LOS ANGELES -- A New Jersey-based bond dealer is unhappy with a California hospital's recent decision to call escrowed-to-maturity debt and has asked the Securities and Exchange Commission to examine whether the issuer acted properly in calling the bonds before maturity.
On Oct. 1, Memorial Health Services, a nonprofit medical center in Long Beach, Calif., redeemed at par the remaining bonds from a $15 million issue sold in 1974.
Officials at Emmet & Co., which had traded the bonds in the secondary market, said they were surprised at the redemption because they believed the bonds were escrowed to maturity to the year 2000 and could not be called.
Medical center officials, who referred calls to their legal counsel, apparently concluded they were well within their rights to call the bonds because they believed the indenture for the 1974 sale still governed the bond issue. That indenture includes language permitting the early redemption.
But Emmet officials said the secondary market established pricing levels for the bonds, recently at a small premium, by relying on a 1984 escrow deposit agreement that did not provide for redemption of the bonds prior to maturity.
Memorial Health reached an agreement in late August 1992 with the bond trustee, Bank of America, to amend that escrow agreement and insert a clause providing for the early redemption terms included in the 1974 indenture.
Although the medical center apparently found there was nothing in the escrow agreement that prohibited such an amendment, "that's where we have a problem," said Dennis Darling, a vice president of Emmet. He said the amendment was similar to "extending the field of play when you're about ready to score."
The concern raised by Emmet over such a redemption is not new.
Previously, the municipal market has witnessed confusion and controversy over attempts to call bonds that had been escrowed to maturity through refundings. That controversy prompted industry groups and the SEC to issue ground rules on notification that must be made to bondholders regarding the right to call the bonds.
But that guidance only focused on situations in which the bonds were escrowed to maturity through refundings.
By contrast, the redemption by Memorial Health involves a different set of circumstances, primarily because the medical center defeased the 1974 bonds with cash on hand in 1984 rather than with a refunding issue. That distinction has led officials at Emmet and the issuer to reach widely different conclusions over the propriety of the redemption.
From an investor's standpoint, Emmet officials argue that the end result is the same because they redemption.
From an investor's standpoint, Emmet officials argue that the end result is the same because they relied on language in the escrow agreement that failed initially to provide for a call.
If that escrow agreement is subject to change, "what can you put you faith in out there?" asked Darling.
But some tax lawyers, who stressed that they are not familiar with details of the Memorial Health redemption, said bondholders in such a situation might incorrectly conclude the escrow deposit agreement is the controlling document.
The lawyers said they might see a distinction when an issuer uses its own funds to establish an escrow. One test, the lawyers said, is whether bondholders are considered a third-party beneficiary to the escrow agreement, with a right to rely on its provisions.
If the bondholders are not party to the escrow agreement, they may remain subject to contractual provisions established in the original indenture, including its redemption options, according to the lawyers.
Regardless of that legal distinction, some lawyers said the Memorial Health situation could raise some thorny issues because of sensitivity over the topic of secondary market disclosure.
That issue seems to be at dispute in the Memorial Health redemption, at least from the investors' standpoint, according to Darling.
In particular, Darling contended that language in the escrow deposit agreement seemingly discharges the lien of the 1974 indenture. "How can you breathe life into the old issue again?" he asked, if the bond trustee appeared to acknowledge the release of the indenture.
Officials at the medical center and the bond trustee referred questions about the redemption to the bond counsel, O'Melveny & Myers.
"We felt they have a reasonable legal position" that supported amending the escrow and treated the 1974 indenture as "still operative," said a senior partner at O'Melveny. "We don't make business judgments," the partner said, adding that it was the medical center's decision whether to effect the redemption.
Escrow accounts, whether they are funded with bond proceeds or an issuer's own resources, typically include sufficient moneys to make scheduled interest payments and to redeem existing bonds at maturity.
Market participants said it made sense for some issuers in past years to do cash defeasances, primarily because investment returns from the escrow accounts were adequate to cover bond payments and generate a surplus return.
It probably was attractive for Memorial Health to collapse the escrow now, the sources speculated, because Treasury securities that are often set aside in such escrow accounts have appreciated in value. As a result, an issuer can collapse an escrow under such circumstances, pay off the existing bonds, and pocket any remaining funds, they noted.
In another twist on the Memorial Health issue, some investors holding the 1974 bonds might have experienced a misunderstanding because of information provided on that issue by a J.J. Kenny Information Systems fact sheet in recent months, according to market participants.
That information showed the 1974 bonds as escrowed to maturity "from an issue dated March 15, 1984," suggesting the escrow was funded with proceeds from the 1984 bond issue. But market participants familiar with the 1984 deal said it had nothing to do with defeasing the 1974 bonds.
The "uses and sources of funds" section from the official statement for the 1984 deal reinforced that notion because it showed none of the proceeds being used for a refunding.
But officials at Emmet said they are upset regardless of how the escrow was funded, arguing that the key issue is their belief that the original escrow deposit agreement controlled the call provisions.
An amendment to the escrow agreement, dated Aug. 28, 1992, between the medical center and the bond trustee, noted that the indenture permits the redemption of the bonds on Oct. 1, 1992, "but the escrow deposit agreement does not provide for the redemption of the bonds prior to maturity."
As a result, the amended agreement includes a clause that permits "earlier redemption, in accordance with the provisions of the indenture."
Officials at Emmet said they learned on the amended agreement when they received a 30-day call notice. They contend the amendment violates an earlier SEC position that stresses the need to provide disclosure in all documents regarding optional redemption rights.
They cited a letter from the SEC, dated June 25, 1988, and sent to the Municipal Securities Rulemaking Board, to support their contention. Emmet officials believe the principles stated in that letter apply, even though the discussion focuses on early calls of bonds that have been escrowed to maturity through refundings.
Emmet officials concede that the medical center's par redemption resulted in relatively small losses for investors who had bought the bonds recently. The small amount of bonds exchanged recently traded at about 103% of par value, dealers said.
"It's easy just to say the hell with it" when smaller amounts are involved, said Christopher Emmet, president of the firm bearing his name.
Saying "I don't care if it's legal or not" how the medical center went about handling the redemption, he argued that broader principles are at stake when an action violates an accepted rule of thumb in the industry regarding redemptions of such escrowed-to-maturity bonds.
Emmet said he might contemplate further legal action, with a final decision partly dependent on whether others in the industry think the matter provides a possible test case.
Darling noted that the SEC, as a point of policy, declined to comment on whether it will look into the issue.
He also expressed disenchantment with the bond trustee's role in agreeing to the amendment, saying it makes him wonder "who's minding the store for bondholders."
Russ Jansky, manager of fixed-income trading, sales, and syndication for Hanifen, Imhoff Inc., in Denver, said one of the firm's clients assumed the bonds were escrowed to maturity until 2000.
"We're going to have one ticked-off customer" over the redemption, Jansky said, adding, "We should find a way to stop these things from happening."
Memorial Health issued the 1974 bonds under its previous name, Memorial Hospital Medical Center of Long Beach Inc.
