Second Circuit Rules Against Make-Whole Premium for Refinancing of Accelerated Debt


The U.S. Court of Appeals for the Second Circuit has upheld a bankruptcy court’s decision enforcing indenture language providing for the automatic acceleration, without make-whole premium, of secured American Airline, Inc. notes upon American Airline Inc.’s bankruptcy filing.  The Second Circuit’s September 12 opinion generally follows that of the lower court, discussed in our February 20, 2013 blogpost, and likewise holds that the subsequent refinancing of the accelerated notes did not convert the acceleration into a voluntary redemption on which a make-whole premium would have been due.

The Second Circuit’s opinion does not hold that make-whole premiums are unenforceable in bankruptcy, it merely applies express language in a particular indenture stating that the make-whole premium is inapplicable to an acceleration upon bankruptcy.  Accordingly, creditors that wish to preserve the possibility of obtaining a makewhole premium (or other type of prepayment premium) if their debt is repaid in bankruptcy should insist upon express indenture language to the effect that a make whole premium (or other premium) is due upon acceleration.  Whether or not a court would enforce such a premium is left unaddressed by the Second Circuit ‘s decision; however, the opinion aligns the Second Circuit with courts that have held that automatic acceleration upon bankruptcy clauses in debt instruments are enforceable, because the bankruptcy code’s proscription on the enforcement of so-called ipso facto clauses triggered by bankruptcy applies only to executory contracts, and debt instruments are not executory.


Ballot Initiative Petitions Filed Seeking Operating Margin Limits on Massachusetts Hospitals

A series of alternative proposed Initiative Petitions were filed Thursday, August 7, with the Office of the Attorney General of Massachusetts (the “AGO”) seeking primarily to establish specified limits on operating margins achieved by many Massachusetts hospitals and on the compensation of the CEOs of such hospitals.  Details are described in the following Public Finance Alert:

Valuing Advance Refundings

Advance refundings may be an appropriate target for the semi-jocund question, "sure it works in practice... but does it work in theory?"  A recent study of approximately 150,000 transactions which concluded that advance refundings "destroy value" is reviewed and critiqued in the following commentary featured in The Bond Buyer

Constitutionality of Detroit's Emergency Manager Challenged


Within days of Kevyn Orr’s appointment as Detroit’s Emergency Manager, a group of elected officials, union representatives, civil rights activist and clergy brought a lawsuit against Gov. Rick Snyder and Treasurer Andy Dillon in federal court, challenging the constitutionality of Public Act 436.  As previously posted, under Public Act 436, an emergency manager (an “EM”) has extraordinary powers over the municipality, including the power to break or modify union contracts; however, any plan implemented by an EM may not attempt to modify debt service payments on public debt. 

The Complaint asserts that Public Act 436 is an unconstitutional encroachment in the due process right of an elected, republic form of government.   The plaintiffs also contend that the new law establishes a “new form of government in Michigan” and citizens “will have effectively lost their right to vote”, which is in violation of the 1965 Voting Rights Act because it disenfranchises voters. 

A link to the Complaint may be found here.

IRS Ruling Treats Certain 529 Account Incentive Payments as Reportable Income


The IRS recently issued a private letter ruling, PLR 201310043 (released on March 8, 2013), of interest to Section 529 plans and their program managers. The ruling relates to the tax treatment of incentive contributions to 529 accounts and was issued in response to a ruling request by a financial services complex described as including a bank and broker. The firm requested guidance on tax reporting of incentive payments credited by the firm to 529 accounts established through the firm. The firm credited the incentive payments directly to the owner’s account when a 529 account owner funded a specified minimum to the account within 30 days of opening the account and maintained that balance for a minimum of 90 days.

The ruling concluded that such incentive payments are properly characterized as a payment by the financial services firm to its client, followed by a contribution by the client to its 529 account. This recharacterization of the transaction from one to two steps avoided the potential applicability of Section 529(c)(2) of the Code, which treats “any contribution to a qualified tuition program on behalf of a designated beneficiary … as a completed gift to such beneficiary…”, and the ruling emphasized that the payment constituted “non-gift funding.” Accordingly, the IRS ruled that the payment was income received by account owner and that, if such income exceeded $600 in one year, the firm was required to report the payment to the IRS and the recipient.

