Issuers that have refunded outstanding Build America Bonds or have plans to do so using an extraordinary redemption provision may have legal backing, regardless of whether bondholders are “unhappy” with the deals, according to the largest bond counsel in the industry.
Chas Cardall, a tax partner at Orrick, the bond counsel that worked on the recent Regents of the University of California deal
Cardall declined to comment on the specific deal, but he said the issuers undertaking these transactions should be “pretty sure they’re right.”
A group of bondholders last week told the bond trustee that they believe “unequivocally” 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.”
Bank of New York Mellon, the trustee on the deal, “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 in a letter.
Orrick declined to comment on the letter, but Cardell said the action will cause market participants to “sit up and take notice” and realize there may be some pushback, even if it’s “superficial.”
“The fact that it’s become something contentious probably slows things down and makes people more cautious,” Cardall said.
However, he said he doesn’t know whether the action by the bondholders will change issuers’ minds. Issuers, he noted, have been “very upset” by the federal government reneging on its promised subsidy.
Cardall added all of this is “fairly nuanced,” as the language in each document can be different.
Reaction from market participants has been mixed on how issuers and the market will proceed.
Some, including Barclays and J.P. Morgan strategists, believe the bondholders’ letter may keep some issuers on the sidelines, with the former noting the BABs refunding this trend could end up being “short-lived.”
J.P. Morgan has identified 16 issuers that have either called BABs via their ERP, posted call notices, or announced consideration of calls, since 2023.
After last week’s developments, Barclays strategists noted in a Friday report that “it is not even clear if many issuers will continue refunding BABs through [ERPs] or if this trend will turn out to be short-lived.”
Barclays said that concerns about the validity of calling BABs through ERPs for most issuers could “keep some of them on the sidelines.”
They noted their previous estimate of nearly $30 million of BAB refundings might be “quite optimistic.”
J.P. Morgan strategists said this action from the bondholders “may give issuers additional reason for pause when vetting similar refundings.”
Prior to the bondholders’ actions, they said there could be $30 billion to $60 billion of BAB bonds outstanding that achieve adequate savings, but “at a minimum, court challenges will delay some BAB ERP calls.”
Given a 5% “shift higher” in ratios, around $15 billion of outstanding bonds, down from around $30 billion, provide 5% or higher savings, while approximately $30 billion, down from around $55 billion, provide 3% or greater savings, according to J.P. Morgan strategists.
“All else equal, putting legal challenges aside, this would suggest BAB ERP refunding in the $15 billion to $30 billion range,” they said.
A lawyer unaffiliated with this action said issuers may “get some questions” from their investors, but she does not believe this is enough to stop deals from proceeding.
She noted the action may urge caution for due diligence and provide extra scrutiny than it otherwise would.
Additionally, Barclays strategists noted there remains a “sizable universe of issuers with weaker ERP language that might proceed with refundings regardless, if it makes economic sense for them.”
Until recently, most BAB issuers had yet to be exercised due to economics, said Vikram Rai, head of municipal markets strategy at Wells Fargo, in a report from late January.
While the issuer could, in theory, realize long-term savings by “calling these bonds and refunding them at lower rates, the upfront cost made it prohibitive,” he said.
In instances when the ERP language “enabled issuers to call the bonds at par or only at a slight premium, exercising the ERP call made sense and thus issuers did so,” Rai said.
Due to higher interest rates, the bond prices are trading closer to par, meaning it makes economic sense for the ERP call, especially for shorter maturity securities, he said.
The crux of the matter in the Regents of the University of California’s case stems from what constitutes an “extraordinary event.”
Several market participants received “favorable guidance” to proceed with refunding outstanding BABs through ERPs following a recently concluded court case,
The court case supports the conclusion that sequestration “resulted in a materially adverse change to the cash subsidy payment obligation,” they said.
BABs were issued with the idea that the subsidy was promised, but the 35% subsidy has been reduced multiple times through sequestration. The current sequestration rate stands at 5.7%.
However, the investors argue in the letter that sequestration does not constitute an “extraordinary event,” which can only happen if there is a change to the Internal Revenue Code.
“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.”