In its ongoing efforts to begin purchasing short-term notes of eligible municipal issuers under the recently created Municipal Liquidity Facility (MLF or Facility), the Federal Reserve System (the Fed) has updated its April 27th version of frequently asked questions (FAQs) and answers as well as the Facility's term sheet. The May 11, 2020, update provides new or revised guidance concerning, among other things, the pricing formula to be used, the application and other documentation regarding the sale process, initial and ongoing issuer disclosure and rating of eligible issuers and their notes sold through the MLF. On May 15, 2020, the Fed released the form of notice of interest (NOI) to be submitted by potential MLF participants to commence the approval of purchase process.
In early April, the Fed announced it would establish the MLF through its creation of a special purpose vehicle (SPV), subsequently created and named Municipal Liquidity Facility, LLC, a Delaware limited liability company. The SPV 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 (a) qualifying short-term (up to 36 months) obligations (tax, tax and revenue anticipation, bond anticipation and similar short-term obligations, herein called Eligible Notes or Notes) from Eligible Issuers, consisting of the States, Washington, DC (but not US territories or possessions), cities with a population of 250,000 or more, counties with a population of 500,000 or more, "on behalf of issuers" in the States (each, a Designated Issuer) and multi-State entities created by Congressionally-approved compact, (b) secured by the strongest security typically pledged to repay the applicable issuer's publicly offered obligations (i.e. a general obligation pledge, a pledge of specific taxes in the absence thereof, or, for multi-State entities, a senior revenue or net revenue pledge) and (c) rated investment grade (or higher, for multi-State issuers) by two nationally recognized rating agencies both immediately preceding the creation of the MLF and at the time of purchase (with the possibility at purchase of an up to full letter rating downgrade).
Eligible Issuers may use the proceeds of any borrowing from the SPV under the MLF for:
- Managing the cash flow impact of income tax deferrals resulting from an extension of an income tax filing deadline.
- Covering potential reductions of tax and other revenues or increases in expenses related to or resulting from the COVID-19 pandemic.
- Debt service on Eligible Issuer obligations.
- The purchase of similar notes issued by, or otherwise to assist, political subdivisions and instrumentalities of the Eligible Issuer for purposes listed in (1)-(3).
The May 11, 2020 update does not change these use of proceeds purposes for Eligible Issuers accessing the Facility. Read our earlier summary of the MLF, as modified by the Fed on April 27, 2020.
The scope of prior guidance about the MLF, as previously updated, left certain subject areas in need of further exposition by the Fed. Among the more important areas were the pricing regimen for Eligible Notes, the application/sale process and Eligible Issuer disclosure requirements. The current update, as summarized below, provides clarification for these topics, among others.
As we noted in our prior client alert, one of the chief open items in the "operationalization" of the Facility was the pricing methodology for Eligible Notes. The Fed in the current update has provided the pricing formula applicable to all MLF participants. For tax-exempt Eligible Notes, the interest rate on Eligible Notes sold to the SPV at par is equal to a taxable index rate (the overnight indexed fixed swap rate (OIS), i.e. the fixed rate that would be swapped for the effective federal funds rate for a term that corresponds to the Notes' maturity) on the pricing date plus a fixed basis point spread that (a) increases as the Eligible Issuer's rating (tied to the credit of the subject Notes) drops and (b) corresponds to the Notes' "relevant tax status." For taxable Eligible Notes, the above formula's "tax-exempt" interest rate is divided by 0.65 (i.e., increased by approximately 54 percent). In determining the applicable OIS rate, it is unclear whether the Fed will refer to a recent published OIS swap index or seek quotes from swap dealers on the pricing date and, if the latter, how it will average or choose among different quotes.
Using May 12, 2020 OIS index data (taken from Bloomberg) for Note maturities of 6, 12, 24, and 36 months, the Fed's pricing formula would have resulted in the per annum rates for tax-exempt Notes with the corresponding ratings (compared to MMD, a surrogate for market rates, for the applicable maturity as of May 13, 2020) shown in the table below:
||MLF Tax-exempt Pricing Rate
* As reported on Thomson Reuters The Municipal Market Monitor (TM3).
