Swaps and Other Hedges

One of the most interesting developments in the public finance market in several years has been the rise of "derivative products," a broad term which includes various methods of repackaging municipal bonds into tax-exempt instruments with characteristics different from the bonds as originally issued, embedding more sophisticated interest rate formulae into tax-exempt bonds, hedging issuers' and investors risk exposures, and products to help issuers manage their fund investments. Derivative products have been developed in response to specific needs of issuers and bond purchasers. Governing law or the issuer's objectives may not permit bonds to be issued in a form that would command the best price in the market. Underwriters or other market participants, either in connection with the initial issuance of the bonds or in totally unrelated secondary market transactions, using custodial receipts, grantor trusts, swaps, puts or other devices, make a different instrument or instruments ("synthetic securities") out of the original bonds that they can market at an aggregate price higher than they paid for the original bonds. It is generally necessary to avoid creating a new debt obligation (that would not be tax-exempt) for tax purposes. For securities law purposes, either (i) no separate security that would be subject to registration with the SEC is created, (ii) a separate security is created and sold by private placement, or, (iii) taking advantage of recent changes in federal securities law, a separate security is created and registered with the SEC so that it can be publicly sold.

Derivative products are a mixture of municipal and corporate finance devices and concepts and require expertise in securities laws and related tax laws, including the Investment Company Act of 1940, and tax laws, such as the rules governing contingent payment debt instruments, notional principal contracts, regulated investment companies, partnerships and grantor trusts (including the so-called "Sears Regulations"), not normally encountered in tax-exempt bond practice. As one of the few major bond counsel firms with a substantial asset securitization practice (generally ranked number one or number two by The American Lawyer) and related tax expertise, Orrick is uniquely suited to provide the specialized legal services required by this area. As a result, the firm has played an important part in its development. We have had extensive experience with the IRS, the SEC, and other government agencies that regulate this area, trade groups such as the Investment Company Institute, and the major buyers of derivative products and their counsel. We have participated in a greater number and diversity of derivative product transactions than any other firm, since the beginning of 1990, have secured as principal counsel in well over 450 secondary market derivative transactions aggregating approximately $15 billion in face amount of securities offered. Examples include:

• partnership structures creating synthetic floating rate and inverse floating rate obligations from fixed rate bonds for Bank of America, Bear Stearns, Chase Securities, State Street Bank, J.P. Morgan Securities, Merrill Lynch, and CS First Boston, among others
• tender option bond programs, utilizing third-party, non-issuer puts to turn fixed rate bonds into synthetic variable rate put bonds, for Merrill Lynch, J.P. Morgan Securities, First Boston, Goldman Sachs, Bankers Trust, Morgan Stanley, Kidder Peabody, and others
• detachable call options
• various kinds of embedded swaps, caps, and forwards
• municipal receivables financings, including New York City's tax lien sale (Institutional Investor 1994 Deal of the Year)
• municipal strips, which separate interest from principal payments to produce zero coupon instruments and several variations, for Bank of America, First Boston, Goldman Sachs, J.P. Morgan Securities, Kidder Peabody, PaineWebber and Rauscher Pierce. Orrick drafted the federal tax legislation in 1986 that gave rise to the use of municipal strips.
• municipal cross-border leases
• various types of sales/dispositions of packaged portfolios of municipal obligations (including municipal leases and distressed multifamily housing bonds)
• synthetic serializations of term bonds
• synthetic advance refundings
• various kinds of forward and swap and/or put based investment agreements
• anticipatory hedging programs for issuers

Orrick is also one of the few firms with significant experience with municipal interest rate swaps, partly as a by-product of our work in derivative products and of our assistance to the Public Securities Association and the International Swaps and Derivatives Association, Inc. and also as a result of representing issuers and underwriters in nonderivative original bond issues that involve swaps: for example, swaps to a fixed rate used in combination with variable rate bonds to produce lower interest rates than those available for fixed rate bonds, swaps to variable rates during construction to maximize investment income, and forward swaps in combination with variable rate bonds to approximate the economic effect of advance refundings, as well as other hedge instruments such as interest rate caps, floors, collars, "swaptions" and currency swaps. We have also represented swap counterparties and other providers of swap and other hedge instruments. The legislation granting California public entities the power to enter into swaps and other similar devices (which was the basis for the ISDA model swaps legislation) was drafted and lobbied by our firm, and we have participated in such legislation in other states (e.g., New York and Washington).