GT Alert

Pennsylvania Enacts SWAP Legislation

October 2003
By Rick L. Frimmer, Greenberg Traurig, Philadelphia

  View or download the PDF version of this Alert here.

Swap Legislation Passed

Pennsylvania has officially joined the few states that have enacted legislation specifically designed to provide the conditions under which municipalities and school districts can legally enter into agreements hedging interest rates. On September 24, 2003, Pennsylvania Governor Edward G. Rendell signed H.B. 1148 into law.

"Entering into interest rate swaps has become a favorite tool of tax-exempt bond issuers."

H.B. 1148 represented the work originally done by lawyers at Greenberg Traurig, LLP, particularly Rick L. Frimmer in GT’s Philadelphia office, in concert with State Representative Stephen Nickol. The legislation received support on both sides of the aisle and received special attention from the Pennsylvania Department of Community and Economic Development.

Entering into interest rate swaps has become a favorite tool of tax-exempt bond issuers and their advisors in order to keep a prudent portion of their debt portfolio linked to the interest rate market. Historically, floating interest rates tied to indices, such as the Bond Market Association (BMA) rate, have been lower than fixed rates for investments of the same maturity. Municipalities previously had to resort to issuing multi-modal debt in order to have the ability to switch from fixed interest rates to floating interest rates and vice versa.

Qualified Interest Rate Management Agreements

For the first time, Pennsylvania municipalities which are not distressed may enter into "qualified interest rate management agreements." Thus, cities (other than the City of Philadelphia), school districts, townships and boroughs of all classes may now legally manage interest rate risk through swaps and other forms of hedging devices, including caps, collars, corridors, ceilings, forward agreements and float agreements.

There are a few basic procedural matters that must be observed by the governmental unit:

• The governmental unit must authorize and award the agreement (or confirmation thereof) by resolution and at a meeting duly and specifically advertised for this purpose at least three (3) days prior to the meeting;
• The resolution must include, either in its text or by appendix, all of the following:
  • A copy of the interest rate management agreement or the confirmation proposed to be executed;
  • A copy of an "interest rate management plan" adopted by the governmental unit or by the municipal authority whose debt is being guaranteed by the governmental unit; and
  • A statement of how the interest rate agreement was awarded.

A "qualified interest rate management agreement" must contain certain provisions:

• It must specify which of the government unit’s existing notes or bonds "relate" to the notional amount of the interest rate agreement (thus preventing "naked" swaps);
• A term, which cannot be longer than the latest maturity date of the bonds or notes which the governmental unit states are "related to" the notional amount;
• It must terminated when the "related" bonds or notes are no longer outstanding;
• It must specify a maximum interest rate for the payments to be made by the governmental unit;
• It must provide that the maximum net payments to be made by the governmental unit during a fiscal year cannot be greater than the sum of the variable rate scheduled payments (computed at the maximum rate) and the interest payments actually made by the governmental unit on the "related" bonds or notes;
• It must specify whether the source of the payments by the governmental unit are general revenues or specific revenues;
• A provision addressing what actions will be taken if the counterparty’s credit rating changes; and
• A provision acknowledging that all payments to be made by the governmental unit on its "related" bonds or notes (or those of a subordinate authority) as well as the periodic payments due under the interest rate agreement are all senior in right and priority to any termination payments which may have to be made under the interest rate agreement.
• Covenants to:
  • Make the payments (including termination payments) required under the agreement;
  • Include the periodic payments in every annual budget for each fiscal year that the agreement is in effect;
  • Appropriate annually the periodic amounts due from general or specific revenues.

A "qualified interest rate management agreement" may contain additional provisions at the option of the governmental unit, including a covenant to include any termination payments in a current or future budget; a provision that the periodic payments due are equally and ratably secured with the debt service on the "related" bonds or notes; and a provision that the agreement may be terminated by the counterparty only with cause.

If specific revenues of the governmental unit are pledged for the repayment of amounts due under the "qualified interest rate management agreement," the governmental unit may grant the counterparty a security interest in those specific revenues. If a security interest is granted in the agreement, it is automatically deemed perfected.

