THE USE OF LETTERS OF AS CREDIT ENHANCERS FOR MUNICIPAL BONDS AND THE COMMONWEALTH OF PUERTO RICO’S BONDS CASE STUDY

ARTÍCULO

ROXANNA SANTIAGO ORTIZ*

Introduction ...... 135 I. L.O.C.s as Instruments for Municipal Bonds ...... 136 A. In General ...... 136 B. When did the Use of L.O.C.s as Credit Enhancers for Municipal Bonds Start? ...... 137 C. Before and After the Financial Crisis of 2008 ...... 138 D. Expiration of L.O.C.s in Recent Years and its Effect on Municipal Bonds ...... 139 E. Types of L.O.C.s Used as Credit Enhancements ...... 139 F. L.O.C.s as Securities and the Registration and Disclosure Requirements under the Securities Act of 1933 ...... 140 G. L.O.C.s vs. Policies as Credit Enhancers ...... 144 II. Market Summary and Statistics of Municipal Bonds Issued with L.O.C.s ...... 145 III. Commonwealth of Puerto Rico’s Bonds Issued with L.O.C.s in the Past Ten Years ...... 147 A. Forms of L.O.C.s Used and Other Provisions ...... 148 Conclusion ...... 151

INTRODUCTION

CREDIT ENHANCER IS A USED TO IMPROVE THE creditworthiness of a borrower in the issuance of a or other A type of financing transaction. The purpose of using a credit enhancer is to reduce the in the transaction by guaranteeing lenders or inves- tors full and timely . There are several types of instruments used as credit enhancers. In the municipal bonds market, the most common instru- ments, which accompany bond issues to provide credit enhancement features, are letters of credit (L.O.C.s) and bond insurance policies. The use of these in-

* Juris Doctor Degree from the University of Puerto Rico School of Law (2013). B.S.B.A. in Busi- ness Administration/ from the University of Puerto Rico, Mayagüez Campus (2007). The author is also a Certified Public Accountant in Puerto Rico since 2009 and currently specializes in and Corporate Law. 135 136 REVISTA JURÍDICA UPR Vol. 84 struments as credit enhancers provides other means of financing to borrowers that may not be well-known in the market but are known to , other institu- tions and guarantors issuing the L.O.C.s, bond insurance policies or other guar- antees. This article will focus on the use of L.O.C.s as credit enhancers when issuing municipal bonds, its benefits and costs, and how the Commonwealth of Puerto Rico has used these instruments in the past ten years in its bond issu- ance. When a L.O.C. secures a , the beneficiary for bondholders of the L.O.C. will be the trustee (also called paying agent, tender agent or regis- trar).1 Usually, the bondholders’ trustee is “appointed by or pursuant to the trust or bond resolution authorizing the issuance of the bonds.”2 The trus- tee will have a claim against the that issued the L.O.C. (the L.O.C. bank or L.O.C. provider) for the full amount of the obligation of the issuer of the bond, upon presentation of the documents specified in the L.O.C.3

I. L.O.C.S AS CREDIT ENHANCEMENT INSTRUMENTS FOR MUNICIPAL BONDS

A. In General

The benefit of accompanying a bond issue with a L.O.C. is that it improves the credit ratings of bonds, thus reducing both the risk to and the in- terest expenses to the issuer. The L.O.C. improves the credit rating of the backed bond because it is given the same rating as the obligations of the L.O.C. bank or its holding company.4 Therefore, in order for an issuer to use a L.O.C. as a credit enhancer for its bond issue, the L.O.C. bank must have a better credit rating than the issuer; otherwise, the L.O.C. will not accomplish the credit enhance- ment feature. L.O.C.s are typically issued for specified periods of one to ten years,5 and must be supported by an unqualified obligation by the issuer to reimburse the L.O.C. bank for any payments made under the L.O.C.;6 this reimbursement obli- gation is established under a reimbursement agreement between the L.O.C. bank and the issuer. It is also important to note that if the L.O.C. expires before its accompanying bond, and the L.O.C. is not renewed or replaced prior to its expi- ration date, prepayment of the issue to the bondholders is generally required.7

1 1 M. DAVID GELFAND, STATE AND LOCAL GOVERNMENT FINANCING § 5:1 (2011). 2 Id. 3 Id. 4 Id. 5 Id.

6 JOEL A. MINTZ ET AL., FUNDAMENTALS OF MUNICIPAL 11 (2010).

7 Id.; see also GELFAND, supra note 1. Núm. 1 (2015) THE USE OF LETTERS OF CREDIT AS CREDIT ENHANCERS 137

B. When did the Use of L.O.C.s as Credit Enhancers for Municipal Bonds Start?

The use of L.O.C.s and bond insurance policies as credit enhancements in- creased in significance during the high -rate period of the early 1980s.8 In the beginning of the 1980s, the high interest rates drove investment bankers to the need of developing new financial instruments to lower debt service costs. Another reason contributing to the popularity of L.O.C.s to support municipal bonds was the introduction of variable rate municipal bonds.9 Also, the intro- duction of credit enhancements raised questions regarding whether a financing transaction involved separate securities and if it enjoyed the same exemption treatment given to municipal securities issued under the Securities Act of 1933. These issues are discussed further. For the purpose of this article, it is important to note the different forms in which municipal securities are issued, such as: fixed rate, zero , and vari- able rate bonds. Fixed rate municipal securities pay a fixed over the term of the security; zero coupon bonds pay the accrued interest only on the date of the bond, and variable rate municipal securities pay interest based on an interest rate that changes periodically as a result of either changes in a reference rate, a commonly followed index, or regular resets by the issuer or a third party.10 There are two main types of variable rate municipal securities, these are: auction rate securities (A.R.S.) and variable rate demand obligations (V.R.D.O.s). A.R.S. are -term municipal bonds with interest rates that are periodically reset through an auction process, which allow the issuer to issue long-term debt but pay -term interest rates.11 On the other hand, V.R.D.O.s are long-term municipal securities with a floating interest rate that resets periodi- cally, either daily, weekly or monthly, and provide investors with the of selling the securities back to the issuer.12 When investors want to sell their V.R.D.O.s, they may do so through a put feature that allows them to put the bond back to an investment dealer at par in addition to any accrued interest. In order to support the credibility of the put feature, V.R.D.O.s are usually secured by a L.O.C. Since the L.O.C. bank serves as the liquidity provider, the L.O.C. bank’s credit rating is often assigned to the bond in place of the issuer’s rating.

