All signs point to increased US regulation of Buy Now, Pay Later
The Buy Now, Pay Later market has experienced exponential growth as an innovative consumer offering.
In response to public questions and comments, the US Federal Reserve Board (the "Fed") released a revised term sheet for its recently established Municipal Liquidity Facility (the "MLF") on April 27, 2020, and answers to a set of frequently asked questions (FAQs). The MLF was established April 9, 2020 to provide liquidity to States, Washington, DC, and certain populous cities and counties ("Eligible Issuers") by enabling them to sell qualifying short-term obligations (described below) to a Fed-created special purpose vehicle ("SPV"). The revised term sheet (1) expands the scope of Eligible Issuers, principally by lowering minimum population thresholds for cities and counties, and clarifies other eligibility requirements, (2) extends the maturity of eligible obligations to three years (from two) and the last date to take advantage of this liquidity backstop to December 31, 2020 (from September 30, 2020), and (3) provides initial guidance on the ability of such Issuers to push down proceeds to related governmental instrumentalities in need of assistance. View a list of Eligible Issuers and the maximum purchase permitted from each.
The revised eligibility criteria may make the MLF either unattractive or unavailable to many or perhaps most Eligible Issuers. As discussed below, to be eligible for funding from the MLF, an Eligible Issuer must (1) satisfy minimum rating requirements both as of April 8, 2020, and at the time of purchase, (2) certify that it is unable to secure adequate credit accommodations from other banking institutions and is not insolvent, and (3) agree to pay a rate of interest set at a premium to "normal circumstances" market benchmark rates or indices. In addition, application (including disclosure) requirements have yet to be announced. Further, even though the permitted final maturity of Eligible Notes has been extended to three years, applicable State law may cause Eligible Note maturities to be much shorter, in some cases only to the end of the Eligible Issuer's fiscal year, and the MLF December 31, 2020 purchase expiration date would appear to prevent shorter-term Eligible Notes to be rolled by the SPV.
To provide the MLF, the Fed announced it would create the "SPV, which will receive a US$35 billion equity infusion from the US Treasury and a recourse loan from the Federal Reserve Bank of New York ("FRBNY"), enabling the SPV to purchase up to US$500 billion principal amount of qualifying short-term obligations (tax, tax and revenue anticipation, bond anticipation and similar short-term obligations, herein called "Eligible Notes") from Eligible Issuers.
On April 9, 2020, the Fed released a term sheet for the MLF. Under the term sheet, Eligible Notes were required to mature within two years and not exceed 20 percent of the Eligible Issuer's fiscal year 2017 "own source" general and utility revenues. Proceeds of purchases may be used for (1) managing the cash flow impact of income tax deferrals resulting from an extension of an income tax filing deadline; (2) covering potential reductions of tax and other revenues or increases in expenses related to or resulting from the COVID-19 pandemic; (3) debt service on Eligible Issuer obligations; and (4) the purchase of similar notes issued by, or otherwise to assist, political subdivisions and instrumentalities of the Eligible Issuer for purposes enumerated in (1)-(3).
Under the initial term sheet, Eligible Issuers were limited to the States, Washington, DC, counties and cities with populations of at least 2 million and 1 million, respectively. Only 10 cities and 14 counties met the initial population thresholds.
During the week that followed publication of the initial MLF term sheet, the Fed invited questions on its scope and operation from market participants and other interested persons. Numerous comments and requests were submitted. Based on the submissions received, the Fed issued a revised MLF term sheet and answers to FAQs. The revisions and answers expand, extend, and provide significantly more direction regarding the scope, operation and potential beneficiaries of the MLF. In releasing the revised term sheet and FAQs, the Fed stated that it is "working expeditiously to operationalize the MLF" with a goal of "ensuring the smooth functioning of the municipal securities market" and acknowledged that the market "is an important part of the [country's] financial system" and has recently been under "considerable strain" with "many issuers [being unable] to meet their financing needs" through traditional sources while "facing severe liquidity constraints" caused by tax and other revenue reductions and increased spending due to the impact of COVID-19.