** MMD for 6-month maturities was unavailable on TM3; for comparison, SIFMA (a 7-day tax-exempt rate) on May 12, 2020 was 0.19%.
Whether an Eligible Issuer will sell its Notes to the SPV given this pricing approach compared to the spread over MMD typically available in the market for its short-term, tax-exempt municipal securities, for example, will remain to be seen. Recent publicly available, short-term, tax-exempt, primary market pricing and secondary market trading examples are currently noting 12- and 24-month borrowing costs, for example, that are much lower than those that would have resulted from the Fed's pricing grid for credits even in the "A/A2" category. The MMD rates included in the table above, which rates incorporate a spread over the "AAA" tax-exempt yield curve tied to the ratings shown, also bear this out. It seems clear, then, that the Fed is making good on its promise, based on its interpretation of Section 13(3) of the Federal Reserve Act, that MLF pricing will for many (if not most) Eligible Issuers be a "penalty rate." It is certainly possible that the Fed's rate grid may provide better pricing in the future, depending on the future movement and relationship of market rates.
Dealing with split ratings
The Fed will assign an increasing numerical "value" to each rating category (taking gradations within a category into account) below "triple A". The corresponding numerical "value" for each Eligible Issuer's applicable ratings will be (i) summed, (ii) averaged and (iii) rounded "to the nearest numerical value that corresponds to a rating" in the Fed's numerical rating assignment. For an average that is exactly midway between two of the Fed's rating values, the higher value (i.e., the lower rating) will be used for pricing. For an Eligible Issuer with only two ratings, one of which is "two or more gradations higher than the other," for example A3/A+, the Issuer is given the option prior to pricing to obtain a third rating and price its Notes based on the average of the corresponding three numerical rating values or to use the lower of the two existing ratings.
Straight line interpolation if no direct OIS quote available
Finally, if there is no direct OIS quotation for an Eligible Issuer's chosen maturity, the applicable OIS rate to be used in the above pricing formula "will be calculated using a straight line interpolation of the direct OIS quotes for the nearest maturity that is shorter than the [Issuer's chosen maturity for its] Eligible Notes and the nearest maturity that is longer than [such chosen maturity]."
SPV purchase process
NOI to start followed by an application
To initiate the purchase process, an Eligible Issuer must submit a "notice of interest" (NOI) indicating an intent by such Issuer to sell Eligible Notes to the SPV. The form of NOI was released by the Fed on May 15, 2020. Thereafter, and prior to commencing the competitive sale process or the pricing of a direct SPV purchase of Eligible Notes, each as described below, the Eligible Issuer must also submit an "Application" for SPV approval. The Application form is "being developed and will be posted on the MLF website when available." Approval of an Application will constitute the SPV's commitment to purchase the submitting Eligible Issuer's Eligible Notes at a price based on the Fed's rating-based pricing schedule described above. The Fed "will provide a [written] purchase commitment to memorialize the terms of the transaction and the conditions to funding," but neither the SPV nor the Fed will sign any closing or other related documents.
While our prior client alert noted a need for application speed in that a rating downgrade might make an otherwise Eligible Issuer ineligible, a possibility that still exists, the updated FAQs make clear that the Facility "is not a 'first come, first served' program," and "no preference is given" to early NOI submitters. Rather, the Fed has allocated available funds to Eligible Issuers in amounts set forth on Appendix A to the FAQs and presumably will reserve the amounts for them for at least some period of time. The FAQs state that an applicant "should not submit" its NOI until its necessary financial data (discussed below) and financing schedule has been firmed. The revised FAQs state that multiple SPV purchases from an individual Eligible Issuer will be permitted (although the MLF is not to be used by it as "line of credit" through "frequent, small" SPV purchases of Eligible Notes), up to the amount allocated to the Eligible Issuer, but the Fed reserves the right to "establish a maximum number" of such individual purchases "or a minimum par amount per issuance." The NOI instructions reiterate this "do not rush" stance.