8 1 ROBERT A. FIPPINGER, THE SECURITIES LAW OF § 2:1, at 2-4 (2d ed. 2009).

9 U.S. SECURITIES AND EXCHANGE COMMISSION, REPORT ON THE MUNICIPAL SECURITIES MARKET 10 (2012), http://www.sec.gov/news/studies/2012/munireport073112.pdf. 10 Id. at 8. 11 Id. at 9. 12 Id. 138 REVISTA JURÍDICA UPR Vol. 84

C. Before and After the Financial Crisis of 2008

L.O.C.s, and credit enhancers in general, were very common between 2000 and 2007.13 During this period at least one type of credit enhancer was used to secure more than half of the municipal bonds issued.14 L.O.C.s were an “easy source of fee income for at least a dozen U.S. and European banks that relied on their high credit ratings to land the business.”15 Since 2008, due to the effect of the financial crisis on banks, the availability of L.O.C.s as a credit enhancer has declined significantly. The effects of the financial crisis and the subsequent de- cline in L.O.C.s as credit enhancers were: (1) that many banks were downgraded by credit rating agencies, and (2) an increase in the costs of L.O.C.s.16 Since the financial crisis in 2008, banks have been downgraded by credit rat- ing agencies, making their less attractive to investors who buy mu- nicipal bonds. Municipal bonds backed with L.O.C.s are entirely or partially de- pendent on the credit ratings of the L.O.C. banks. When L.O.C. banks’ credit is downgraded by credit rating agencies, municipal bonds’ credit will also be downgraded, resulting in an increase in borrowing costs (interest expenses) for issuers.17 Thus, the result of the L.O.C. banks’ credit downgrade is that L.O.C.s lose the credit enhancement feature and become less attractive for issuers and municipal bond investors. Also, the current fees for L.O.C.s are substantially higher than they were be- fore the 2008 crisis.18 The number of banks providing L.O.C.s to municipal bond issuers is less, and those that are still offering L.O.C.s are demanding more.19 Many L.O.C.s, used to back municipal bonds, expired in 2011 and banks started to offer other financing options to substitute L.O.C.s, like allowing borrowers to “replace floating-rate debt with debt that a bank buys and keeps for itself,” also called a bank-qualified placement or private placement transaction.20

13 Id. at 11-13. 14 Id.

15 Carrick Mollenkamp & Michael Corkery, Banks Get Tough with Municipalities, WALL ST. J. (Jan. 27, 2011), http://online.wsj.com/article/SB10001424052748704062604576106282512683312.html. 16 Id.

17 See id.; Michael Connor, MUNIS-Tax-Free Investors Saw Bank Downgrades Coming, CHI. TRIB. (June 22, 2012), http://articles.chicagotribune.com/2012-06-22/news/sns-rt-markets-municipalsl2e8h m72y-20120622_1_downgrades-tax-free-debt-municipal-market-data (last visited Sep. 5, 2014); Robert Slavin, Moody’s Drops Key Banks, Sparking Muni Downgrades, THE BOND BUYER (June 22, 2012), http://www.bondbuyer.com/issues/121_121/moodys-downgrades-45-billion-munis-related-banks-1041 194-1.html (last visited Sep. 5, 2014).

18 See Taylor Riggs, LOCs Losing Their Luster, Drop 30% for the First Half, THE BOND BUYER, Aug. 15, 2011, at 13A. 19 Mollenkamp & Corkery, supra note 15. 20 Id. Bank-qualified placement or private placement are “transactions in which a borrower di- rectly places a with investors or a bank, either with or without a placement agent.” Caitlin De- vitt, Private Placements Take Off Thanks to Expiring LOCs, THE BOND BUYER, Feb. 13, 2012, at 7A. The deals allow issuers to avoid risks associated with traditional variable-rate bonds, and they often cost Núm. 1 (2015) THE USE OF LETTERS OF CREDIT AS CREDIT ENHANCERS 139

D. Expiration of L.O.C.s in Recent Years and its Effect on Municipal Bonds

According to Moody’s Investors Service, about $130 billion in credit en- hancements in the United States, including L.O.C.s, expired in 2011.21 As previ- ously mentioned, if the L.O.C. is due to expire before the municipal bond, the L.O.C. needs to be renewed or replaced prior to its expiration date.22 In cases where the issuer is unable to renew or replace the expiring L.O.C., the L.O.C. bank generally buys the bond in order to provide prepayment of the issue to the bondholders, as required. As a result of the L.O.C. bank buying the bond, the issuer faces an accelerated repayment schedule with the bank.23 Another way for the municipal bond issuer to raise proceeds to refund variable-rate facilities to investors, in case of expiring L.O.C.s, is to sell fixed-rate bonds. In sum, these are the consequences that municipal bond issuers are facing in recent years when their L.O.C.s are near expiration and banks are currently resentful to do business with state and local governments.