The term sheet revisions:
The FAQ answers shed additional light on these revisions, make other clarifications beyond the term sheet, and state that the Fed "continues to encourage Eligible Issuers to make funding from the [MLF] available to" those subordinate entities that need such funding and "is considering expanding the [MLF] to allow a limited number of such entities to participate directly in the MLF…, taking into consideration the objective of quickly and efficiently making the [MLF] available to the currently defined set of [Eligible Issuers]." While these statements are helpful, applicable State constitutional lending of credit or other statutory provisions may prevent an Eligible Issuer from issuing recourse Eligible Notes and loaning proceeds to subordinate government entities.
The chief Eligible Issuer revisions (1) expand the number of city and county borrowers by almost nine-fold by lowering the population thresholds as noted above, (2) permit participation in MLF by multi-State entities and, "subject to [Fed] review and approval," an entity issuing Eligible Notes "on behalf of the [corresponding] State, City or County for purposes of managing its cash flows," and (3) add an investment grade rating requirement for all Eligible Issuers.
Eligible Issuers (other than multi-State entities) must have had long-term, investment grade ratings (at least BBB-/Baa3) "relating to the same type or source of repayment and security as is offered for the Eligible Notes" from at least two "major nationally recognized statistical rating organizations" ("NRSROs") as of April 8, 2020 (the day prior to the initial creation of the MLF). Only S&P Global Ratings, Moody's Investors Service, Inc., and Fitch Ratings, Inc. are currently recognized as NRSROs by the Fed for these purposes, although it is considering others. If an Eligible Issuer's relevant obligations are not rated by two recognized NRSROs, the Eligible Issuer must apply for and obtain the requisite ratings. If a non-multi-State entity Eligible Issuer's rating is thereafter downgraded, it must be rated at least BB-/Ba3 by two NRSROs at the time of purchase.
Multi-State entity borrowers (those created by Congressionally-approved compacts, such as Port Authority of New York and New Jersey, Delaware River Bay Authority and Washington Metro Area Transit Authority), are newly authorized to participate in MLF, but must have been rated even higher (at least A-/A3 on April 8, 2020 and no lower than BBB-/Baa3 at the time of purchase).
These limits may disqualify some otherwise Eligible Issuers, should they be downgraded as a result of COVID-19 or otherwise and fail to meet the minimum rating at the time of purchase. This places a premium on accessing the MLF quickly (subject, of course, to the required application materials being available and passing the Fed's review process; steps that are still to come from the Fed). Population-eligible jurisdictions with fewer than two outstanding ratings may be hard pressed to obtain an additional eligible rating, depending upon their near- and medium-term financial outlooks. In addition, depending on State law authority, some Eligible Issuers' Eligible Notes may be payable only from a limited portion of the sources from which its long-term, general obligations are payable, and may have been assigned only a short-term rating. It remains to be seen whether an Eligible Issuer's long-term general obligation bond ratings will qualify such Eligible Notes for purchase.
US territories and possessions are not Eligible Issuers due to Federal Reserve Act restrictions on providing assistance to those jurisdictions.
The revisions clarify that, while "subject to review and approval by" the Fed, "the source of repayment and security will depend on" the issuer's constitutional and statutory limits and "should generally be consistent with the source of repayment and strongest security typically pledged to repay publicly offered obligations" of the Eligible Issuer. Consequently, tax anticipation or tax and revenue anticipation notes backed by a general obligation or by a pledge of taxes should qualify, but revenue anticipation notes would not appear to qualify unless the Eligible Issuer does not have or may not pledge its taxing authority. "On behalf of" issuers "must either commit the credit of, or pledge revenues of, the applicable State, City or County" or such entity must guaranty the Eligible Notes of the particular "on behalf of" issuer. While not stated, it seems likely that the pledged revenues must also be the strongest permitted to be pledged under applicable law. Multi-State entities must secure their borrowings from the SPV on a parity with their outstanding senior lien gross or net revenue debt.