The NOI is detailed but effectively follows the FAQs and MLF term sheet as to initial information required to be submitted by an Eligible Issuer
The NOI is intended to provide FRBNY with indications of "the Eligible Issuers that intend to participate in the MLF" as well as "information…to anticipate the staff allocation and market timing needed to fully execute the MLF." Much of NOI consists of checking appropriate boxes or providing written descriptions or explanations regarding (i) Issuer rating eligibility (although not its latest census data for cities and counties), whether it will use a Designated Issuer, (iii) base CUSIP number (presumably for the type of credit/security being offered to the SPV, although neither the form nor the related instructions so specify), (iv) anticipated use of proceeds, (v) type of note (and, if other than a TAN, TRAN or BAN, a description of the other "similar…instrument…and an explanation of why it is being proposed" must be included), (vi) Note term, (vii) principal amount expected to be offered, (viii) Note security, (ix) type of sale (competitive vs. direct SPV purchase), and (x) proposed timing (but the SPV will not agree to a closing date until it has approved the subsequent Application). Some responses, as indicated below, will require the furnishing of additional explanations or other information.
NOI receipt and approval
The Fed has engaged BLX Group, LLC, as Administrative Agent for the MLF. Submission of a NOI and its attachments will be acknowledged by the Administrative Agent via e-mail to the Issuer's primary contact person. Confirmation of approval of the NOI will be similarly e-mailed by the Administrative Agent to that contact person and will invite the Issuer to submit an Application. If the Issuer's subsequent Application is approved, then prior to Note pricing the SPV will provide "evidence" of its purchase commitment via a note purchase agreement or other documentation, which will include "the conditions to funding."
Submission of memoranda of counsel required with regard to Note security
If a general obligation pledge is offered but the Issuer has "other credit(s) that are…rated [higher] than its general obligation credit", the Issuer must submit "a memorandum of counsel explaining why the…Issuer's higher rated credit(s) is not otherwise available to secure the Eligible Notes." If the Issuer is not offering a general obligation pledge as Note security, it must "provide a memorandum of counsel explaining compliance with" the pledge of specific taxes as set forth in the MLF term sheet and FAQs. A similar counsel memorandum will be required for a multi-State entity regarding such compliance as to its senior parity pledge of net or gross revenues. If a Designated Issuer intends to sell Eligible Notes to the SPV, submission of a counsel memorandum explaining that the "Designated Issuer is legally authorized to commit the credit of, or pledge the revenues of, the applicable State, City or County" or that such State, City or County "is legally authorized to guarantee the Eligible Notes issued by the Designated Issuer" is required.
Backstop SPV purchase after a competitive sale or direct SPV placement
SPV purchases of Eligible Notes may be either (a) as "a backstop" to an Eligible Issuer conducted competitive sale process, where the SPV will commit "to purchase Eligible Notes that are not awarded to bidders in the competitive sale" rather than submitting a competitive bid (except as described below) or (b) directly from the Eligible Issuer "without the Eligible Issuer first undertaking a competitive sale process." "Each Eligible Issuer will specify its preferred [SPV purchase] method" in the NOI.
If an Eligible Issuer "is required by law" to sell Eligible Notes competitively and lacks "the authority to sell…directly to the SPV" outside a competitive sale even if the competitive sale results in fewer than all such Notes being sold, the SPV will "arrange to submit a bid" in the Eligible Issuer's competitive sale. The NOI requires each Issuer that does not have such legal authority to submit with its NOI a counsel memorandum "to that effect, including the citation to the legal authority prohibiting such direct sale."