E. Types of L.O.C.s Used as Credit Enhancements

There are three types of L.O.C.s used to back municipal bonds: (1) direct pay L.O.C.s; (2) commercial L.O.C.s, and (3) standby L.O.C.s. A direct pay L.O.C. requires the L.O.C. bank to directly pay the beneficiary each amount secured by the L.O.C. As previously mentioned, the beneficiary of a L.O.C. that backs a mu- nicipal bond is the trustee,24 therefore, in a direct pay L.O.C., the L.O.C. bank directly pays the trustee the amount of each semi-annual interest and each annual installment of principal,25 being the L.O.C. bank the first source for payment of principal and interest. Also, in a direct pay L.O.C., the issuer is obli- gated to immediately reimburse the amount of each payment to the L.O.C. bank, under a reimbursement agreement.26 A commercial L.O.C. forces the issuer to transfer funds or assets to the L.O.C. bank at or before the time the L.O.C. is issued. It is similar to the direct pay in that in both, the issuer directly pays the beneficiary. The difference is in the time at which the issuer pays the L.O.C. bank. In a commercial L.O.C., the

lees, since there is no underwriter or rating agency fees involved and no disclosure requirements. Wells Fargo was “one of the first banks to start offering direct placements as an alternative to LOC- backed variable-rate debt.” Id. 21 Karen Pierog, Expiring of U.S. Muni Backstops Going Well-Moody’s, REUTERS (May 9, 2011), http://www.reuters.com/article/2011/05/09/municipals-bank-moodys-idUSN0619931220110509 (last visited Sep. 5, 2014). This article also states that, according to Moody’s Investors Service, $94 billion of were estimated to expire in 2012. See also Devitt, supra note 20.

22 MINTZ, supra note 6.

23 GELFAND, supra note 1. 24 Id. 25 Id. § 5:2. 26 Id. 140 REVISTA JURÍDICA UPR Vol. 84 issuer pays to the L.O.C. bank the amount of each payment or installment before a draw is made on the L.O.C., and in a direct pay L.O.C. the issuer reimburses the L.O.C. bank after a draw is made on the L.O.C.27 In a standby L.O.C., the L.O.C. bank pays the trustee only upon a by the issuer in making a timely payment under the terms of the bond,28 making the issuer the first source of payment of principal and interest, with the L.O.C. bank as a backup if the issuer fails to make a payment. In the event of a default by the issuer, the trustee makes a draw on the standby L.O.C. and accelerates payment of the bond. Therefore, “the amount payable under the L.O.C. will equal all the unpaid principal” of the bond, the accrued interest to the date of payment29 and a premium, if any.30

F. L.O.C.s as Securities and the Registration and Disclosure Requirements under the Securities Act of 1933

Section 5 of the Securities Act of 1933 (the “1933 Act”) requires the filing of a registration statement in order for any person to, directly or indirectly, offer to sell or buy any security. Section 5(c) states the following:

It shall be unlawful for any person, directly or indirectly, to make use of any means or instruments of transportation or communication in interstate com- merce or of the mails to offer to sell or offer to buy through the use or medium of any prospectus or otherwise any security, unless a registration statement has been filed as to such security, or while the registration statement is the subject of a refusal order or stop order or (prior to the effective date of the registration statement) any public proceeding or examination under section 77h of this ti- tle.31

Moreover, section 3 lists classes of securities that are exempt from the appli- cation of the 1933 Act, except if a particular section specifically states that it is applicable to one or more classes of the exempted securities. Section 3(a)(2) in- cludes as exempted securities:

Any 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 instrumental- ity of one or more States or territories, or by any person controlled or supervised by and acting as an instrumentality of the Government of the United States pur-

27 Id. The determination of a L.O.C. as either a direct pay L.O.C. or a commercial L.O.C. may have important tax consequences. For more information on federal tax issues regarding L.O.C.s used as credit enhancement, see GELFAND, supra note 1, § 5:4.

28 GELFAND, supra note 1, § 5:2. 29 Accrued interest to the date of payment is limited to a specified maximum. Id. 30 Id. If a premium is included in the amount payable under the L.O.C., it is limited to a specified maximum. 31 Securities Act of 1933 § 5(c), 15 U.S.C.A. § 77e(c) (2006). Núm. 1 (2015) THE USE OF LETTERS OF CREDIT AS CREDIT ENHANCERS 141

suant to authority granted by the Congress of the United States; or any certifi- cate of deposit for any of the foregoing; or any security issued or guaranteed by any bank; or any security issued by or representing an interest in or a direct ob- ligation of a Federal Reserve bank . . . .32

In general, public finance transactions are exempt from the application of the 1933 Act, unless a particular section specifically states that it applies to secu- rities exempt under section 3(a)(2); therefore, municipal bonds are outside the registration requirement under section 5, since such section does not specifically incorporate into its scope the securities referred to in section 3(a)(2).33 On the other hand, section 17 of the 1933 Act sets forth the provisions of the disclosure responsibility in order to avoid fraudulent interstate transactions.34 In summary, section 17 “makes it unlawful for any person in the offer or sale of se- curities to defraud, to make an untrue statement of a material fact, to omit a material fact, or to engage in conduct having the effect of a fraud on the pur- chaser.”35 Section 17(c) specifically states that the exemptions provided in section 3 shall not apply to the provisions of this section. This means that securities clas- sified as section 3(a)(2) securities are not exempt from complying with the anti- fraud provisions of section 17. In other words, the requirements under section 5 and section 17 of the Act are independent of each other, despite their common purpose of assuring full disclosure. The result in public finance transactions is that the security is exempt from registration under section 5, but subject to the antifraud provisions of section 17.36 The term security is defined under section 2(a)(1) of the Act as:

[A]ny note, , treasury stock, security future, security-based swap, bond, de- benture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable , investment contract, voting-trust certificate, for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privi- lege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a security, or any certificate of interest or participation in, temporary or interim certificate for, re-

32 Securities Act of 1933 § 3(a)(2), 15 U.S.C.A. § 77c(a)(2) (2006 & Supp. 2014).

33 FIPPINGER, supra note 8, § 2:2, at 2-7 (“[T]his conclusion states the simple case that assumes the absence of troublesome separate securities.”). 34 Securities Act of 1933 § 17, 15 U.S.C.A. § 77q (2006 & Supp. 2014).

