The COVID-19 pandemic has upended our lives and our financial markets. It is hard to assess the long-term effect of the virus, but it is clear the short-term and mid-term effects on the markets are and will be significant. This is especially true in the tax-exempt 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 measures to control the spread of COVID-19, obligors of tax-exempt financing are likely to continue to see a significant drop in revenues. Because of this, revenue bonds may see a deterioration in credit quality. While some types of revenue bonds may be less adversely affected than other types of revenue bonds, the entire market could see significant stress as the pandemic continues.
In addition to traditional revenue bonds issued by municipalities, project financing supported by tax-exempt bonds could also be adversely affected. This is because in the typical project finance scenario, the underlying debt is supported by user fees or increased tax revenues associated with the project.
For investors in the secondary market and long-term holders of revenue-backed financings, 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 any financial professional knows, diligence is key. Because of the unique characteristics of tax-exempt financings, investors need to understand what the underlying assets securing the financing are. Below are three questions among many that the municipal professional should ask when reviewing a bond issuance.
First, are the bonds or notes secured solely by a pledge of revenues, or are there additional assets that secure the financing?
Bonds issued by a sewer or water system are likely secured only by a pledge of sewer or water fees, but bonds issued by a municipal authority to fund a project, perhaps a shopping mall, may be secured by increased tax revenues created due to the project and/or a mortgage on the underlying property. 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 pledged underlying assets 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.
Second, 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 how secure the issuance is with respect to that perfection. This is important if a restructuring is required, or obligor ultimately responsible for bond payments files a petition under the U.S. 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 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. UCC financing statements are not meant to last into perpetuity, and depending on underlying state law, after a certain number of years of a loan remaining outstanding, a continuation statement must be filed.
Further, by operation of Section 552(a) of the Bankruptcy Code, except in certain situations applicable to liens arising under statute or qualifying, in the event of a Chapter 9 municipal bankruptcy filing, as a pledge of special revenues, a consensual lien will be cut-off as of the date of a bankruptcy filing. 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 goods sold by a nonprofit entity (and not the goods themselves), or a pledge of convention fees charged by a convention center), the potential exists that revenues collected after a bankruptcy filing may not be subject to the consensual lien because the revenues received after the bankruptcy petition are not proceeds of revenues to which the pre-petition lien attached. 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, if an organization receiving tax-exempt financing through a municipal authority has pledged its bank accounts to secure financing, inventors should 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 and ultimately court 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.
While many provisions in bond financing documents are uniform, complacency should not take the place of caution when reviewing the underlying financing documents. 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. Reviewing 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 debt holders is important.
The three topics 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, this protocol will likely be much more expansive. At the end of the day, 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 consider waiving that default. In other situations, a forbearance agreement that imposes tighter controls on an obligor may be advisable. In other situations, however, 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 introduced stress on the market unlike that which we have seen before, 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.
