New VRDO Provisions Raise Concern

WASHINGTON — Money-market fund officials are warning that new terms some banks and issuers are beginning to include in variable-rate debt transaction documents can be difficult to monitor and limit bondholders’ rights.

They are concerned that more expansive “most favored nation” provisions that banks are pushing in some standby bond purchase agreements that support variable-rate demand obligations may have the effect of concealing from investors when banks can walk away from the agreements.

Fund officials also claim issuers’ changes in bond indentures for some deals involving letters of credit have reduced bondholders’ ability to pursue legal action in the remote chance that the LOC bank is financially troubled and does not purchase the variable-rate bonds tendered to it.

Under most new indenture language, if a bank fails and does not honor its LOC commitment, neither the obligor nor the bank is in default — or the obligor’s default is delayed for several months — and the bondholder is left without legal recourse under the indenture. Typically in the muni market, bondholders have legal rights through the indenture trustee but only after a default event.

The document changes have become more pronounced in the past six to nine months, according to fund managers. In the case of so-called most-favored-nation clauses, the changes reflect the increased power of banks to dictate terms favorable to themselves when selling such liquidity facilities. Rating agencies have indicated as much, as well.

“High demand by municipal issuers for bank credit and liquidity facilities and reduced supply of these facilities have enabled the banks that provide these products to negotiate terms that are typically more favorable to the banks than the issuers,” Moody’s Investors Service wrote last year in a report on the rating implications of most-favored-nation provisions, which is market lingo borrowed from international trade agreements.

One fund official, who declined to be identified, said: “It’s emblematic of [bank] providers tightening controls around their risk management and giving themselves as many outs as they can without having to follow through on their obligations.”

But Richard Cosgrove, a partner at Chapman & Cutler LLP in Chicago whose firm has a large bank counsel practice, said he is unaware of any attempts by banks to apply most favored nation, or MFN, provisions to automatic termination events in standby bond purchase agreements. An official at a top financial industry trade association also said she is unfamiliar with the liquidity lines being structured any differently.

But fund managers insist these provisions are showing up in a handful of SBPAs and that they do not want them to become more prevalent. While the changes to the bond indentures were possibly accidental at first, many bond attorneys have stuck with them because they favor their issuer clients, according to the money market fund officials.

Fund managers raised the concerns recently, including at a National Association of Bond Lawyers conference last month, to sway attorneys to work with them to strip MFN clauses from standby bond purchase agreements and modify the new language in the bond indentures to restore certain legal rights to bondholders that they traditionally had on LOC-backed deals.

The fund managers agreed to talk about their concerns after the NABL meeting, but only on the condition of anonymity. NABL’s press policy prohibits reporters from quoting panel speakers without permission if the panel does not include federal officials.

As fund managers weighed in on these document changes, they also took the side of bond attorneys in the lawyers’ long-standing debate with Securities and Exchange Commission officials on whether the underlying borrowers in conduit bond transactions should provide full financial disclosures in offering statements for LOC-backed VRDOs.

Many fund officials contend, contrary to what the SEC staff has said, that full-form disclosure is not needed from the borrower for such deals because it is making a “full credit substitution” with the bank.

“When we have a seven-day VRDO with a full letter of credit and the bank is on the hook to pay ... I do not believe that you need disclosure on the underlying borrower,” Mary Jo Ochson, chief investment officer at Federated Investors Inc. in Pittsburgh, said in an interview.

Two officials from large buy-side firms who spoke on a variable-rate demand obligation panel at NABL’s conference last month said they only need a couple of pages of information about the underlying borrower, which includes who they are, where they are located, and what they are doing with the bond proceeds.

“We need to have detail about the borrower and the project, but do not need as much information as if there were no letter of credit,” said one fund analyst. “We view ourselves as lenders and we want to know where the money is going.”


In interviews, fund managers explained their concerns about MFN clauses banks have begun to include in some SBPAs that allow them more opportunities to walk away from the agreements.

Unlike a letter of credit, which is irrevocable and covers both credit and liquidity, a standby bond purchase agreement only covers liquidity and traditionally permits a bank, under certain circumstances, to terminate the agreement if the borrower’s credit quality deteriorates significantly.

Fund officials said it is “incredibly important” for these automatic termination events to be clearly listed in the agreement and to be monitorable, and they should be set in stone and not subject to change.

“We carefully review and negotiate immediate-termination events and if there is ambiguity in the language or if the events are not in our judgement remote and monitorable, our funds will not buy the securities because we believe they do not meet the requirements of 2a-7,” the fund analyst said. The analyst was referring to the SEC’s money market fund rule that generally requires funds to invest in securities rated double-A or higher or unrated debt of equal quality.