35 FIPPINGER, supra note 8, § 2:2, at 2-7. 36 For more information about the application of section 3(a)(2) exemption in public finance transactions, see id. § 2:2, at 2-16. 142 REVISTA JURÍDICA UPR Vol. 84

ceipt for, of, or or right to subscribe to or purchase, any of the foregoing.37

It is important to determine if a specific financial transaction is within the definition of security under section 2(a)(1) and, as such, if it will be subject to the mandatory registration requirements of section 5 or, otherwise, to the exemp- tions under section 3, as mentioned above. As you can see, the definition of secu- rity is very broad; it starts with mentioning the traditional securities (i.e. notes, , bonds, futures, puts, calls, options, etc.) and then the list goes beyond the typical securities in order to include a number of instruments that are likely to appear with “any of the foregoing.”38 In the case of L.O.C.s, in order to identify if certain L.O.C. is a security, a dis- tinction between a L.O.C. as a commercial product and a L.O.C. as a guarantee of a security needs to be made. In general, a L.O.C. transaction entails a relation between the customer of the L.O.C. bank and a third party, or the beneficiary to whom the L.O.C. bank will have to make a payment in a stated amount, and when the L.O.C. bank makes such payment to the beneficiary, it has made a loan to its customer and is entitled to repayment under a reimbursement agreement between the bank and the customer. If the relation between the customer and the beneficiary is a commercial contract, then the L.O.C. is a commercial prod- uct. But if the relation between the customer and the beneficiary is based on a debt instrument that is a security, such as municipal bonds, and the L.O.C. guar- antees the principal and payment of such a security, then the L.O.C. is defined as a security under section 2(a)(1) of the 1933 Act.39 Also, issuers of L.O.C.s are considered to be “issuers of municipal securi- ties.”40 Under rule 15c2-12 of the Securities and Exchange Commission, issuers of municipal securities means “the governmental issuer specified in section 3(a)(29)41 of the Act42 and the issuer of any separate security, including a separate

37 Securities Act of 1933 § 2(a)(1), 15 U.S.C.A. § 77b(a)(1) (2006 & Supp. 2014) (emphasis added).

38 FIPPINGER, supra note 8, § 2:3, at 2-23. 39 Id. § 2:3, at 2-32.

40 GELFAND, supra note 1, at § 5:1. 41 Securities Exchange Act of 1934 § 3(a)(29), 15 U.S.C.A. § 78c(a)(29) (2006), which defines mu- nicipal securities as: [S]ecurities which are direct obligations of, or obligations guaranteed as to principal or in- terest by, a State or any political subdivision thereof, or any agency or instrumentality of a State or any political subdivision thereof, or any municipal corporate instrumentality of one or more States, or any security which is an industrial development bond (as defined in section 103(c)(2) of Title 26) the interest on which is excludable from gross income under section 103(a)(1) of Title 26 if, by reason of the application of paragraph (4) or (6) of section 103(c) of Title 26 (determined as if paragraphs (4)(A), (5), and (7) were not included in such section 103(c)), paragraph (1) of such section 103(c) does not apply to such security. Id. 42 Refers to the Securities Exchange Act of 1934 §§ 1-39, 15 U.S.C.A. §§ 78a-78pp (2006 & Supp. 2014). Núm. 1 (2015) THE USE OF LETTERS OF CREDIT AS CREDIT ENHANCERS 143 security as defined in rule 3b–5(a)43 under the Act.”44 Since L.O.C.s that guaran- tee municipal bonds are securities, in order to be exempt from registration under the 1933 Act, they require a specific exemption under such Act and section 3(a)(2) provides such exemption when it states that “[a]ny security issued or guaranteed by any bank” is exempted.45 Therefore, banks’ L.O.C.s are exempt from the registration requirements pursuant to the 1933 Act. However, securities issued by banks, such as L.O.C.s, which are exempt by the bank clause under section 3(a)(2), are subject to the antifraud rules under section 17,46 by reason of section 17(c).47 As such, the L.O.C.s that secure municipal bonds are subject to disclosure requirements. In general, material information regarding the L.O.C.s’ terms and conditions, as well as information from the L.O.C.s banks, are re- quired to be disclosed to the municipal bonds’ investors.48 The Statement of the Commission Regarding Disclosure Obligations of Mu- nicipal Securities Issuers and Others,49 in particular, states that investors need to be informed about the nature and effects of each significant term of the debt and the L.O.C.s as credit enhancements. It also adds that municipal bond investors “should be aware of their exposure to interest rate volatility” under all possible scenarios and that “any concerning the issuer’s authority to issue secu- rities with unconventional features needs also to be disclosed.”50 The statement

43 General Rules and Regulations, Securities Exchange Act of 1934, 17 C.F.R. § 240.3b-5(a) (2014), which defines separate security as: Any part of an obligation evidenced by any bond, note, , or other evidence of indebtedness issued by any governmental unit specified in section 3(a)(12) of the Act which is payable from payments to be made in respect of property or money which is or will be used, under a lease, sale, or loan arrangement, by or for industrial or commercial enterprise, shall be deemed to be a separate security within the meaning of section 3(a)(10) of the Act, issued by the lessee or obligor under the lease, sale or loan arrangement. Id. 44 General Rules and Regulations, Securities Exchange Act of 1934, 17 C.F.R. § 240.15c2–12(f)(4) (2014); see also 15 U.S.C.A. §§ 78a-78pp (2006 & Supp. 2014). However, issuers of L.O.C.s, bond insur- ance, and other liquidity facilities are not obligated persons for purposes of the Rule 15c2-12. See 17 C.F.R. § 240.15c2–12(f)(10) (2014). 45 Securities Act of 1933 § 3(a)(2), 15 U.S.C.A. § 77c(a)(2) (2006 & Supp. 2014) (The bank clause).