The ruling declined to characterize the incentive payment as non-reportable income on a 529 account, stating that the payment “is paid by you of your own accord as a bank and brokerage, and not by or on behalf of [the] State as an establisher and maintainer of a [qualified tuition program.]” Accordingly, the ruling does not address state matching or incentive programs in which money is contributed to an account by the 529 program sponsor rather than by its program manager or another third party entity. The ruling also does not address contributions of credit card “rewards” to 529 accounts; such “rewards” typically are treated as discounts on the purchase price of the charged item, rather than as income.

AMR Decision Highlights Bankruptcy Court Split on Enforceability of Ipso Facto Clauses


A recent ruling in the American Airlines bankruptcy case enforcing an automatic acceleration upon bankruptcy provision serves as a reminder that the enforceability of so-called ipso facto provisions in debt instruments remains an unsettled, forum-dependent question.      

In the American Airlines case, the question of the enforceability of an automatic acceleration upon bankruptcy provision arose in an unconventional context: the invalidity of the provision was argued not by the debtor but by the indenture trustee.  The issue in dispute was whether a refinancing of certain taxable debt would require the debtor to pay (i) a make-whole premium due upon an optional redemption of the debt or (ii) par per the indenture provisions automatically accelerating the debt at par upon a bankruptcy.  The U.S. Bankruptcy Court for the Southern District of New York held that the automatic acceleration provision had been triggered and controlled the amount due, so that the amount payable to satisfy the debt would be par, not par plus the make-whole premium.  The indenture trustee is in the process of appealing the court’s ruling, which also involved an interpretation of a specialized Bankruptcy Code provision relating to debt secured by aircraft.   .

The indenture trustee argued that the automatic acceleration upon bankruptcy provision in the indenture should be disregarded as an invalid ipso facto clause. The court disagreed, quoting the language of Section 365(e)(1) of the Bankruptcy Code, which precludes enforcement of contractual modifications triggered by a bankruptcy only if the relevant contractual provisions are located in “an executory contract or unexpired lease of the debtor.”  As all parties agreed that the applicable debt instruments were neither executory contracts nor leases, the court found no basis for invalidating the ipso facto acceleration provisions in such debt instruments.

The federal bankruptcy court in New York declined to follow a 2012 decision by a federal bankruptcy court in Delaware in the W.R. Grace bankruptcy that the prohibition of ipso facto clauses is not limited to the specific types of instruments referenced in Section 365(e)(1).  The New York court found precedents in other Southern District of New York bankruptcy cases more persuasive than the reasoning in In re W.R. Grace & Co., and also distinguished the W.R. Grace holding on the facts.

Except in special circumstances such as the ones presented in the American Airlines case, the enforceability or unenforceability of an automatic acceleration upon bankruptcy clause in a debt instrument should not make much of a difference to litigants, as generally debt is accelerated for claim purposes upon a filing in any event.  However, the potential enforceability in at least some jurisdictions of bankruptcy-triggered provisions in debt instruments may encourage creditors to require other types of ipso facto provisions in debt documents just in case they prove both enforceable and beneficial to such creditors in the event the borrower becomes a bankruptcy debtor.

Securities Regulators Provide Good News, Not-so-Good News for Section 529 Programs


Municipal securities regulators this week provided previews of upcoming regulatory action that suggest that one issue of concern to Section 529 college savings programs will fade away while another one may appear on the horizon.  

In Valentine's Day testimony for the Senate Banking Committee, SEC Chairman Elisse Walter provided what may be the nail in the coffin regarding the SEC's suggestion in proposed regulations issued in 2010 that appointed board members of municipal issuers, including state issuers of Section 529 program municipal fund securities, might be obligated to register as municipal advisors.  After receiving a proliferation of comment letters from state issuers and their associations, the SEC has gradually retreated from that controversial position. Chairman Walter's testimony confirms that the final regulations will contain a registration exception for appointed as well as elected board members of public sector issuers.

On another front, recent surveys by FRC (a division of Strategic Insight) regarding sales of Section 529 program investments received attention in the Section 529 community this week, including from an MSRB representative whose pronouncements were less warmly received than Commissioner Walter's.  The surveys indicate that approximately 60% of brokers and financial advisors discourage their customers from purchasing Section 529 securities through the applicable broker/advisor and encourage such customers to purchase no-load shares directly from a Section 529 program offering such shares.  This conduct is motivated by a variety of considerations, including that no-load shares in one Section 529 program may outperform, due to their lower expenses, advisor-sold shares in a different (or the same) Section 529 program, as well as the potential availability of state tax advantages if the no-load shares are offered by a Section 529 program sponsored by the state in which the purchaser resides. 

