. Announcement 84-62, I.R.B. 29 (June 11, 1984). For a discussion of the type of direct issuance financing arrangement that Announcement analyzed, see Chapter 3, Pass-Through Status of a Conduit Grantor Trust. See also PUBLIC SECURITIES ASSOCIATION (now The Bond Market Association), A GUIDE TO CERTIFI- CATES OF PARTICIPATION (1991) for a discussion and analysis of primary market certificates of participation.

9 Symbiotic Contents Markets xxv a sponsor or other private entity owns or controls and the issuance of securities to enable the conduit to acquire those assets. This book focuses primarily on the federal and state tax, municipal, securities, bankruptcy, banking, and other legal requirements that uniquely shape secondary market TEA securitization. This book discusses and analyzes solely the securitization of state and local government obligations, interest on which is federally tax-exempt, using partnerships, custodial arrangements, trusts, and other structures that pass-through to investors that interest income without changing its character for federal income tax purposes. To avoid the needless repetition of what would otherwise be the ubiquitous modifier federally tax-exempt in its various contexts throughout this book, the reader should bear in mind that this book is not about any assets other than those the interest on which is federally tax-exempt or the issuance of debt securities payable from and secured by a pledge of receivables (whether or not such receivables are federally tax-exempt). Unless otherwise stated, all references in this book to (a) assets, securitized assets, state and local government obligations, and obligations are modified by the phrase federally tax-exempt ; (b) securitization and conduit are limited to legal and financial structures that are designed to pass-through to investors federally tax-exempt interest income; (c) securitization program and securitization transaction refer to a secondary market taxexempt asset securitization program and transactions entered into pursuant to such program; and (d) the municipal bond market relate solely to the portion of that market that involves the issuance, sale, and trading of federally tax-exempt state and local government obligations and not to the portion that involves obligations that are intended to be taxable.