46 FIPPINGER, supra note 8, § 2:2, at 2-7. 47 Id. at 8. 48 See Statement of the Commission Regarding Disclosure Obligations of Municipal Securities Issuers and Others, Securities Act Release No. 7049, Securities Exchange Act Release No. 33741, Re- lease No. FR–42, 56 S.E.C. Docket 479 (March 9, 1994). In summary, with this release the Securities and Exchange Commission published its views with respect to the disclosure obligations of partici- pants in the municipal securities markets under the antifraud provisions of the federal securities laws, both in connection with primary offerings and on a continuing basis with respect to the sec- ondary market. This interpretive guidance is intended to assist municipal securities issuers, brokers, dealers and municipal securities dealers in meeting their obligations under the antifraud provisions. 49 Id. 50 Id. at 7-8. 144 REVISTA JURÍDICA UPR Vol. 84 also declares the following regarding the disclosure obligations for credit en- hancers, which includes L.O.C.s:

The existence of bond insurance or other credit enhancement creates the need for disclosure concerning the provider of the credit enhancement and the terms of the enhancement to avoid misleading investors concerning the value of the enhancements provided and the party’s ability to fund the enhancement provid- ed and the party’s ability to fund the enhancement. The [Government Finance Officers Association] recommends that appropriate financial information about the assets, revenues, reserves and results of operations of credit enhancers be provided in the official statement. In determining the extent of disclosure, con- sideration should be given to the amount of the enhancement relative to the in- come and flows of the issuer or obligor, conditions precedent to application of the enhancement, duration of the enhancement, and other factors indicating a material relationship between the enhancement and the ’s anticipated return.51

Regarding the information about the L.O.C. bank to be disclosed in the mu- nicipal bonds’ official statements, it is important to clarify that it is not the same as the information that would be material to an investor in the bank’s stocks or debentures; this would be a bank’s disclosure obligation under a different sce- nario. Information to be included about the L.O.C. and the L.O.C. bank in the official statement shall be “sufficient if it provides the beneficiary with a basis for determining the likelihood of a draw on the being honored.”52

G. L.O.C.s vs. Bond Insurance Policies as Credit Enhancers

When an issuer wants to include a credit enhancer with its bond issue, it has to decide among different financial instruments that provide credit enhance- ment features. As mentioned before, the most common credit enhancers are L.O.C.s and bond insurance policies.53 L.O.C.s differ from the bond insurance policies in the following ways:

1. Finance charges: LOCs have periodic finance charges while, on the other hand, bond insurance premiums are ordinarily paid “in full at the time of the issuance of the bonds.”54 The periodic charges of the LOCs have its pros and cons for the issuers. Since the LOCs do not have a fixed cost, it may not be paid for completely from bond proceeds at the time of issuance. Usually only the upfront costs of an LOC, plus its costs during any construction pe-

51 Statement of the Commission Regarding Disclosure Obligations of Municipal Securities Issuers and Others, supra note 48, at 7-8.

52 FIPPINGER, supra note 8, § 2:3.2, at 2-35. 53 Bond insurance policies can be negotiated to insure the payment of the principal of and inter- est on the municipal bond, thereby, giving the issue a credit rate equal to that of the insurance com- pany.

54 GELFAND, supra note 1, § 5:7. See also FIPPINGER, supra note 8, § 8:11.1, at 8-168. Núm. 1 (2015) THE USE OF LETTERS OF CREDIT AS CREDIT ENHANCERS 145

riod, may be paid from bond proceeds. Also, commonly the LOCs finance charges are subject to escalation due to changes in law or banking regula- tions.55 Second, if the issuer calls the bonds on their first redemption date or issues an advance refunding prior to that date, the issuer will not have to continue paying the LOC finance charges, unlike a bond insurance premi- um, in which case the issuer cannot recover the unused bond insurance premium that was paid up front with the bond proceeds, unless the insur- ance company is willing to provide a refund.56 2. Period covered: Normally, LOCs don’t extend to more than ten years, the most likely periods going from one to seven years, while bond insurance policies remain in force during the entire period that the bonds are out- standing.57 Issuers with bonds secured by LOCs will be concerned with the renewal or substitution of their LOCs, or will face possible redemption of the bonds and accelerated repayment schedule if the LOCs are not renewed or substituted.58

Therefore, when the issuer decides to use a L.O.C. instead of a bond insur- ance policy to guarantee a bond issue, the different characteristics of these in- struments and their effects should be considered. This includes the length of the time period in which the bond is going to be outstanding, how it would be best to pay for the finance charges, plans to make a redemption before the expiration date of the bond, and the consequences in an event of a default.

II. MARKET SUMMARY AND STATISTICS OF MUNICIPAL BONDS ISSUED WITH L.O.C.S

As mentioned before, the use of L.O.C.s to guarantee municipal bonds was very popular from 2000 to 2007, but the L.O.C. market has declined since the Financial Crisis in 2008, the L.O.C.s market has declined.59 Based on the statis- tics provided by Thomson Reuters for the municipal bonds market in the United States (including Puerto Rico), in 2008 the use of L.O.C.s in bond issues was still increasing, and it was in 2009 that the market faced a significant decline. In 2007, the number of bond issues that included L.O.C.s was 1,048, with a total amount of $20,732,300,000 guaranteed by L.O.C.s, while in 2008, there were 1,412 bond issues backed with L.O.C.s guaranteeing a total amount of $70,708,900,000, representing an increase of 241.1% from 2007.60 Then, in the following year, there were 486 bond issues that were backed with L.O.C.s, guar- anteeing a total amount of $20,177,300,000, for a decrease of approximately 71.8%

55 GELFAND, supra note 1, § 5:7. 56 Id. 57 Id. 58 Id.

59 U.S. SECURITIES AND EXCHANGE COMMISSION, supra note 9.

60 Michael Scarchilli, Bond Insurers Go Off the Cliff, and LOCs Take Up Some Slack, THE BOND BUYER’S ANNUAL REVIEW: 2008 IN STATISTICS, Feb. 9, 2009, at 10A. 146 REVISTA JURÍDICA UPR Vol. 84 from the previous year 2008.61 In 2010, the amount of bond issues that included L.O.C.s continued to decline, this time by 41.6% from the previous year.62 However, in 2011, the market experienced a small increase in the amount of bonds issued with L.O.C.s. During the year 2011, there were 182 bonds issued with L.O.C.s, for a total backed amount of $13,160,300,000, which is an 11.4% in- crease from the total amount in 2010.63 But in 2012, the L.O.C. backed bonds saw a decline of 38.6% from 2011.64 The L.O.C. backed bonds for that year totaled 115 issues worth $6,076,700,000. It is important to note that the biggest providers of L.O.C.s have changed over the years. The top L.O.C. providers in the past five years have been (in de- scending order):65

