Latest from my friend and mentor David Kotok at Cumberland Advisers -- Chris
The issue is complex. Let’s dissect it into two parts with a generic storyline.
As a bondholder you, along with other bondholders, are concerned about default risk. You want to be sure that you get paid principal and interest when they are due. So you have a discussion with the bond issuer, who wants to avoid a default and welcomes your support. But the bond issuer also has to comply with security law and to deal with a public and governmental entity and disclosure rules.
You agree to sign a nondisclosure agreement (NDA) with the bond issuer. Now you have details that are in addition to the public information the bond issuer is supposed to give everyone each month. You may therefore obtain from and discuss with the bond issuer certain information that has yet to be released to the public. You may give private advice to the issuer as to the ways the bond issuer can restructure its debt in order to reduce default risk. You and the issuer honor the NDA. The meetings are informal.
You now have more information than the public has. You also know that you cannot legally trade that security with the public until they have the same information that you have. You are an “insider.” If you trade on the inside information, there is a violation of securities laws as we understand them. It seems to be okay for you as a bondholder to help the issuer improve its circumstances, provided that the information is not used to transact in the security for your benefit.
Let’s extend the case study.
You then find another bondholder. That bondholder is also concerned about default risk. You ask this other bondholder to join you and agree to the NDA. When both meet informally with the issuer, both give the issuer advice as to how the issuer can improve its financial security.
Now there are two bondholders and an issuer. The three have an NDA.
Suppose a third, fourth, and fifth bond owner agree to join the group. Pretty soon, a large block of these bonds is owned collectively. All signed an NDA. All agreed, ostensibly, to use the information to assist the issuer in clearing up a financial structure for reduction of default risk.
What if one of those bondholders needs to transact in the bonds? None of the bondholders can transact with the public, because they have information that the public does not.
So, another component is then added to the NDA agreement. That clause is simple. You and members of the group may transact with each other and not violate securities law. Why not? Because you are all under an NDA, and you all have the same privately obtained information. Your lawyers advise that the public securities laws are not being violated.
Now we have an unusual condition. It pertains to the obligation of public disclosure and may or may not create a burden on the issuer. The issuer wants the help of the bondholder groups. The issuer is in serious financial difficulty. It needs to restructure its finances. On the other hand, the issuer has reporting requirements to all bondholders, not just some. There is now a tension between two classes of bondholders – those that are under the NDA and the rest of the bondholders that are not.
Make this even more complicated by having the NDA-bound bondholders assemble a fairly large position in the bonds. We assume that they buy them BEFORE they join the NDA since they would be trading on inside information if they purchased after they signed it. The case study gets even more complex because bondholders under the NDA cannot transact with bondholders that are not under the NDA.
By sopping up the tradable inventory, the NDA bondholders may now be influencing the market price by making this bond less liquid. The bondholders who are not party to the NDA watch the market price change. They try to derive information from market activity. They want to figure out what may be going on with the issuer. They use the market to assess the payment or default probabilities of their bonds.
At the same time, independent money managers, some mutual funds, certain research organizations, and the credit rating agencies that follow the bonds are under the same constraint. They are not part of the NDA or the new private club of bondholders that obtains inside information. These agents are retained and paid for their market observations and opinions. Their market observations may now be distorted by the behavior of the NDA bondholders.
Where am I going with all of this?
Friday afternoon, the story broke about the Puerto Rico Electric Power bond contract that involves an NDA. We have copied and pasted the Bloomberg citation at the bottom of this commentary as well as adding the link here. We congratulate Bloomberg for timely and comprehensive reporting.
Puerto Rico Electric Power Authority, known as PREPA, has entered into arrangements with certain hedge funds and is in confidential dialogue with some bondholders, at the exclusion of others. PREPA says it will comply with the publically required reporting under its contracts with all bondholders.
At Cumberland Advisors, we have a specialized management and credit assessment mechanism that focuses on Puerto Rico debt, of which there is about $73 billion outstanding. We track all Puerto Rico bonds and disclosures. We examine them thoroughly. Our selections about, which debt to hold and which not to hold, are made under rigid internal and proprietary disciplines. We examine layers of credit enhancement and see the cross-claims and collateralization in, among, and between the various Puerto Rico agencies. Our starting point is that this is a deservingly weak credit that earned its junk credit status and has been mismanaged for many years.
Our second point is that within this large array of Puerto Rico debt there are some great opportunities for investors. Our job is to seize these opportunistically and to avoid risks for which our clients are not properly compensated. Puerto Rico debt structures are a specialty on their own.
Suddenly, we now have a new class: those bondholders who are under the NDA versus those who are not. That is a new game in the Puerto Rico debt saga. It also means that certain market-based indicators may be influenced by the accumulation of holdings involved with the NDA. We have no way to know for sure.
Cumberland Advisors is not a signatory to an NDA on any Puerto Rico debt. We believe we must be able to trade for our client’s managed accounts without any restrictions. Cumberland Advisors’ positions in Puerto Rico debt are determined by our own research and analysis based on public information.
We will leave it to regulators, market agents, and media to determine whether or not a two-class bond-holding system is beneficial to the public securities markets or detrimental to them. From our firm’s view, we will not participate in this new bifurcated bond-holding structure.
The citation in Bloomberg follows:
Puerto Rico Power Bond Contract Limits Disclosure, MMA Says (1)
2014-09-12 19:54:35.53 GMT
By Michelle Kaske
Sept. 12 (Bloomberg) -- An agreement between Puerto Rico’s junk-rated power utility and investors holding the bulk of its debt gives the agency time to mend its finances. It also offers some bondholders non-public information, says Municipal Market Advisors’ Bob Donahue.
The Puerto Rico Electric Power Authority, called Prepa, the main electricity supplier on the island, last month entered into an agreement with investors who collectively hold more than 60 percent of the utility’s $8.3 billion of debt. For signing on to the contract, those bondholders will receive monthly cash statements and financing plans, according to the document for the deal, known as a forbearance agreement.
Such an arrangement is typical in the $3.7 trillion municipal-bond market, yet the amount of Prepa’s obligations makes the situation unique, said Donahue, managing director at Concord, Massachusetts-based MMA. If the utility restructures its debt, it would be the biggest ever in the municipal market.
“The many disclosures that they will receive, that will create a real asymmetry in the market between those in the agreement and those outside,” he said.
David R. Kotok, Chairman and Chief Investment Officer