Over the past 18 months, MFN provisions in a number of SBPAs essentially stated that if the issuer sells additional VRDOs backed by an SBPA from another bank, the terms of that second agreement automatically apply to the first agreement if they are more favorable to the first bank.

“Essentially, it’s a promise from the borrower that it won’t seek a better arrangement with another bank, but if [the borrower] does get one, it promises to give the first bank the same arrangement,” the fund analyst said.

Roger Davis, a partner at Orrick, Herrington & Sutcliffe LLP in San Francisco, said these provisions are not uncommon in VRDOs, and can apply to a variety of aspects of the transaction, including bank fees, financial covenants and information reporting. Some of their applications are reasonable and obvious, such as continuing the type and timing of the issuers’ release of financial disclosures to the banks.

If the first bank is assured that it will receive annual financial information but a second bank is promised quarterly financials, it is reasonable that the issuer, at very little cost, send quarterly information to the first bank as well, according to Davis.

Other aspects of the provisions may be less fair to the borrower, Davis said, particularly those that apply to fees for the liquidity facility. For instance, if the first SBPA costs 90 basis points but the second one costs 100 basis points, he asked whether it is fair to require the issuer to pay the higher rate to the first bank if the initial agreement was struck when market rates were lower.

But Davis added it’s easy to see the situation from the banks’ perspective. “To the extent that these provisions effect the real security of the bank, you could see the first bank saying, 'We don’t want to be any less secure than the second or third bank,’ ” he said.

In its report, Moody’s cited an example of an MFN provision in an SBPA:

“In the event that the borrower shall enter into or otherwise consent to any agreement or instrument (or any amendment, supplement or modification thereto) under which, a person undertakes to make or provide credit or loans to the borrower, which agreement (or amendment thereto) provides such person with more additional or restrictive covenants, additional or different events of default and/or greater rights or the remedies related thereto than are provided to the lender in this agreement, the borrower shall provide the lender with a copy of each such agreement (or amendment thereto) and, in any event, such additional or more restrictive covenants, such additional or different events of default and/or such greater rights and remedies shall automatically be deemed to be incorporated into this agreement.”

Money market managers warn that while MFN terms have historically applied largely to issuers’ financial covenants with banks, in some cases the terms are being extended to apply to automatic-termination events, making it difficult, if not impossible, for bondholders to monitor the risk of VRDOs. In such deals, the SPBA agreement could, in certain circumstances, be terminated without any notice to the bondholder if the obligor breached its bank agreement.

Fund managers declined to provide documents showing specific instances in which issuers have sought to extend MFN provisions to automatic-termination events, saying they have successfully pushed back against at least two dealer firms that tried to include them.

But they said MFN provisions are difficult to spot, because most are not being disclosed in offering document summaries of the SBPAs, even though many investors believe them to be material.

Without asking for a full copy of the standby bond purchase agreement, investors may not even know they exist.

Chapman & Cutler’s Cosgrove said it is his impression that such provisions are being used to ensure the first bank providing liquidity or credit enhancement is not put in a less-favorable position than subsequent banks providing such facilities regarding an issuer’s financial covenants or legal remedies in the event of default, which encompass such issues as rate covenants or acceleration of payments of principal and interest on the bonds.

If an issuer breaches its financial covenants, the bank would not be able to just walk away. Rather, it would have to post notice to the trustee of a default, prompting a mandatory tender. Then the bank would have to purchase the bonds and pursue any legal remedies it has against the issuer, he said.

He added that as a condition of the provisions’ effectiveness, a bank must obtain affirmations from rating agencies that the bonds’ ratings will not be reduced or withdrawn once they go into effect.

That confirmation, Cosgrove said, should give investors comfort that conditions on any termination of the liquidity facility and their ability to tender the bonds will not be compromised.

Fund managers responded by saying that, while it’s true that MFN clauses initially applied only to financial covenants between the issuer and the bank, there have also been attempts in the past two to five months to apply them to automatic-termination events. But because this type of MFN clause is so difficult to monitor, fund managers said they do not buy SBPA-backed VRDOs featuring them. They added that they could not rely on rating agency affirmations because funds are required under Rule 2a-7 to monitor the conditions that would result in a termination of their put right. 


The other issue raised by fund officials revolves around the removal of traditional legal remedies bondholders have had in the unlikely event that an LOC-providing bank collapses and does not honor its commitment to purchase bonds tendered to it.

Their concerns stem from VRDOs originally sold with credit support from a bond insurer coupled with liquidity in the form of an standby bond purchase agreement from a bank. But after the insurers imploded during the financial crisis, many of the deals were converted to LOC-backed transactions.