TABLE 1. TOP L.O.C. PROVIDERS 2008-2012

Year Top L.O.C.s Providers 200866 1. Bank of America 2. JPMorgan Chase Bank 3. Wachovia Bank 4. Dexia Group 5. US Bank 200967 1. JPMorgan Chase Bank 2. US Bank 3. Wells Fargo Bank 4. Bank of America 5. SunTrust Bank 201068 1. JPMorgan Chase Bank 2. Bank of America 3. Wells Fargo Bank 4. Barclays Bank 5. PNC Bank 201169 1. Citibank

61 Christine Albano, Spreads, THE BOND BUYER’S ANNUAL REVIEW: 2009 IN STATISTICS, Feb. 8, 2010, at 8A. 62 The number of issues with L.O.C.s in 2010 was 251, for a total backed amount of $11,942,100,000. Dan Seymour, Giving Credit Where It’s Due: LOCs See Shrinkage, THE BOND BUYER’S ANNUAL REVIEW: 2010 IN STATISTICS, Feb. 14, 2011, at 7A.

63 THE BOND BUYER’S ANNUAL REVIEW: 2011 IN STATISTICS, Feb. 13, 2012, at 14A.

64 THE BOND BUYER’S ANNUAL REVIEW: 2012 IN STATISTICS, Feb. 11, 2013, at 6A. 65 Ranked by the enhanced amount of the L.O.C.s. 66 Scarchilli, supra note 60. 67 Albano, supra note 61. 68 Seymour, supra note 62.

69 THE BOND BUYER’S ANNUAL REVIEW: 2011 IN STATISTICS, supra note 63. Núm. 1 (2015) THE USE OF LETTERS OF CREDIT AS CREDIT ENHANCERS 147

2. JPMorgan Chase Bank 3. Wells Fargo Bank 4. Bank of America 5. Government Development Bank of Puerto Rico 201270 1. US Bank 2. Wells Fargo Bank 3. PNC Bank 4. Citibank 5. Royal Bank of Canada

As you can see, the JPMorgan Chase Bank, Bank of America, Wells Fargo Bank, and the US Bank have been constantly in the list of top providers of L.O.C.s over the past five years. Also, another important fact is that the Govern- ment Development Bank of Puerto Rico (G.D.B. of P.R.) was ranked as the fifth top L.O.C. provider in the year 2011. The G.D.B. of P.R. provided a L.O.C. to se- cure a issued by the Puerto Rico Infrastructure Financing Authori- ty (hereinafter, “P.R. Financing Authority”) on December 16, 2011, in the amount of $669,215,000. This bond issue was ranked as the fourth largest L.O.C. issued in 2011 in the United States.71 More information regarding the G.D.B. of P.R.’s L.O.C. with the P.R. Financing Authority’s bond issue will be further discussed.

III. COMMONWEALTH OF PUERTO RICO’S BONDS ISSUED WITH L.O.C.S IN THE PAST TEN YEARS

The information used for this study was acquired from the official state- ments of the municipal bonds issued by the Commonwealth of Puerto Rico, in- cluding its agencies and instrumentalities (hereinafter, all together, the “Com- monwealth of P.R.”), which is available at the G.D.B. of P.R. website.72 Of the municipal bonds issued by the Commonwealth of P.R. in the past ten years, only seven bonds were issued with L.O.C.s securing the payments of principal and interest.73 Of these, seven L.O.C.s backed municipal bonds, five were issued be- tween 2005 and 2008, and the other two were issued in 2011.

70 THE BOND BUYER’S ANNUAL REVIEW: 2012 IN STATISTICS, supra note 64.

71 THE BOND BUYER’S ANNUAL REVIEW: 2011 IN STATISTICS, supra note 63.

72 Investor Resources, GOVERNMENT DEVELOPMENT BANK FOR PUERTO RICO, http://www.gdb-pur .com/investors_resources/exempt-securities.html (last visited Sep. 5, 2014). 73 These bonds are: (a) Commonwealth of Puerto Rico Tax and Revenue Anticipation Notes, Series 2006 (Dec. 22, 2005); (b) Commonwealth of Puerto Rico Public Improvement Refunding Bonds, Series 2007A-6, A-7, A-8, and A-9 (General Obligation Bonds) (Oct. 16, 2007); (c) Common- wealth of Puerto Rico Tax and Revenue Anticipation Notes, Series 2008 (Oct. 18, 2007); (d) Com- monwealth of Puerto Rico Public Improvement Refunding Bonds, Series 2008 A and B (General Obligation Bonds) (Apr. 25, 2008); (e) Commonwealth of Puerto Rico Tax and Revenue Anticipation Notes, Series 2009A (Nov. 7, 2008); (f) Commonwealth of Puerto Rico Public Improvement Refund- ing Bonds Sub-Series 2003 C-5-2 (General Obligation Bonds) (June 16, 2011), and (g) Puerto Rico 148 REVISTA JURÍDICA UPR Vol. 84

In general, the L.O.C.s used in these bonds are backing a total principal amount of $4,172,075,000. Of those, $562,685,000 are variable-rate general obli- gation bonds,74 and $3,609,390,000 are fixed-rate revenue bonds.75 As mentioned before, in the municipal , L.O.C.s are commonly used to secure var- iable-rate bonds. In the case of the bonds issued by the Commonwealth of P.R., it seems that L.O.C.s are used more to secure fixed-rate bonds instead of varia- ble-rate bonds.