Type of competitive sale left to Eligible Issuer discretion with a caveat
The type of competitive sale procedure used (the FAQs mention "a traditional 'all or none' [with one winning bidder]…[and]…a 'modified Dutch auction'" [with multiple winners] as potential candidates) is left to the discretion (and authority) of the particular Eligible Issuer. The Fed currently expresses no preference for the type of sale but "reserves the right to indicate a preference or require one type of sale in the future."
For SPV purchases through the competitive sale process, Eligible Issuers must provide "the same level of disclosure normally prepared in connection with" publicly offered Eligible Notes and use "standard form" competitive sale materials (notices of sale and the like) for securities of the type similar to such Notes. Thus, Eligible Issuers should be prepared to compile and provide to the SPV a customary notice of sale (whether in summary form or not will be determined by each Issuer's policy for competitively selling similar notes) and a competitive sale preliminary official statement. These disclosure requirements seem intended in part to fairly test the market, avoiding draws on the MLF if the market can beat MLF pricing.
For direct placements not involving or preceded by a competitive offering, no offering document is required. Instead, an Eligible Issuer must provide the Fed with its website and EMMA links, because the Fed "will review the financial information and operating data provided" there. Historical data posted to Eligible Issuer websites and EMMA are likely to be stale, given current State and local government operating and budget conditions due to responses to the COVID-19 pandemic. In addition, however, and perhaps because of this, each Eligible Issuer will also be required to provide:
- For tax or tax and revenue (and similar) anticipation notes, the immediately prior fiscal year actual cash flow statement along with a 12-month projection of cash flows and an explanation of "statutorily required or policy-determined 'set asides'" from the applicable taxes and revenues designated for repayment of the notes (or, if no such "set asides" are required, "a plan for the repayment" of the notes).
- For bond anticipation notes, the Issuer's (presumably statutory) "authorization to issue bonds to pay off" the notes along with an explanation regarding its ability "to issue such bonds on or before the [notes'] maturity."
- For all Eligible Notes, copies of "financial information and operating data that have been provided to the rating agencies in connection with the process to obtain confirmation of the Eligible Issuer's ratings."
- Any other "additional publicly available information" the Fed may request.
The federal securities law anti-fraud provisions will apply to the SPV's purchase of Eligible Notes. Eligible Issuers must be cognizant of their responsibilities under those provisions when contemplating participation in the MLF (as they must be in connection with any sale of their securities). They should make sure to update stale historical data with current data, if materially different. They should make sure that forecasts are honestly believed, based on reasonable assumptions, and accompanied by a discussion of substantial risks that could prevent them from being realized. If "additional publicly available information" requested by the Fed was prepared by the Eligible Issuer without regard to whether it might be relied upon in connection with the purchase of securities, it should be supplemented as necessary to avoid a misstatement or misleading omission of a material fact. Issuers considering MLF participation should carefully review their publicly available information with counsel and, if necessary, update any such information with federal securities law provisions and responsibilities in mind.
The Issuer's note form should be the one "typically use[d]" when issuing such securities.
Rule 15c2-12 ongoing annual and listed event submissions required
"[R]egardless of…whether or not the sale of Eligible Notes would otherwise be subject to Rule 15c2-12," Eligible Issuers must "provide the continuing disclosure described" in the Rule.
Additional ongoing disclosure
For "all transactions in which the SPV purchases Eligible Notes," each Eligible Issuer must provide:
- On its website a report of (i) "actual and projected" quarterly cash flow results and (ii) "funding…planned set-asides" together with in each case "an explanation of any negative variances."
- On its website "access to quarterly financial reports and/or information in a format regularly provided to any governing body or otherwise made public."
- To the Fed at six months and then again at three months prior to the applicable notes' maturity, "a written report explaining how it will repay" the Notes at maturity (and for any bond anticipation notes, include and identify "any material credit or other matters relating to issuing" the applicable take-out bonds).
- To the Fed "other information relating to the ability of the Eligible Issuer to repay the Eligible Notes when…due."
