The recent no-action letter, issued jointly by the staff of the Division of Investment Management (“IM”) and the Division of Corporate Finance (“Corp Fin”) of the Securities and Exchange Commission (the “Commission”) to Eaton Vance Management (pub. avail. June 13, 2008) (the “Eaton Vance Letter”), represents another step down the circuitous path that eventually leads to money market funds acquiring preferred stock issued by closed-end funds. The Eaton Vance Letter introduces a new type of closed-end preferred stock that it calls “Liquidity Protected Preferred” (“LPP”). The letter has something for everyone involved in LPP financing:
- it permits money market funds to invest in LPP without violating rule 2a-7;
- it lets closed-end funds agree to repurchase the LPP shares without being deemed to issue “redeemable securities”; and
- it lets liquidity providers offer to purchase LPP shares that cannot be remarketed without complying with tender offer regulations.
This Client Alert first examines the difference between LPP and traditional auction rate preferred stock (“ARPS”). The Alert then reviews the 20-year history of no-action letters regarding the treatment of ARPS under rule 2a-7 that culminated in the Eaton Vance Letter. After summarizing the positions in the Eaton Vance Letter regarding redeemable securities and tender offers, this Alert concludes by considering whether the no-action letters have become fixated on the wrong question (what triggers payments by the liquidity provider?), whether a holder has a legal entitlement to sell shares for their amortized cost value, which is what rule 2a-7 actually requires.
1. Auction Rate and Liquidity Protected Preferred Stock in a Nutshell
Closed-end management investment companies (“closed-end funds”) issue preferred stock in order to leverage the returns (particularly the dividends) on their common shares. Preferred stock is a type of “senior security” that closed-end funds may issue under § 18(a)(2) of the Investment Company Act of 1940 (the “1940 Act”). Section 18 requires asset coverage of only 200 percent for preferred stock, as compared to 300 percent of senior indebtedness, which results in greater leverage. More importantly, so long as the preferred stock qualifies as equity for purposes of Subchapter M of the Internal Revenue Code, and the closed-end fund invests exclusively in tax-exempt securities, dividends on the preferred will also be taxexempt. This makes preferred stock the cheapest means of financing for most municipal bond closed-end funds.
ARPS was designed to further reduce financing costs. ARPS relies on a periodic, single-price auction to determine the dividend paid on the ARPS and to provide liquidity to ARPS holders. Basically, holders tell the auction agent the dividend rates at which they are willing to sell or hold their ARPS, and potential buyers tell the auction agent the amount of ARPS they are willing to buy at various dividend rates. The auction agent then declares a dividend rate that “clears the market,” i.e., results in an equal quantity of bids and offers, while inducing the balance of current holders to retain their ARPS. Every holder of ARPS receives the same dividend rate, which is why it is called a “single-price auction.”
There is a catch, of course, in the form of a maximum dividend rate. To avoid the risk of dividends spiraling out of control, ARPS limit the maximum dividend payable to spread or percent-age over an index interest rate. For example, ARPS may not permit bids in excess of 120 percent of one-month LIBOR. If this rate is insufficient to “clear the market,” then the auction fails and current holders are left holding their ARPS and receiving dividends at the maximum rate. These maximum rates have led to the current freeze-up in the ARPS auctions, as new buyers have been unwilling to bid below the maximum rate.
In contrast, LPP uses a remarketing agent, rather than an auction, to set the dividend rate and provide liquidity to holders. The remarketing agent attempts to resell LPPs on a weekly basis. LPP holders notify the remarketing agent of the number of shares that they want to sell, and the remarketing agent solicits matching offers for the LPPs. The weekly dividend rate is the lowest rate necessary to obtain matching offers for all the shares being remarketed that week. As with ARPS, all LPPs would receive dividends at the same weekly rate.
LPPs are also subject to a maximum rate, which, like ARPS, would be expressed as a spread or percentage over an index rate. Unlike ARPS, however, the remarketing agent will have a liquidity facility to draw upon if it cannot resell all the tendered LPPs at less than the maximum rate. This prevents any potential freeze-up in the remarketing process by providing a buyer of last re-sort. If the remarketing agent draws on the liquidity facility, then LPPs automatically pay dividends at the maximum rate. The maximum rate may even increase if the liquidity provider holds more than a specified percentage of LPPs.
The liquidity provider’s obligation to purchase LPPs is not subject to any condition other than a failure to resell the LPPs. LPP holders will receive notice of any such failure. LPP holders will also receive at least two weeks’ notice of any election by the liquidity provider to terminate, or fail to renew, the liquidity facility. This would give the LPP holders at least two opportunities to tender their LPPs for remarketing before the liquidity facility terminates.