The adopting resolution must contain, in its body or in an appendix, an "interest rate management plan." This is a written plan prepared or reviewed by an independent financial advisor which contains at least the following:

• A schedule showing all debt service on all outstanding debt of the governmental unit. In the case of variable rate debt, the debt service must be listed both by computing interest at expected rates and by computing interest as well at the maximum rate specified in the debt instrument;
• A schedule listing the notional amounts of all previous and active qualified interest rate management agreements (although probably all outstanding swap agreements were meant to be included here);
• A schedule of all fees of every kind to be paid both by the governmental unit and the counterparty;
• A schedule of the estimated and maximum payments both to be made and received by the governmental unit under the agreement;
• An analysis of the interest rate risk, basis risk, termination risk, credit risk, market access risk and other risks involved in the transaction to the governmental unit; and
• The governmental unit’s plan to monitor the risks of the current agreement, including obtaining valuations of the periodic market and termination values of all active qualified interest rate management agreements.

The government unit must establish a process for selecting the potential counterparties to the "qualified interest rate management agreement." No entity is eligible to be a counterparty unless it is then rated in the top three rating categories by at least one nationally recognized rating agency (e.g., Moody’s, Standard & Poors, Fitch). The award can be made either by private negotiation or in a public bid.

The form of the agreement to be entered into and adopted in the resolution must contain financial terms and conditions which, in the opinion of an independent financial advisor, are fair and reasonable.

An "independent financial advisor" must be experienced in interest rate risks and in interest rate management agreements, and must not be the counterparty or affiliated with the counterparty.

Default by the Governmental Unit

If the governmental unit fails to include the amount of periodic payments in its annual budget, the counterparty may bring an action for mandamus in the court of common pleas, whereupon the court may order the governmental unit to pay the periodic payments out of the first revenues received thereafter by the governmental unit which are not required to be placed in a sinking fund for certain tax anticipation notes.

If the governmental unit fails to pay any amount due under a "qualified interest rate management agreement" for thirty days or more, the counterparty, subject to any contrary provisions in the agreement, may sue the governmental unit in common pleas court. Any judgment rendered in favor of the counterparty will, subject to a few exceptions, be payable of the first revenues received thereafter by the governmental unit.

If the governmental unit is a school district and fails to make periodic payments under a "qualified interest rate management agreement," the Pennsylvania Secretary of Education must be notified (by either party). The Secretary of Education will then notify the school board and the Pennsylvania Department of Economic and Community Development. Additionally, until paid, any amounts due to the school district from the state will thereafter be paid to the counterparty.

Also, any judgment rendered against a governmental unit for failure to pay and an unpaid termination payment is now eligible to be the subject of new bonds issued for "unfunded debt."

Further, termination payments can now be included in refunding issues.

Administrative Matters

A certified copy of the resolution adopted for a "qualified interest rate management agreement" must be filed within fifteen (15) days with the Pennsylvania Department of Community and Economic Development.

If the maximum amount of net payments that could be made under a "qualified interest rate management agreement" are greater than the debt service that would be payable on the "related" bonds and notes, computed at their maximum rates, the governmental unit must adopt a resolution increasing the maximum interest rate on the "related" bonds and notes. No other approvals are required.

The governmental unit must account for all "qualified interest rate management agreements" in its financial statements under applicable principles adopted by the Government Accounting Standards Board of the American Institute of Certified Public Accountants.

In H.B. 1148, Pennsylvania municipalities have been given a broad authority, subject to appropriate checks and balances, to enter into sophisticated transactions and can manage their borrowing needs on a more streamlined and efficient basis.

Greenberg Traurig’s public finance lawyers in Philadelphia and elsewhere are experienced in these sophisticated transactions and proud to have assisted the Commonwealth of Pennsylvania in being among the few states recognizing the need to have formal guidance in this area.

© 2003 Greenberg Traurig

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