The prioritization by a healthy majority of brokers of the customer’s financial interest over the broker’s short-term interest in a sales commission is heartwarming news.  But such brokers may well think that no good deed goes unpunished.  At a College Savings Foundation conference earlier this week, a MSRB representative stated that this trend may motivate the MSRB to issue guidance to the effect that such broker conduct might involve a “recommendation” by the applicable broker that would implicate MSRB Rule G-19’s suitability determination requirements and supervisory procedures. 

Alarm bells have started to ring, both from brokers regulated by the MSRB and to some extent from state sponsors of Section 529 programs that fear that regulation of such non-sales by brokers may motivate some brokers to steer clear of Section 529 programs entirely.

However, what constitutes a “recommendation” is a highly fact-based determination, and what constitutes a recommendation of a particular security is a particularly complicated question in the context of Section 529 programs, which offer multiple investment choices involving a variety of asset classes.  If the MSRB does eventually issue guidance on this point, experience suggests it will be nuanced and responsive to industry input, and that it will remain feasible for a broker to advise a customer against purchasing a Section 529 security through that broker given the availability of no-load direct-sold 529 program shares without triggering suitability review, provided the emphasis is placed on the generic benefit of lower expenses versus the particular virtues of a particular Section 529 program investment.      



SEC Comforts Appointed Board Members of Municipal Issuers on Valentine's Day


On February 14, 2013, SEC Chairman Elisse Walter at long last indicated, in testimony for the Senate Banking Committee, that the SEC’s final regulations regarding “municipal advisors” will “address ,,, the need for an exception” to the definition of “municipal advisor” for appointed board members of municipal securities issuers.  This acknowledgment came more than two years after the firestorm ignited by the SEC’s suggestion in proposed regulations issued December 20, 2010 that appointed board members of issuers of municipal securities were or might be required to register as “municipal advisors,”  That suggestion provoked a substantial share of the over 1,000 comment letters received by the SEC on the proposed regulations.

The SEC’s final regulations have not yet been issued and the phrasing of the exception remains to be seen.  However, Chairman Walter’s testimony is consistent with the conclusion long since reached by most municipal market participants that the SEC’s interpretation of the Dodd-Frank legislation as requiring or potentially requiring registration as municipal advisors by non-elected board members who provide input relating to issuance of municipal securities in the course of their board duties was an overreach that would not be implemented.  For board members appointed to municipal bond issuers or to issuers of state-sponsored Section 529 program municipal fund securities, Chairman Walter’s pronouncement is as close to a valentine as the SEC dispenses.


MSRB Proposes Rule G-47 on Time of Trade Disclosure Obligations


MSRB Rule G-17 has been interpreted by the MSRB as requiring a broker or dealer (“broker”) to  disclose to its customer, at or prior to the time of trade of a municipal security, all material information about the transaction known by the broker, as well as material information about the security that is reasonably accessible to the market.  On February 11, 2013, the MSRB issued a notice of its proposal to consolidate some, but not all, of its multiple interpretive notices relating to the Rule G-17 “time of trade disclosure obligation” in a new Rule G-47.

The proposed rule is not intended to alter the substance of a broker’s time of trade disclosure obligation, merely to make it easier to locate that substance in rule form rather than by reviewing a collection of G-17 interpretive notices previously issued by the MSRB, some of which deal with unrelated topics, as G-17 is a fair dealing rule of wide scope.  Facilitating the finding and reviewing of applicable legal requirements is a sensible goal, and it seems unlikely that there will be significant opposition to MSRB’s objective in proposing the “new” rule.

As is generally the case with any attempt to consolidate or summarize, comments on the proposed rule, which are due by March 12, 2013, are likely to focus on what is left out of the rule and on requests for clarification of items that have been unclear under the G-17 interpretations and remain unclear under the proposed rule.

A few preliminary observations on potential improvements to the proposed rule:

