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Lagos State’s Municipality Note Default: Understanding The Issues, Implications and Lessons

State and Local Govts	8039 VIEWS
State and Local Govts
8039 VIEWS

Friday, March 08, 2019 02.48AM / By Teslim Shitta-Bey Managing Editor, Proshare / Header Image Credit: Visionscape

As at the close of business at 5pm on March 07, 2019 the Lagos State Government, in breach of the terms of a N4.85bn 15.75% Series 1, Tranche B Secured Rate Medium Term Note due in 2022 and Issued by a private company, Municipality Waste Management Contractors Limited, is yet to pay the due incomes to investors in the Fixed Interest Rate Medium Term Note (‘The Municipality Note’).

Since Proshare broke the story on March 5, 2019; a couple of narratives have emerged in main stream and social media which has created more emotion than clarity on the issues; including the narrow interpretation of which entity is in default or the nature of the default. An interrogation of these matters, outside of political considerations around the transaction will reveal a lot of teachable moments that serves up improvement needs for the development of the private sector-led bond market.

In furtherance of our remit - professional obligation to offer clarity on market developments in the interest of capital market stability, integrity, and in fairness to the State Government/stakeholders involved in the transaction (especially the investing public), we highlight below the salient issues concerning the reported payment default on the 15.75% Series 1 Fixed Rate Note issued by Municipality Waste Management Contractors Limited (“MWMCL”) and secured by an Irrevocable Standing Payment Order (ISPO) of the Lagos State Government.

The intervention covers there major elements:

1. Who is in default and does this qualify as a technical default?
2. What lessons can be extracted about the default as it relates to risks related to bonds and the importance/place of ratings in investment grades; and
3. The sanctity of contracts and the place/role of Guarantees.

The third point which basically addresses the return of capital vs. return on capital issue will be a matter for a future deep-dive which should offer some illuminating perspectives on what is possible and how we can reinforce safety measures in the all-important fixed income/bond market.

Sticking to the Facts

Background To Note

To complement the Federal National Environmental Standards and Regulations Enforcement Agency (Establishment) Act, 2007 (“NESREA”), various States passed their Environmental Laws and Regulations as advancements to this law.

Lagos State was one of such states, when in March 2017, it passed into Law the Lagos State Environmental Management Protection Law, 2017 (“EMPL 2017”). This Law consolidated all the Laws and Regulations applicable to the management, protection and sustainable development of the environment in Lagos State.

Though the EMPL 2017 has fourteen (14) parts, with 526 Sections, various Schedules and is 239 pages long, this Law considerably attempts to delve into more modern cosmopolitan environmental issues like waste management, litter, dumping of untreated toxic and or radioactive material into public drains; sanitation, street trading and hawking; obstruction to drainage systems, water generation, effluents, noise, signage, advertisement, gardens and parks, etc.

The Government of Lagos State through the Ministry of the Environment introduced the Cleaner Lagos Initiative (CLI) backed by a recently passed Environmental Management and Protection Law (EMPL 2017).

Lagos State Government then awarded contracts to the Visionscape Sanitations Solutions Limited and its strategic partners for deployment of appropriately scaled waste management infrastructure.

Visionscape Group executed a Memorandum of Understanding on February 23, 2017 authorising the incorporation of a Special Purpose Vehicle (“SPV”) – the Municipality Waste Management Contractors Limited for the purpose of issuing Medium Term Notes (bonds) to finance implementation of the CLI.

Further to this, the Lagos State Executive Council at a meeting held on March 21, 2017 passed a resolution to secure the financing structure adopted by the Consortium to raise funds for the project via issuance of an Irrevocable Standing Payment Order (ISPO) as a charge on the State Internally Generated Revenue account/ Environmental Trust Fund.

The Note

In early 2018, Municipality Waste Management Contractors Limited approached the capital market through registered and authorized technical parties to raise N4.85bn for the mobilization of assets for residential and general waste collection under the Cleaner Lagos Initiative of the Lagos State Ministry of Environment.

The Offer, with a nominal face value of N1, 000 per unit, opened on February 26, 2018 and closed on February 28, 2018. The Issue price was 100% of par value and promised a coupon of 15.75% or N157.50 per unit.

