THE USE OF LETTERS OF CREDIT 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 Credit Enhancement 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. Bond Insurance 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 FINANCIAL INSTRUMENT USED TO IMPROVE THE creditworthiness of a borrower in the issuance of a security or other A type of financing transaction. The purpose of using a credit enhancer is to reduce the credit risk in the transaction by guaranteeing lenders or inves- tors full and timely payments. 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/Accounting 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 Tax 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 banks, 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 municipal bond, 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 indenture or bond resolution authorizing the issuance of the bonds.”2 The trus- tee will have a claim against the bank 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 investors 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 DEBT FINANCING § 5:1 (2011). 2 Id. 3 Id. 4 Id. 5 Id. 6 JOEL A. MINTZ ET AL., FUNDAMENTALS OF MUNICIPAL FINANCE 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 interest-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 coupon, and vari- able rate bonds. Fixed rate municipal securities pay a fixed interest rate over the term of the security; zero coupon bonds pay the accrued interest only on the maturity 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 long-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 short-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 option 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 PUBLIC FINANCE § 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 guarantees 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.