A. Forms of L.O.C.s Used and Other Provisions

In all of the seven L.O.C.s-backed bonds issued by the Commonwealth of P.R., the form of L.O.C.s used is the irrevocable direct pay. This means that L.O.C. banks are the first source of repayment of bonds, and pay the amount represented by each interest payment and each installment of principal directly to the beneficiaries or trustee.76 Also, in all of the L.O.C.s-backed bonds, the Commonwealth of P.R. is obligated, under a reimbursement agreement, to im- mediately reimburse the amount of each payment to the L.O.C. banks. Moreover, some of these bonds were secured by L.O.C.s issued by more than one bank. Take for example the fixed-rate revenue bond issued on October 18, 2007, with a principal amount of $1,010,000,000, which has a syndicate of seven banks that are issuing the irrevocable direct pay L.O.C. on a several basis, not joint basis.77 In this case, the Official Statement discloses the names of the L.O.C. banks, the maximum amount of their several payment obligations under the L.O.C., the corresponding amount of interest that will accrue on such amounts until the bonds’ maturity date, and the percentage of their several payment obli-

Infrastructure Financing Authority Revenue Bonds (Ports Authority Project), Series 2011 A, B, and C (Dec. 16, 2011). Id. 74 A general obligation bond is an ; the source of security for the holder of a gen- eral obligation debt is the constitutional, statutory, or charter procedures imposed on the issuer of the debt. Frequently, general obligation bonds contain a pledge of the full faith and credit of the issuer; this is a commitment by the issuer to avail itself of its revenue-producing powers to raise amounts sufficient to pay the principal of and interest on the bonds or notes. See FIPPINGER, supra note 8, § 1:6.1, at 1-68. Normally, the Official Statements of the general obligation bonds of the Com- monwealth of P.R. contains a paragraph stating that the good faith, credit and taxing power of the Commonwealth are irrevocably pledged for the prompt payment of the principal and interest on the bonds; and that the Constitution of Puerto Rico provides that public debt of the Commonwealth constitutes a first claim on available Commonwealth resources. See any of the Official Statements of a general obligation bond at supra note 74. 75 A revenue bond is a limited obligation, since it is limited to a specifically identified source of revenue that is pledged for the payment of the principal of and interest on the bond. In a revenue bond, the source of repayment of the bond is limited to a specified fund of revenues set aside. See FIPPINGER, supra note 8, § 1:6.2, at 1-69.

76 GELFAND, supra note 1. 77 See the Official Statement for the Commonwealth of Puerto Rico Tax and Revenue Anticipa- tion Notes, Series 2008 (Oct. 18, 2007). Investor Resources, GOVERNMENT DEVELOPMENT BANK FOR PUERTO RICO, http://www.gdb-pur.com/investors_resources/commonwealth.html (last visited Sep. 5, 2014). Núm. 1 (2015) THE USE OF LETTERS OF CREDIT AS CREDIT ENHANCERS 149 gations under the L.O.C.78 Also, in this case, a description of each of the L.O.C. banks was provided as an appendix.79 Note that not all of the official statements of the municipal bonds with L.O.C.s provide a description of the L.O.C. banks, something that is required under the disclosure provisions of the 1933 Act and the Securities Act Release No. 7049, as previously mentioned. Regarding other information disclosed about the L.O.C.s, all of the official statements include the name of the institution authorized to present a draw on the L.O.C.s, this is the trustee or paying agent assigned, which in most cases is Banco Popular of Puerto Rico. Also, all of the official statements disclose the expiration date and time of the L.O.C.s. On the other hand, not all of the official statements provide the Form of Letter of Credit as an appendix; but some of the ones that do provide it, also include a Drawing Certificate in blank as appendix, which is the document that needs to be completed by the trustee to demand the payment of principal of, and interest on, the bond.80 As for the effect of the credit enhancement feature that provides the L.O.C.s to the bond issue, some of the official statements include the bond’s rating tak- ing in the strength of the L.O.C. that secures such bond, and also provide the ratings for the Commonwealth of P.R. By disclosing both ratings for the bond, backed by the L.O.C. and the Commonwealth, an investor can see and analyze the effect of the credit enhancement feature that the L.O.C. provides. An example of this is the ratings information included in the Official Statement of the Commonwealth of P.R., Public Improvement Refunding Bond Sub-Series 2003 C-5-2 of June 16, 2011, which states that the bond was assigned a long- term/short-term rating of Aa1/VMIG-1. The L.O.C. provider was rated Aa3/P-1 and the Commonwealth was rated A3, as stated by Moody’s.81 It also states that “[a]ny change in the long-term rating of either the Provider or the underlying rating of the Commonwealth or any change in the default dependence between the two, as determined by Moody’s, will result in the long-term rating being reevaluated.”82

78 Id. at 7. 79 Id. at app. III. 80 The Official Statements that do include the Form of Letter of Credit as part of the appendixes are: (a) the Commonwealth of Puerto Rico Tax and Revenue Anticipation Notes, Series 2008 (Oct. 18,2007), see Appendix I; (b) the Commonwealth of Puerto Rico Tax and Revenue Anticipation Notes, Series 2009A (Nov. 7, 2008), see Appendix I (includes Drawing Certificate), and (c) the Puerto Rico Infrastructure Financing Authority Revenue Bonds, Series 2011 A, B, and C (Dec. 16, 2011), see Appen- dix C (includes Drawing Certificate). Investor Resources, GOVERNMENT DEVELOPMENT BANK FOR PUERTO RICO, http://www.gdb-pur.com/investors_resources/exempt-securities.html (last visited Sep. 5, 2014). 81 Official Statement for the Commonwealth of Puerto Rico Public Improvement Refunding Bonds, Sub-Series 2003 C-5-2 (General Obligation Bonds) (June 16, 2011). Commonwealth of Puerto Rico, GOVERNMENT DEVELOPMENT BANK FOR PUERTO RICO, http://www.gdb- pur.com/investors_resources/commonwealth.html (last visited Sep. 5, 2014). 82 Id. at 44. 150 REVISTA JURÍDICA UPR Vol. 84