The FAQs state that the interest rate on the Eligible Notes will be a "penalty rate," i.e. a premium to the normal circumstances market rate that, while affording liquidity in the current "unusual and exigent circumstances", also "encourages repayment of the credit" when those circumstances "recede and economic conditions normalize." The FAQs go on to state that the Fed will establish a pricing methodology that will be broadly applicable to all Eligible Issuers, will be based on the Eligible Issuer's long-term rating at the time of purchase and the maturity of the Eligible Notes, and will include a spread over a publicly available benchmark or index.
No substantive change was made to the amount of Eligible Notes that the SPV may purchase from an Eligible Issuer, which remains capped at 20 percent of the fiscal year 2017 general revenue "from own sources and utility revenue of the applicable" eligible State, city or county. The revisions add a similar limit for multi-State entities equal to 20 percent of the entity's fiscal year 2019 audited gross revenues. "States may [continue to] request that the SPV purchase Eligible Notes in excess of the applicable limits in order to assist political subdivisions and other governmental entities that are not eligible" to secure funding from the SPV directly. The Fed stated that it will provide additional procedures for requesting and allocating Eligible Note purchase amounts in cases, for example, where the demand exceeds the current US$500 billion purchase cap. The SPV will purchase only newly issued Eligible Notes and will not purchase refinancing notes (even if otherwise eligible) issued after December 31, 2020, leaving open the possibility that the SPV may purchase refinancing notes prior to that date (payment of debt service is a permitted use of Eligible Note proceeds).
The revised term sheet and the FAQs are silent as to whether the SPV might sell Eligible Notes in the secondary market. Any such sales could provide an avenue for the SPV to reduce its balance sheet and pay down its recourse FRBNY loan(s). It will be interesting to see whether Fed authorization to sell will be provided, and whether any such Fed approval might require restrictions on further transfers or be coupled with a lock-out on Eligible Issuer prepayments.
Although not included in the revised MLF term sheet, some FAQ answers shed additional light on the scope and operation of the facility. Important answers are summarized below:
PFM Financial Advisors LLC will be the administrative agent in charge of coordinating and reviewing purchase applications "based on criteria [to be] established by the FRBNY."
Post-April 6, 2020 population revisions by the Census Bureau "will not affect" the cities and counties that are Eligible Issuers.
"Broadly defined…as determined by the" applicable Eligible Issuer, and includes any county, city, municipality, township, village, school district, special district, utility, authority, agency or other government unit.
Thus, where an Eligible Issuer uses its Eligible Note proceeds to purchase similar notes of its political subdivisions or other governmental entities, a default by the latter must be made up by the Eligible Issuer, which must "bear the credit risk associated with any notes it purchased from" those entities.
"May be paid at such times as are consistent with applicable constitutional and statutory requirements" of the Eligible Issuers, but in any case no later than final maturity. No amortization of principal in advance of maturity or earlier redemption is currently required.
Interest on Eligible Notes may be either taxable or tax-exempt at option of Eligible Issuer. It is not clear whether tax-exempt Eligible Notes will bear a lower rate of interest than taxable Eligible Notes.
Standard validity and enforceability opinions of issuer's counsel (the FAQs do not mention a tax opinion, although if the interest is exempt, such an opinion may be required); Eligible Issuer must also certify in writing "that it is unable to secure adequate credit accommodations from other banking institutions and…is not insolvent." The inability to secure adequate credit "does not mean that no credit is available." Rather, the certification may provide that if credit is available, it is available at a price or with conditions "inconsistent with a normal, well-functioning market." As noted above, no definition of "insolvent" is provided.
In addition to its statutorily required periodic disclosure to the Congress monthly as to names of Eligible Issuers participating, borrowed amounts, rates charged and "overall costs, revenues and other fees."
In addition to those still to be provided by the Fed referred to above, (a) requisite issuer disclosure, (b) application materials, and (c) additional information regarding opinions and certificates. For participants and others to be fully informed, "sign up for email alerts" here.
If you have further questions regarding the operation or impact of the revised MLF on the municipal securities market, or would like advice concerning possible government borrower action to take advantage of the MLF, please reach out to Lawrence Bauer, Fredric (Rick) Weber, Paul Braden or your customary Norton Rose Fulbright lawyer or lawyers.
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