Historically, legal remedies did not exist on insured variable-rate demand obligations backed by SPBAs, because issuers assumed if anything bad ever happened to the bank, the triple-A rated insurers would help the issuer find a new liquidity facility. As a result, there never would be a need for bondholders to sue a failed bank over the loss of the liquidity facility.

But fund officials believe that after the insurers began losing their gilt-edged ratings and issuers switched to VRDOs backed by letters of credit, their attorneys initially copied and pasted the terms of bond indentures from the SBPA-insured VRDO deals into the new indentures for transactions backed with LOCs.

As a result, bondholders lost the remedies they traditionally had in LOC-backed deals. One fund analyst said that five years ago, 80% of such deals had so-called remedies and controls if the bondholder was not paid par price for tendered bonds.

“Now, it’s probably less than a quarter of the deals,” he said, adding that there is also a much lower volume of deals coming to market.

In addition, the documents on the offerings originally said that, if for some reason the LOC-bank does not pay, the nonpayment would count as a default by the borrower. If there ever were a default under a bond indenture, typically a group holding 25% or more of the outstanding bonds could direct the trustee to seek acceleration of repayment of the debt or initiate lawsuits.

But over time, such provisions have been removed, as well, because issuers do not believe they should be at fault if a bank fails to meet its contractual obligations, according to fund officials.

The fund officials say they agree issuers should not be at fault. As a compromise, they are seeking to have provisions added to bond documents that give the bondholder the authority to direct the trustee to sue a bank that fails to meet its obligations.

“This is a remote, hopefully far-fetched situation where the LOC bank fails,” the fund analyst said, stressing that he knows of no letter-of-credit bank that has not bought tendered VRDOs.

While bond attorneys have indicated that the funds seem to be making reasonable requests, funds often receive bond documents on the day of pricing and it is hard to get changes made to them on such a tight time frame, the analyst warned.


Investor opinions about disclosing information on an underlying borrower are significant because they differ from those made recently by Securities and Exchange Commission officials.

Martha Mahan Haines, the SEC’s municipal securities chief, for years said she is regularly told by investors that they want information about the underlying credit, and that she believes they are looking for full disclosure.

The issue has long been one of Haines’ concerns. She last brought up the issue publicly at a NABL conference in October, after the bond attorney group filed a comment letter on the SEC’s proposed changes to its Rule 15c2-12 on disclosure.

In its letter, NABL said it welcomed changes to the rule that include the removal of a 20-year exemption for VRDOs from continuing-disclosure undertakings. But the bond attorneys urged the SEC to clarify that the rule change would not require disclosure about underlying obligors in LOC-backed VRDOs.

The remark surprised Haines, who told NABL she was “stunned” by their comment “about no need to include information on the underlying obligor” — especially “after the events of the last year and a half.” She reiterated that investors she talks to want full disclosure.

While buy-side analysts who spoke at last month’s NABL conference say they do not believe full disclosures for the underlying borrower are needed for LOC-backed VRDOs, some analysts cautioned that investors have nuanced takes on the issue.

Mark Stockwell, chairman of the National Federation of Municipal Analysts and the head of muni research at PNC Capital Advisors LLC in Philadelphia, said he is concerned that excluding disclosure for the underlying credit on LOC deals would hinder some analysts. He added that they may not rely solely on the bank’s credit when they perform an analysis to determine whether a VRDO presents a minimal credit risk to their money market funds.

Alternatively, he said, they may rely solely on the bank credit for now, but may shift their position if the bank gets into financial trouble in the future.

Stockwell said it’s important to see full disclosure of the structure of VRDOs in order to track how a problem with an issuer’s variable-rate transaction might impact the credit quality of the issuers’ other debt — that is, to make sure the VRDO is appropriate for a money market fund.

“That’s why it’s so important to have the continuing-disclosure exemption for VRDOs removed from 15c2-12,” he said.

Ochson suggested that issuers might consider “springing disclosure,” in which an underlying borrower would be ­obligated to disclose more information about its finances in a very remote scenario, such as if the letter-of-credit provider defaults on its obligations and the LOC is not substituted by an equivalently rated bank.

But Stockwell cautioned that such a commitment would need to clearly state who would monitor the bank quality and determine when to implement the additional disclosures for the borrower.

Haines, who declined to comment for this story, has said SEC staff has continued to sift through comments received on the 15c2-12 proposal, which is silent on whether issuers should disclose financial information about the underlying borrower.

The five-member commission is expected to consider a final proposal sometime this spring.

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