A group of investors have challenged the legality of the Regents of the University of California's ability to trigger an extraordinary redemption provision to refund their outstanding Build America Bonds. This may not be the last challenge as several issuers have made clear they intend to use the ERP to refund billions of their outstanding BABs this year.
The
The bondholders wrote in the letter, which was first reported by Bloomberg News and obtained by The Bond Buyer, that they believe "unequivocally" that the Regents of the University of California "has no legal basis to redeem any of the above securities pursuant to exercising the Extraordinary Optional Redemption provisions."
The trustee representing the bondholders, the Bank of New York Mellon "is prohibited from executing the redemption of any of the Prior Bonds, as such action would constitute a violation of bondholder rights, and a violation of contractual agreements established in the official statements," they wrote.
The registered bondholders that signed the letter include MetLife Investment Management, Safety National Casualty Corp., DCM US Credit Fund, Mackay Shields, PGIM, Hartford Investment Management Company and several insurance companies including Houston Casualty and Philadelphia Insurance.
The bondholders have met with an unnamed law firm to take additional measures, according to an investor.
This action by bondholders is unlikely to be the last. In a different matter investors have also reached out to the Bank of New York Mellon which is trustee on a recent $622.765 million deal from the Maryland Transportation Authority, sources said.
The Maryland Transportation Authority ERP called their BABs bonds worth $721 million.
The letter comes as
The Regents of the University of California is only one of 11 issuers that have either called BABs, posted conditional call notices, or announced that they are considering financing plans in this regard, this year, according to J.P. Morgan strategists.
The 11 issuers combine to total $8.5 billion, up exponentially from 2018-2022 when the average amount of calls per year, they noted. Barclays strategists expect $20 billion to $30 billion of ERPs to be triggered this year.
After this week's developments in the Build America Bonds, Barclays strategists said, "it is not even clear if many issuers will continue refunding BABs through Extraordinary Redemption Provisions (ERPs) or if this trend will turn out to be short-lived."
This action from the bondholders "may give issuers additional reason for pause when vetting similar refundings," J.P. Morgan strategists said.
"Concerns about validity of calling BABs through ERPs for most issuers could keep some of them on the sidelines," Barclays strategists said.
They noted their previous estimate of nearly $30 million of BAB refundings might be "quite optimistic," although there remains a "sizable universe of issuers with weaker ERP language that might proceed with refundings regardless, if it makes economic sense for them."
A lawyer unaffiliated with the action concurred though she does not think it will stop the deals from proceeding.
Issuers "heading down this path" have already concluded they could legally trigger an ERP call, she said.
However, the action may urge caution for due diligence and provide extra scrutiny than it otherwise would, the lawyer said.
The lawyer's beliefs come in opposition to the bondholders' goals, said the investor, who shared that the bondholders are looking for BABs ERP calls to be stopped overall because there is no legal basis to do so.
"The reasons for the call do not meet the reasons outlined in the extraordinary redemption provision," the investor said.
The lawyer also noted some investors may decide not to buy bonds from issuers that trigger the BABs ERP calls in the future, which could be "more meaningful" to certain issuers.
A frequent issuer in the tax-exempt market may not care about a taxable investor as opposed to a less frequent issuer with a smaller pool of investors who may care more, she said.
Taxable municipal bonds have outperformed USTs and corporate bonds and have become scarcer as taxable refundings and issuance in general plummeted in 2022 and 2023. This taxable supply scarcity has led to the outstanding BABs being more valuable to taxable bond investors.
If the issuers call the BABs it may also lead to an increase of tax-exempt supply this year if the refundings can move forward.
Banks may also have to contend with whether there will be "unhappiness" from investors, even if the ERP call is "perfectly legal," the lawyer noted.
The letter is a reminder to issuers to be careful in drafting language, the lawyer said.
"Going forward special consideration will probably be given to that language around these kinds of special redemption features," the lawyer said.
"The message for issuers is to be careful and precise in the language that allows them the most flexibility to do what they may want to do," the lawyer said.
The crux of the matter in the Regents of the University of California's case stems from what constitutes an "extraordinary event."
A recently concluded court case gave several market participants the go-ahead to include sequestration as a means to use the ERP.
BABs were issued with the idea that the subsidy would not be cut retrospectively, but the 35% subsidy has been reduced multiple times through sequestration. The current sequestration rate drop stands at 5.7%.
Cardall and League noted the recent case "supports the conclusion that sequestration resulted in a materially adverse change to the cash subsidy payment obligation."
However, the investors argue in the letter that an ERP call can only be exercised if any "extraordinary event" has happened, and sequestration does not constitute an "extraordinary event."
They said a change to the Internal Revenue code would be needed to constitute an "extraordinary event."
"Thus, no Extraordinary Event has occurred because the reduction in the BAB subsidy is not material," the investors wrote. "If the reduction in the subsidy related to the sequestration provisions of the Budget Control Act of 2011 were indeed material, surely the Issuer would have exercised the extraordinary optional redemption more than 10 years ago, when such reduction in the Build America Bond subsidy initially went into effect."