From the holder’s perspective, LPPs clearly offer superior liquidity and lower risk than ARPS. From the closed-end fund’s perspective, however, LPPs may be more expensive than ARPS, be-cause the fund must pay for a liquidity facility. The Eaton Vance Letter mentions several features intended to lower the liquidity fees. First, the fund may pay the liquidity provider a higher fee for amounts drawn on the facility than for undrawn amounts, which will reduce the fees so long as the LPPs are successfully remarketed. Second, the fund’s sponsor may give the liquidity provider a put on any LPPs acquired under the liquidity facility. Finally, the closed-end fund may give the liquidity provider such a put.
2. Closed-End Preferred Stock and Money Market Funds
At this time, money market funds are viewed as the best potential source of financing for lever-aged closedend funds, particularly tax-exempt funds. Moreover, if closed-end funds can develop a preferred stock that meets the exacting requirements of rule 2a-7, they may also attract traditional ARPS investors back into the market. This explains why Eaton Vance sought to obtain IMs imprimatur for LPP. In order to understand the Eaton Vance Letter’s position on rule 2a-7, however, it is necessary to understand why money funds cannot invest in traditional ARPS, and to review the positions taken by IM in three previous no-action letters.
(a) Why Money Market Funds Cannot Invest in Traditional ARPS
Rule 2a-7(c)(2)(i) generally prohibits a money market fund from acquiring securities with remaining maturities in excess of 397 days. Rule 2a-7(d) measures a security’s maturity from:
the period remaining ... until the date on which, in accordance with the terms of the security, the principal amount must unconditionally be paid ...
Closed-end fund preferred stock suffers from rule 2a-7’s version of the Peter Pan Syndrome—it never matures. There are several reasons that rule 2a-7 does not treat preferred stock as having a remaining maturity. First, preferred stocks have liquidation preferences rather than principal amounts. Second, even if the liquidation preference is treated as the equivalent of a principal amount, many preferred stocks do not require payment of the liquidation preference by any particular date. In fact, most closed-end funds issue “perpetual” preferred stock to limit the risk that the IRS might characterize the stock as debt. Finally, even if the fund undertakes to redeem the preferred stock, its obligation cannot be unconditional. Corporate laws typically prohibit an issuer from redeeming stock (including preferred stock) if it would impair the issuer’s stated capital or would result in the issuer’s insolvency.
This lack of maturity need not be fatal, however. Rule 2a-7(d)(3) provides an exception for a “Variable Rate Security, the principal amount of which is scheduled to be paid in more than 397 calendar days, that is subject to a Demand Feature.” Rule 2a-7(a)(29) defines a “Variable Rate Security” as:
a security the terms of which provide for the adjustment of its interest rate on set dates (such as the last day of a month or calendar quarter) and that, upon each adjustment until the final maturity of the instrument or the period remaining until the principal amount can be recovered through demand, can reasonably be expected to have a market value that approximates its amortized cost.
Rule 2a-7(a)(8)(i) defines a “Demand Feature” as:
A feature permitting the holder of a security to sell the security at an exercise price equal to the approximate amortized cost of the security plus accrued interest, if any, at the time of exercise. A Demand Feature must be exercisable either: (A) At any time on no more than 30 calendar days’ notice; or (B) At specified intervals not exceeding 397 calendar days and upon no more than 30 calendar days’ notice.…
Under rule 2a-7(d)(3), a Variable Rate Security subject to a Demand Feature is “deemed to have a maturity equal to the longer of the period remaining until the next readjustment of the interest rate or the period remaining until the principal amount can be recovered through demand.” For the past 20 years, purveyors of auction rate securities have attempted to surmount the 397-day maturity limitation by developing a product that satisfies rule 2a-7(d)(3).
(b) The First Assault—The Goldman Sachs Letter
IM first considered whether money market funds could acquire auction rate securities in a letter denying noaction relief to Goldman Sachs & Co. (pub. avail. Sep. 7, 1988) (the “Goldman Sachs Letter”). In its request, Goldman Sachs argued that the auction process should be treated as equivalent to a Demand Feature and the auction rate as equivalent to a Variable Rate. They included the following statement, which cannot be read today without a sense of irony:
We recognize, of course, that in certain circumstances the interest rate necessary to cause the market value of a Note to approximate par may exceed the Maximum Rate and that, in such event, upon readjustment, the market value of such Note may be less than par. Goldman Sachs are of the firm belief, however, that, be-cause the Maximum Rate will vary along with changes in the credit of issuer and because at each credit rating level the Maximum Rate will be substantially in excess of the interest rate normally required by the market for a debt security of an issuer with such a credit rating to approximate par, such a scenario is highly unlikely.