In addition, some official statements provide detailed information about the reimbursement agreement between the issuer and the L.O.C. bank, pursuant to which the issuer is required to reimburse the L.O.C. bank or provider for the drawings made under the L.O.C.83 It defines what constitute an event of default under the reimbursement agreement and what happens upon the occurrence of such an event. Normally, an event of default includes, among other things, a default in payment due when any of the payments required to be made by the Commonwealth for reimbursement to the L.O.C. provider of any drawings or any other amount owed is missed, and such default continues for a period of ten business days after the L.O.C. provider has given notice to the Commonwealth that such amount is due. In the occurrence of an event of default, the L.O.C. bank may, upon notice to the trustee and the Commonwealth, among other ac- tions, requires a mandatory tender and purchase of all the bonds, thereby caus- ing the L.O.C. to terminate. The L.O.C. may also declare all amounts payable to the L.O.C. provider by the Commonwealth, under the reimbursement agree- ment, immediately due and payable. All of the stated possible actions upon oc- currence of an event of default are up to the L.O.C. bank’s discretion. However, there was a special scenario under the reimbursement agreement between the Puerto Rico Ports Authority (hereinafter, “P.R. Ports Authority”) and the G.D.B. of P.R. on the revenue bonds issued by the PR Infrastructure Fi- nancing Authority in the amount of $669,215,000 on December 16, 2011.84 These bonds were secured by two irrevocable, transferable direct pay L.O.C.s issued by the G.D.B. of P.R.,85 and the reimbursement agreement states that the bonds are not subject to acceleration upon a payment default by the P.R. Ports Authority.86 As such, a default by the P.R. Ports Authority, under the reimbursement agree- ment, does not constitute an event of default. This provision is contrary to the

83 The Official Statements that provide detailed information about the Reimbursement Agree- ment are: (a) Commonwealth of Puerto Rico, Public Improvement Refunding Bonds, Series 2007 A-6, A-7, A-8, and A-9 (Oct. 16, 2007); (b) Commonwealth of Puerto Rico Public Improvement Refunding Bonds, Series 2008 A and B (Apr. 25, 2008); (c) Commonwealth of Puerto Rico Public Improvement Refunding Bonds, Sub-Series 2003 C-5-2 (June 16, 2011), and (d) Puerto Rico Infrastructure Financing Authority Revenue Bonds (Ports Authority Project), Series 2011 A, B, and C (Dec. 16, 2011). Investor Resources, GOVERNMENT DEVELOPMENT BANK FOR PUERTO RICO, http://www.gdb- pur.com/investors_resources/exempt-securities.html (last visited Sep. 5, 2014). 84 The P.R. Financing Authority loaned the proceeds from the sale of these bonds to the P.R. Ports Authority in order to prepay certain indebtedness of the P.R. Ports Authority. See the Official Statement for the Puerto Rico Infrastructure Financing Authority Revenue Bonds (Ports Authority Project), Series 2011 A, B, and C (Dec. 16, 2011), Plan of Financing at 9. Puerto Rico Infrastructure Financing Authority (PRIFA), GOVERNMENT DEVELOPMENT BANK FOR PUERTO RICO, http://www.gdb- pur.com/investors_resources/prifa.html (last visited Sep. 5, 2014). 85 Note that the Official Statement discloses the following under the Risk Factors section: “[t]he Bonds are being offered solely on the financial capacity of Government Development Bank as Issuer of the GDB Letter of Credit and not on the financial capacity of the Ports Authority or any other security, other than the GDB Letter of Credit.” Id. at 6. 86 Id. at 6, 20; see also id. app. D. Núm. 1 (2015) THE USE OF LETTERS OF CREDIT AS CREDIT ENHANCERS 151 actions taken by L.O.C. providers upon the occurrence of an event of default, under reimbursement agreements of the other bond issues.

CONCLUSION

The use of L.O.C.s as credit enhancers for municipal bonds is relatively new (considering the history of L.O.C.s in general) and not commonly analyzed and written about by scholars specialized in this area of study. However, the use of L.O.C.s is not strange to the municipal bond market, which has dealt with L.O.C.s since the early 1980s, and still does. Also, L.O.C.s are not foreign to the Commonwealth of P.R.’s bond market, which, in a lesser way compared to the statistics from the states of the Union, has taken advantage of the credit en- hancement feature that the L.O.C.s has offered in some of its bonds. The amount of L.O.C.s guaranteeing municipal bonds is decreasing every year and it seems that it will be very difficult for L.O.C.s, as credit enhancers, to become as popular as they were before the 2008 financial crisis. As long as banks’ credit ratings continue to be low or downgraded by the credit rating agencies, the L.O.C.s, as credit enhancers, will not be attractive to issuers of municipal bonds. Moreover, the banks are also reluctant to issue L.O.C.s to governments, therefore, making it harder for the amount of municipal bonds issues with L.O.C.s to increase in the next few years.87

87 There is an ongoing dispute between the Government of Puerto Rico and different bond credit rating agencies on the effects of the Recovery Act, a recent legislation that allows public corporations to restructure their debt with bondholders. See Law for Compliance with and Recovery of Public Corporations of Puerto Rico, P.R. Pub. L. 71 (2014), http://www.oslpr.org/2013- 2016/leyes/pdf/ley-71-28-Jun-2014.pdf; see also Garcia Padilla’s Administration Presents Bill for the and Recovery of Public Corporations Law, LA FORTALEZA (June 25, 2014), http://www.fortaleza.pr.gov/node/644 (last visited Sep. 5, 2014). Véase Franklin Cal. Tax-Free Trust v. Commonwealth of P.R., 2015 WL 522183 (D.P.R. Feb. 6, 2015), appeal docketed, No. 14-1518 & No. 15- 1221 (1st Cir. Feb. 18, 2015).