  • The Rule G-47 disclosure obligation would apply to purchases and sales between a broker and its customer, whether unsolicited or recommended, and whether in a primary offering or secondary market transaction.  However, prior interpretations deem the time of trade disclosure obligation automatically satisfied if the customer is a “sophisticated municipal market professional” or “SMMP”.  This important exception deserves to be called up from the minor leagues of interpretation to the major leagues of the new rule.
  • Rule G-47 provides a non-exhaustive list of potentially material information that must be disclosed by a broker at or prior to sale or purchase, but, beyond noting that such information may be provided “orally or in writing”, appears deliberately vague about permissible mechanisms for delivering material information.  Rule G-47 indicates that the public availability of material information through EMMA or other established industry sources does not relieve brokers of their obligation to make the required time of trade disclosures to a customer, and that a broker may not satisfy its disclosure obligation by directing a customer to an established industry source.  Though unstated in the proposed rule, presumably a broker can satisfy its obligation to disclose material features of the security by providing a copy of the official statement for the security, which is the primary source of such information, versus by attempting to synthesize, reword or isolate “material” information from immaterial information.  In circumstances where an official statement would include all available material information (which may be the case if there has been no material change to the basic features of the security or credit profile since the date of the official statement), it is unclear whether the Rule is intended to spare the customer the trouble of going to EMMA to review such material disclosure by forcing a broker to provide such disclosure directly to the customer, or whether the Rule's wording is merely intended to differentiate a generalized statement by the broker that “you can find all material information on EMMA” from a broker-provided link or links to specific EMMA disclosure for the applicable security that the broker has determined contains all required material information.  The MSRB might consider clarifying in the rule whether the provision that “a broker may not satisfy its disclosure obligation by directing a customer to an established industry source” is intended to require the broker to determine whether an established industry source such as EMMA in fact contains all material information at the time of trade (and, if not, to require the broker to supplement EMMA by providing missing material information available from other public sources), or whether it is a complete ban on use of any time of trade disclosure mechanism that does not create a record of whether the customer actually accessed the publicly available information to which the customer was referred by the broker.
  • Proposed Rule G-47 lists 15 specific items that may be material in certain scenarios for purposes of the time of trade disclosure obligation.  This non-exhaustive list focuses primarily on technical features of the security, with the only listed “material” item relating to the underlying credit being item c, “[t]he credit rating or lack thereof, credit rating changes, credit risk of the municipal security, and any underlying credit rating or lack thereof.”  Although the specified items are consolidated from prior notices intended to emphasize the MSRB’s view that such items are or may be material, and are not intended to constitute a compendium of the most frequently material items, when assembled as a list in the proposed rule they highlight the incompleteness of the list.  It seems odd, for example, to list “the investment of bond proceeds” as a potentially material item, while omitting, for example, items such as whether the security is a general obligation, revenue or conduit bond, whether the interest is an AMT preference item and whether a conduit bond is secured by a mortgage and/or gross receipts lien.  The MSRB will need to consider whether half a list is better than none.

"28% Cap" Unlikely to Trigger Wave of Municipal Bond Tax Calls


Market commenters have suggested that billions of dollars in municipal bonds may be subject to par redemptions if the much-discussed “28% cap” on the value of certain federal income tax deductions or exclusions is enacted and if the capped items include municipal bond interest.  While such commenters flag an issue worthy of consideration, enactment of a 28% cap applicable to muni interest should not result in a wave of unanticipated tax calls.

Tax call language comes in a variety of permutations.  The language of most tax calls focuses on whether interest on the bonds is excluded from gross income.   Legislation implementing a 28% cap may or may not be written in a manner that directly includes a portion of the value of tax-exempt interest in gross income (versus, for example, using an alternative tax calculation methodology, as is used in calculating the AMT tax).

Even assuming that a 28% cap clearly includes a portion of municipal bond interest in gross income for higher tax bracket holders, it is far from clear that tax call language would apply.  Many variations of tax calls distinguish between taxability caused by the issuer/borrower versus by change in law.  Those that don’t make such a distinction typically are written (as is the case with the particular tax call language referenced in a recently disseminated article sounding the alarm on tax call risk) to require a redemption of all of the bonds upon an IRS or judicial (or in some cases bond counsel) determination that interest on “the bonds” is not excluded from gross income.  Such redemption language suggests a triggering event that affects all the interest on all the bonds - otherwise it is overkill.  It seems unlikely that a court would interpret such language as permitting or requiring an issuer to redeem all its bonds because a portion of interest on some of the bonds (those held by higher bracket bondholders) is or may be taxable.

It is possible that there are some specially negotiated tax call provisions among the billions of dollars of municipal bonds that are triggered by absence of full tax exemption on any of the bonds, but those would be outliers.  (Such specially negotiated provisions would likely be bondholder-friendly and therefore would likely involve a redemption premium rather than a par redemption.)

In any event, concerned holders will want to look at the specific tax call language in their bonds and perhaps seek a bond or tax lawyer’s interpretation if the language seems unclear in the context of a potential 28% cap.  But the odds are against tax calls being triggered on a widespread basis.