It is hard to assess the long-term economic effects of COVID-19, but it is clear that the short-term and mid-term effects on the markets are and will be significant. This is especially true for stakeholders in the tax-exempt financing market. From traditional municipal bonds to conduit financing issued by municipal authorities, the impact will be vast.
As state and local governments continue to enact social distancing measures to control the spread of COVID-19, obligors of tax-exempt financing are likely to see a significant drop in revenues. Because of this significant drop, revenue bonds — bonds payable from a discrete source of funds such as user fees (e.g., transportation fares) — may see a deterioration in credit quality. While some types of revenue bonds may be less adversely affected than other types of revenue bonds (e.g., sewer user charges), the entire market could see significant stress as the COVID-19 pandemic continues. 1
In addition to traditional revenue bonds issued by municipalities, projects supported by tax-exempt bonds could also be adversely affected in today’s climate. Examples of qualifying private activities include tax-exempt financing to support nonprofit colleges, retirement communities and certain projects pursued by nonprofit entities.
For long-term holders of revenue-backed financing and for investors in the secondary trading market, now, more than ever, it is important to understand the underlying credit supporting the revenue-backed financing and to prepare for a potential restructuring scenario. As discussed below, diligence is key.
Diligence, Diligence, Diligence
As any financial professional knows, diligence is key. Because of the unique characteristics of tax-exempt financing, here are some questions to bear in mind as you conduct your diligence protocol.
What are the underlying assets securing the financing?
Are the bonds or notes secured solely by a pledge of revenues, or are there additional assets that secure the financing? For instance, bonds issued by a sewer or water system are likely secured only by a pledge of sewer or water fees, but bonds issued to support qualifying private activities could be secured by a mortgage on the underlying property and other collateral. Similarly, bonds issued by an airport authority may only be secured by a pledge of fees received from the use of that airport.
Understanding the collateral package is helpful in understanding the value that secures the bond issuance, and also helpful where the bond trustee or investors must negotiate a path forward if the underlying obligor of the financing becomes financially unstable.
How is the underlying pledge perfected?
After understanding the source and type of pledged property, it is important to understand whether the pledged property has been properly perfected and the source of that perfection. This is important if a restructuring is required, or if the obligor ultimately responsible for bond payments files a petition under the U.S. Bankruptcy Code (Bankruptcy Code).
Under the Bankruptcy Code, for a court to recognize a security interest, that interest must be properly perfected. If the pledged property is personal property of a sort that a financing statement under the Uniform Commercial Code (UCC) is required to perfect the bond trustee’s interest (and the issuer is not exempt from filing under the UCC), it is important to confirm whether and where those UCC financing statements have been filed and if those financing statements remain valid. 2 UCC financing statements are not effective in perpetuity. Depending on underlying state law, a continuation statement must be filed after a certain number of years if a loan remains outstanding.
Further, by operation of Section 552(a) of the Bankruptcy Code, a consensual lien will be cut-off as of the date of a bankruptcy filing, except in certain situations applicable to liens arising under statute or in the event of a Chapter 9 municipal bankruptcy filing qualifying as a pledge of special revenues. Where the underlying documents provide, Section 552(b) of the Bankruptcy Code permits a prepetition lien to stay in place to the extent that it attaches to proceeds of underlying pledged property in many situations, but the proceeds of a revenue pledge may not exist. Thus, if the underlying financing is secured by a pledge of revenues (for instance, revenues derived from the sale of merchandise sold by a nonprofit entity, or a pledge of convention fees charged by a convention center), revenues collected after a bankruptcy filing may not be subject to the consensual lien because revenues received after the bankruptcy petition are not proceeds of revenues to which the pre-petition lien attaches. This is an important consideration in understanding any revenue credit, and it is important to closely review any pledge to determine what property has been pledged, and how that property will be treated in a bankruptcy filing.
Additionally, with respect to private activity bonds, the obligor may have pledged its bank accounts to secure financing. If this is the case, it is important to confirm that control agreements exist on that organization’s accounts. In the event of a bankruptcy filing by the organization, a control agreement is an important component because the debtor will need the bond trustee’s permission to use its cash collateral pursuant to a cash collateral order, thus permitting the bond trustee, and ultimately the bondholders, to help guide the bankruptcy case.
What do the underlying financing documents say?
While many provisions in bond financing documents are uniform, complacency should not take the place of caution when reviewing the underlying financing documents. For instance, bond financing documents, even financing documents within the same sector, may contain different financial covenants and controls, as well as definitions, and it is important to review each distinct issuance. Separately, it is important to review whether the underlying financing documents have meaningful financial covenants and whether the documents permit issuers to, for instance, delay payments of principal and interest in certain situations, or to borrow additional funds at the expense of current debtholders.
Going Forward
The three questions above will help guide the municipal investor with respect to its diligence protocol. Depending on the particular investor and the sector in which it invests, the diligence protocol will vary, and likely be much more expansive. A responsible investor can maximize the value of its investment by dedicating time to diligently reviewing the particulars of the underlying credit.
In the event that careful diligence and monitoring indicates that a default is likely to occur, or has occurred, bond trustees and investors have a number of tools to address the default before it leads to a bankruptcy filing. For instance, if an obligor appears financially healthy, but has a likely one-time default on a covenant, investors may want to waive that default. In other situations, a forbearance agreement that imposes tighter controls on an obligor may be advisable. Ultimately, in some circumstances, the underlying conditions may indicate that a bankruptcy filing is the most advisable path.
Although the rights and remedies of bond trustees and investors are numerous and depend on the specific facts of individual cases, on thing is clear: the COVID-19 pandemic has inflicted historic stress on the market, and bond trustees and investors should review their playbooks now to ensure that they are ready for what is likely to occur in the future.
FOOTNOTES
- General obligation bonds issued by municipalities – that is bonds secured by the full faith and credit of a municipality – potentially may better weather the storm created by the COVID-19 pandemic because of prudent debt issuance policies, and state constitutional and local debt limitations.
- This is as opposed to real estate for which a mortgage or deed of trust would be required.
