Most hospitals know that a bank letter of credit which terminates within one year of fiscal year end must be extended, or the underlying variable rate demand obligations (VRDO) will be classified as a current liability, which could wreak havoc on covenants. Some borrowers, including those with LOCs renewing for the first time, are finding out the hard way that VRDOs can still end up as a current liability no matter how much time is left to expiration.
By design, VRDOs are highly liquid instruments which contain a “put” or demand feature. This feature allows money market funds to dump the paper back to issuers on short notice, thereby maintaining a stable value of $1 per share to avoid “breaking the buck”.
The most common VRDOs are weekly floaters with a coupon reset each Wednesday based on the SIFMA index. If on remarketing day the bonds are put back to the remarketing agent for whatever reason, the LOC bank steps up to ensure the bondholders are made whole, then seeks repayment from the borrower based on the term-out provisions contained in the reimbursement agreement.
VRDOs backed by a LOC expiring within one year of fiscal year end are almost always classified by auditors as current liabilities on the balance sheet. What some hospitals don’t realize is that even if there is plenty of time to go until LOC termination, term-out provisions and/or acceleration clauses may still cause the bonds to be classified as a current liability.
Typical LOC term-out provisions require that draws be repaid based on the original bond principal amortization schedule, with any remaining balance paid in full on the LOC expiration date as a balloon payment. Payments scheduled within one year are classified as current. If the balloon is at least one year out, it is classified as noncurrent. In that case, the hospital is no worse off than if it were making original scheduled payments. That is of course until the balloon comes due, but this gives time to address the problem and the audited financial statements and covenants are not yet affected.
Complications arise if the LOC contains more aggressive term-out provisions and acceleration clauses.
Any term out provisions which require the hospital to repay draws on a shorter schedule could have a serious impact on accounting classification. For example, a term-out provision may have the hospital pay back draws in equal monthly payments starting on draw date and over 24 months. Here, auditors will assume a worst case scenario where a draw occurs on the next business day following fiscal year end, and we now have a big problem because half of the VRDO outstanding principal (the first year of the two-year term-out) is treated as current. The shorter the term out, the bigger the problem.
Additional problems could occur if the LOC terms contain an acceleration clause which gives the bank the right to demand accelerated or immediate repayment based on what auditors deem to be “subjective” criteria. These criteria could include a material adverse change (MAC) language, which can be vague and may not list specific events. Under certain circumstances, auditors will assume that the debt will be accelerated, thus triggering a current classification.
With the slew of LOCs terminating in 2011, hospitals are well advised to get an early start before they get the call from their auditors.
HFA Partners is an independent financial advisory firm helping hospitals and other healthcare providers mitigate financial risk, optimize the capital structure, and lower their cost of capital. For more information, visit www.hfapartners.com.
By design, VRDOs are highly liquid instruments which contain a “put” or demand feature. This feature allows money market funds to dump the paper back to issuers on short notice, thereby maintaining a stable value of $1 per share to avoid “breaking the buck”.
The most common VRDOs are weekly floaters with a coupon reset each Wednesday based on the SIFMA index. If on remarketing day the bonds are put back to the remarketing agent for whatever reason, the LOC bank steps up to ensure the bondholders are made whole, then seeks repayment from the borrower based on the term-out provisions contained in the reimbursement agreement.
VRDOs backed by a LOC expiring within one year of fiscal year end are almost always classified by auditors as current liabilities on the balance sheet. What some hospitals don’t realize is that even if there is plenty of time to go until LOC termination, term-out provisions and/or acceleration clauses may still cause the bonds to be classified as a current liability.
Typical LOC term-out provisions require that draws be repaid based on the original bond principal amortization schedule, with any remaining balance paid in full on the LOC expiration date as a balloon payment. Payments scheduled within one year are classified as current. If the balloon is at least one year out, it is classified as noncurrent. In that case, the hospital is no worse off than if it were making original scheduled payments. That is of course until the balloon comes due, but this gives time to address the problem and the audited financial statements and covenants are not yet affected.
Complications arise if the LOC contains more aggressive term-out provisions and acceleration clauses.
Any term out provisions which require the hospital to repay draws on a shorter schedule could have a serious impact on accounting classification. For example, a term-out provision may have the hospital pay back draws in equal monthly payments starting on draw date and over 24 months. Here, auditors will assume a worst case scenario where a draw occurs on the next business day following fiscal year end, and we now have a big problem because half of the VRDO outstanding principal (the first year of the two-year term-out) is treated as current. The shorter the term out, the bigger the problem.
Additional problems could occur if the LOC terms contain an acceleration clause which gives the bank the right to demand accelerated or immediate repayment based on what auditors deem to be “subjective” criteria. These criteria could include a material adverse change (MAC) language, which can be vague and may not list specific events. Under certain circumstances, auditors will assume that the debt will be accelerated, thus triggering a current classification.
With the slew of LOCs terminating in 2011, hospitals are well advised to get an early start before they get the call from their auditors.
HFA Partners is an independent financial advisory firm helping hospitals and other healthcare providers mitigate financial risk, optimize the capital structure, and lower their cost of capital. For more information, visit www.hfapartners.com.