Publication of Eligible Issuer information provided to Fed
The FAQs alert potential MLF participants that the Fed may make public any information provided to it "pursuant to its rights described herein [presumably it means described in the FAQs even though the quoted text appears in Item 4 immediately above], including to the Congress or otherwise." Information required to be provided on an Eligible Issuer's website (including required forecasts), as described above, and perhaps other information made public by the Fed, could be viewed as statements made in connection with not only the SPV's purchase of Eligible Notes but also the purchase or sale of an Eligible Issuer's other outstanding debt securities, and would thus be subject to the antifraud provisions of the federal securities laws. Accordingly, Eligible Issuers should conduct the same careful review in preparing and evaluating its MLF-required continuing disclosure information as it undertook in compiling the information supplied to the Fed with an Application.
Rating requirement revisions/clarifications
The rating requirements as set forth in the April 27th FAQs update remain basically unchanged with one important difference. The Fed "will not require ratings on Eligible Notes that are sold to the SPV without first conducting a competitive sale process." However, Eligible Issuers "must provide a confirmation at the time of pricing of all of the existing long-term ratings on the applicable credit to be used for the Eligible Notes." The NOI requires each Eligible Issuer to list its April 8, 2020 ratings and provide rating reports for each of those ratings. The NOI requires the Issuer (or its Designated Issuer) to submit (i) "written evidence at the time of pricing of all existing long-term ratings on the applicable credit" that the Notes will offer, (ii) at the time of purchase, "confirmation letters from all major NRSRO's rating the proposed credit," and (iii) with the NOI, the status of rating confirmation requests and when they are expected to be received. It is possible that the "gap" between pricing and closing will be short, thereby putting pressure on an Issuer (or its counsel) to secure the confirmation letter in (ii). Finally, the NOI asks the Issuer to provide the "anticipated short-term ratings on the Eligible Notes." This last requirement was not addressed either in the MLF term sheet or the FAQs, both as updated.
The updated FAQs (a) permit an otherwise Eligible Issuer to sell Eligible Notes to the SPV if it had only one investment grade rating from an eligible NRSRO immediately prior to the Fed's creation of the MLF in early April, if (i) the Issuer obtains a second NRSRO rating by the applicable SPV purchase date and (ii) neither rating is lower than the Fed's previously established minimum ratings (BB-/Ba3 for a State, City, County or "on behalf of" issuing entity and BBB-/Baa3 for multi-State issuers), and (b) include Kroll Bond Rating Agency, Inc. in its list of eligible NRSROs. If the Issuer will undertake to obtain a second rating, it must include in its NOI a description of "the process and timeline required to obtain" it along with including the rating expected to be received.
Other FAQs clarifications
Prepayment still requires SPV approval. In addition, if the Eligible Notes were purchased by the SPV at a premium through a competitive sale process, the redemption price will be par plus unamortized premium rather than just par.
CUSIP numbers will be required
CUSIP numbers must be assigned to Notes and obtained by the Eligible Issuer or its financial advisor.
Eligible Notes must be DTC eligible and close through DTC
Still to come
Still to be resolved, among other things, are (a) whether the Fed will expand MLF to include purchases of Eligible Notes issued by government entities providing essential services but not currently eligible to participate, (b) additional information on required legal opinions (beyond the current requirement for Issuers to deliver "standard legal opinions for the issuance of debt," including approving opinions by nationally recognized note counsel), (c) the definition of "insolvent" for purposes of the Issuer's certification to the Fed that it isn't, (d) whether the Fed will accept an inability to secure adequate credit accommodations that simply tracks the FAQ's language on the matter without additional corroborating information (in the absence of a failed competitive bid process), and (e) whether the Fed 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, or amounts allocated to other Eligible Issuers go unused. The NOI instructions note that FRBNY will make the determination whether an Eligible Issuer may sell Notes to the SPV in an amount greater than the Issuer's applicable limit to assist MLF ineligible political subdivisions and other government entities. Information regarding this determination remains to be provided.
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.