IM disagreed, finding that:
A [Demand Feature], as defined in the Rule, entitles a holder to receive the principal amount of the underlying security, whereas the Notes, by their terms, only provide that the holder may offer the security in an Auction to be held by Gold-man, Sachs & Co. We view [a] commitment to hold Auctions as more similar to an underwriter’s intent to maintain a secondary market. The staff takes the position that for purposes of measuring the maturity of debt instruments under Rule 2a-7, the fact that an underwriter intends to make a secondary market in an issue is irrelevant. [Citation omitted]
Arguably, this “technical” distinction between a “legal entitlement” to sell a security, and a high likelihood of finding a buyer in an auction, is all that kept money market funds from holding auction rate portfolio securities when the auctions began to freeze up at the end of 2007. In retrospect, this was clearly a distinction that mattered.
(c) The Second Assault—The DLJ Letter
Having failed to convince IM that an auction was as good as a Demand Feature, the next logical step was to attach a Demand Feature to the ARPS. IM considered whether attaching a Conditional Demand Feature to ARPS would satisfy rule 2a-7 in a letter to Donaldson, Lufkin & Jenrette Securities Corporation (pub. avail. Sept. 23, 1994) (the “DLJ Letter”). DLJ sought to attach a Demand Feature by depositing ARPS into a trust and giving the trustee a standby-purchase agreement from a highly rated bank. The trust would issue Certificates to money market funds that passed through payments from the ARPS (less trust expenses). Holders would have the right to tender the Certificates to a remarketing agent, and if the remarketing agent could not resell the tendered Certificates, it would draw on the standby-purchase agreement. DLJ would reimburse the bank by purchasing any Certificates acquired under the standby purchase agreement and, presumably, would recover its money by selling the underlying ARPS in the next auction.
The structure described in the DLJ Letter was patterned on tender option bonds that are widely held by tax exempt funds. Unfortunately, the Certificates included the same limitations on the bank’s obligations as tender option bonds. This made the Demand Feature “Conditional,” insofar as the bank was not obligated to purchase Certificates following a default or significant down-grading of the underlying ARPS. Rule 2a- 7(c)(3)(iv)(C) requires a security underlying a Conditional Demand Feature to have “received either a shortterm rating or a long-term rating, as the case may be, … within the NRSROs’ two highest short-term or long-term rating categories.” Al-though “the Certificates [would] receive ‘the highest preferred stock rating,’” IM found “that, unlike a long-term debt rating, a preferred stock rating does not reflect the issuer’s capacity to repay principal when due. The Certificates thus will not carry the requisite debt ratings.”
In the DLJ Letter, IM made another technical distinction between “preferred stock” and “debt” ratings. In contrast to the Goldman Sachs Letter, however, subsequent market developments have not proved this to be a useful distinction. Regardless, at this point, a closed-end fund cannot satisfy the maturity requirements of rule 2a-7 by adding a Conditional Demand Feature to its preferred stock.
(d) The Long Way Over—The Merrill Lynch Letter
Having failed to convince IM to permit investments in ARPS backed by a Conditional Demand Feature, the next logical step was to attach an Unconditional Demand Feature. Rule 2a-7(a)(26) defines an “Unconditional Demand Feature” as “a Demand Feature that by its terms would be readily exercisable in the event of a default in payment of principal or interest on the underlying security or securities.” Unlike Conditional Demand Features, rule 2a-7 permits a fund to acquire Variable Rate Securities subject to Unconditional Demand Features regardless of their quality, because a fund can look to the provider of the Unconditional Demand Feature for payment in all circumstances.
Using this approach, Merrill Lynch Investment Managers, L.P. succeeded in obtaining a no-action letter (pub. avail. May 10, 2002) (the “Merrill Lynch Letter”). Unlike the DLJ Letter, Merrill Lynch did not use the tender option bond structure. Instead, each closed-end fund would arrange for a financial institution to issue a Demand Feature directly for the benefit of the ARPS holders. According to Merrill Lynch’s request for noaction:
The Demand Feature will not be transferable or assignable independent of the underlying Preferred Stock, but will accompany each transfer of the Preferred Stock. It will be exercisable upon (i) a failed auction ..., (ii) a failure to hold a scheduled auction ..., (iii) a failure by a Fund to make a scheduled payment of dividends or redemption proceeds, or (iv) a failure to make scheduled payments of the required liquidation amounts, in each case at the liquidation preference plus accumulated but unpaid dividends, whether or not earned or declared. If any holder of the Preferred Stock wishing to sell the Preferred Stock cannot do so on a scheduled Settlement Date for a scheduled auction or remarketing, whether or not such auction or remarketing process actually takes place, at the liquidation preference plus accumulated but unpaid dividends, whether or not earned or declared, then the Counterparty [providing the Demand Feature] will buy the Preferred Stock at a price equal to such liquidation preference plus accumulated but unpaid dividends, whether or not earned or declared.
In its legal analysis, Merrill Lynch:
Acknowledge[d] that the Demand Feature, when viewed in isolation, does not technically meet the definition of demand feature in that it is exercisable neither “at any time” nor “at specified intervals.” Viewed in conjunction with the terms of the Preferred Stock auction or remarketing process, however, the Demand Feature effectively provides Money Market Funds with maturity protection that is equivalent to that provided by a demand feature that complies with all of the conditions of paragraph (a)(8) of Rule 2a-7.
IM accepted this analysis, and agreed not to recommend enforcement action if a money market fund acquired ARPS subject to a Demand Feature.1 IM required, among other conditions, that the Demand Feature be exercisable under four circumstances: a failed auction, failure to hold an auction, failure to make scheduled payments or failure to pay the liquidation preference.
(e) Shortening the Path—The Eaton Vance Letter
In the Eaton Vance Letter, IM reduced the circumstances in which an Unconditional Demand Feature must be exercisable to two: a failed remarketing or failure to remarket. IM accepted the argument that the other two circumstances (which the Eaton Vance Letter termed “Non-Payment Triggers”)—
are not necessary because at worst a Fund’s failure to make a dividend or redemption payment would require the Money Market Fund to wait six days until the next scheduled remarketing to sell its shares, when it would be entitled to the liquidation preference of the shares plus any accumulated and unpaid dividends.
In other words, so long as a money market fund can still access the liquidity facility through a remarketing after a Non-Payment Trigger, there is no reason to create an additional right to access the liquidity facility because of a Non-Payment Trigger.
3. Other No-Action Positions Taken in the Eaton Vance Letter
The Eaton Vance Letter also dealt with two collateral legal issues. First, IM agreed not to recommend enforcement action to the Commission if the closed-end fund agreed to purchase LPPs from the liquidity provider under certain circumstances. Second, Corp Fin agreed not to recommend enforcement action if the liquidity provider did not comply with provisions and rules under the Securities Exchange Act of 1934 (the “1934 Act”) regulating tender offers for equity securities issued by closed-end funds.
(a) LPPs are not Redeemable Securities
Section 2(a)(32) of the 1940 Act defines “redeemable security” as “any security, other than short-term paper, under the terms of which the holder, upon its presentation to the issuer …, is entitled … to receive approximately his proportionate share of the issuer’s current net assets, or the cash equivalent thereof.” The definition of a “closed-end fund” in Section 5 of the 1940 Act effectively prohibits closed-end funds from issuing redeemable securities.
The liquidity facility would not cause LPPs to qualify as “redeemable securities” because only the liquidity provider, not the issuer, is required to purchase the LPPs. Hence, payments from the liquidity facility would not represent a “share of the issuer’s current net assets.” If, however, the liquidity provider has the right to put the LPPs to the closed-end fund, then LPPs might share the characteristics of redeemable securities. To avoid this, the Eaton Vance Letter represented that any put would be subject to significant restrictions. First, the liquidity provider could not exercise the put until it has held the LPPs for a period of at least three months. Second, the liquidity provider must offer the LPPs for sale in every remarketing during the threemonth period. IM agreed that, subject to these restrictions, a put from the liquidity provider to the closedend fund that issued the LPPs would not cause the LPPs to become redeemable securities.2
(b) The Liquidity Provider is not making a Tender Offer
Sections 13(e), 14(d) and 14(e) of the 1934 Act, and regulations 14D and 14E thereunder, regulate tender offers for, among other securities, equity securities issued by closed-end funds. The 1934 Act does not define a “tender offer,” however, which raises the question of whether the liquidity facility represents a “tender offer” for the LPPs.
Courts and the Commission have grappled with the meaning of “tender offer” in a number of cases, generally following an eight-factor test first used in Wellman v. Dickinson, 475 F. Supp. 783 (S.D.N.Y. 1979). An unstated premise of the eight factors is that the person making the offer actually wants to buy the securities. This would not be true in the case of the liquidity facility, because the liquidity provider would prefer to collect its fees and never have to purchase a share of LPP. Indeed, an offer to, in essence, “buy this security if you ever decide that you want to sell it and cannot find anyone else who wants it,” seems too lackadaisical for a tender offer subject to the 1934 Act. Instead of a “hostile” or “friendly” tender offer, this would be an ambivalent one.
In its request for a no-action position, Eaton Vance made this and other sensible arguments for why the liquidity facility was not a tender offer. Instead of accepting these arguments, however, Corp Fin agreed not to recommend enforcement action against the liquidity provider only if the LPPs complied with 13 conditions. The 13 conditions largely codify the terms of the LPPs de-scribed in the Eaton Vance Letter.
4. Why Looking at “Triggers” Takes Your Eyes off the Ball
Although it is hard to characterize any analysis of rule 2a-7 as unduly complicated, this may be said of the Merrill Lynch and Eaton Vance Letters. This is because Merrill Lynch probably conceded too much in acknowledging that their Demand Feature did not meet the technical requirements of the definition. They arguably took their eye off the ball by focusing on what “triggered” a purchase of the ARPS under the liquidity facility, rather than focusing on the holder’s right to sell the ARPS.
Rule 2a-7 defines a “Demand Feature” in terms of what the holder is entitled to—not what any-one else is obligated to do. The combined terms of the ARPS and the Demand Feature described in the Merrill Lynch Letter “permitt[ed] the holder … to sell the security at an exercise price equal to the approximate amortized cost of the security plus accrued [dividends], if any, … (B) [a]t specified intervals” simply by exercising the right to sell in the weekly auction. Once a sell order was submitted to the auction agent, the holder would receive the full amortized cost value of the ARPS either from a successful auction or from the Demand Feature. Furthermore, a holder could exercise this right even if the closed-end fund failed to make required payments on the ARPS, making the Demand Feature Unconditional.
This is not just a “technical reading” of rule 2a-7’s definition of a “Demand Feature.” Nearly all variable rate demand obligations (“VRDOs”) held by tax exempt money market funds require a remarketing agent to attempt to resell tendered VRDOs before drawing on the letter of credit or standby purchase agreement securing the obligations. The Commission was aware of this when it added the original definition of a “Demand Feature” to rule 2a-7.3 Thus, the fact that a credit or liquidity facility provides for a period in which to resell tendered VRDOs, and is not drawn upon if the VRDOs are resold, has never been treated as inconsistent with the requirement that a Demand Feature be exercisable at any time or at specified intervals. Funds have understood that a Demand Feature is the right to trigger a process that ultimately may lead to a drawing on a credit or liquidity facility, even if the process rarely results in an actual drawing.
To be fair, the Demand Feature in the Merrill Lynch Letter did not operate in the same manner as most VRDOs, which draw on the credit or liquidity facility automatically if the VRDOs are not successfully remarketed. Instead of immediately selling tendered ARPS to the Demand Feature provider following a failed auction, Merrill Lynch proposed to notify all ARPS holders of the failed auction and then give them the right to exercise the Demand Feature. By giving holders an option not to exercise the Demand Feature after a failed auction, Merrill Lynch made it more difficult to treat the election to sell ARPS in an auction as the first step in the ultimate exercise of the Demand Feature. Their structure, coupled with the Goldman Sachs and DLJ Letters, makes Merrill Lynch’s concern for the technical definition of a Demand Feature understandable.
In contrast, LPPs follow basically the same process as VRDOs once the holder participates in a remarketing—the holder tenders LPPs to the remarketing agent, who attempts to resell them and, failing that, draws on the liquidity facility without further direction from or action by the holder. In other words, a holder of LPPs becomes entitled to the amortized cost value of the LPPs simply by electing to participate in the remarketing—no further action is required. The remarketing process merely determines whether the source of payment is a resale of the LPPs or a draw on the liquidity facility, it does not affect the holder’s entitlement to the payment.
By asking for a modification of the Merrill Lynch Letter, Eaton Vance implied that LPPs failed to comply with the “technical definition” of a Demand Feature. While the history of no-action letters on the topic make the desire for greater certainty understandable, it might have been better to try to distinguish LPPs from the ARPS described in the Merrill Lynch Letter. In any event, we hope that no one feels the need for another no-action letter reestablishing that funds may treat ordinary VRDOs as “subject to a Demand Feature,” even if they do not have the Merrill Lynch “triggers.”