The Note has the following additional features:

It has a tenor of four and a half years to be repaid in 9 equal semi-annual installments;
Payments are to be made on March 5 and September 5 of each year in arrears up to and including the Maturity Date;
The Maturity Date is September 5, 2022;
The Offer was made by way of a Private Placement;
The Note was given an ‘A+’ Rating by Rating Agency Agusto & Co and an ‘A’ Rating by GCR (formerly known as Duff & Phelps);
The Offer is backed by an Irrevocable Standing Payment Order (ISPO) of the Lagos State G0vernment charged against the states Internally Generated revenue (IGR); and
In September 2017, Municipal Waste Management Contractors Limited (MWMCL) Issued a Series 1 Tranche A Bond amounting to N20.5bln as part of the N27bln series 1 Fixed Rate Note.

The Note is part of a larger N50bln Medium Term Note Programme designed to raise money to address the environmental challenges of Lagos State which presently generates an official average of 13,000 tonnes of solid waste daily.

Rating Agency, Agusto & Co noted in its extracts of the Rating Report published in the Note’s Offer document that, among other things, “the series 1 Note Issuance is fully guaranteed by the Lagos State Government (“LASG” or “the State”) in form of a duly executed Irrevocable Standing Payment Order (ISPO) authorizing monthly deductions of N715. 7m from the State’s internally generated revenue for the repayment of the entire series 1 Note obligation. The assigned series 1 Tranche B rating (which is the same “A+” rating issued to series 1 Notes by Agusto & Co in June 2017) therefore reflects the strong financial condition of the Lagos State Government” (see extract image below).

Figure 1: Extract of Agusto & Co’s Rating Report for the Note

Source: Supplemental Information Memorandum, Municipality Waste Management Contractors Ltd

The Agusto Credit Rating report further goes on to note that”

“In our view, the Series 1 Note has a low credit risk profile and strong capacity to pay coupon and principal in a timely manner mainly supported by the continuous fulfillment of monthly ISPO deductions of approved amounts by the Lagos State Government for the repayment of the series 1 Note obligation”.

Legal Basis

According to Michael Orimobi in his September 29, 2011 published overview in Proshare titled “The Issuance of State Government Bonds in Nigeria”, he avers that:

“The power of State Governments to issue registered bonds (and promissory notes) is enshrined in Section 223 of the Investment and Securities Act 2007 (“ISA”).

In issuing a State Government bond, the requirements for obtaining the SEC’s approval are provided for in Section 224 of the ISA and Rule 307 of the Securities and Exchange Commission’s Rules and Regulations (“SEC Rules”) made pursuant to the ISA. Section 224(3)(a) of the ISA provides that an application to the SEC by a State Government to raise funds from the capital market shall be accompanied by such documents as may be prescribed by the SEC, from time to time, and shall include:

1. a Law authorizing the bond issuance exercise and creating a sinking fund to be fully funded from the consolidated revenue fund account of the issuer;

2. a Rating Report by an accredited Rating Agency registered with the SEC; and

3. an Irrevocable Letter of Authority (ILoA) from the Accountant General of the State, authorising the Accountant General of the Federation to deduct payment obligations due on the bond from the issuer’s statutory allocations in the event of a default by the Sub-national.

The Sinking Fund simply refers to a fund into which an issuer sets aside monies with a view to liquidating its debt instruments. The Sinking Fund can be funded through the Irrevocable Standing Payment Order (ISPO) and or any other source of repayment as discussed in the offer documents (in this case, the Bond Prospectus and the Trust Deed). The ISPO established by reason of the ILoA is a credit enhancement tool as it is backed by the full faith and credit of the Federal Government of Nigeria. In other words, it improves the credit rating of the instrument and enhances the attractiveness of the instrument to prospective investors.

However, under Rule 107(6) of the SEC Rules, a State Government bond can be approved by the SEC without an ILoA/ISPO E.g. the Lagos State N57.5bn Series II Fixed Rate Bonds issued in April 2010 under the N275bn Debt Issuance Programme of the State Government, was issued via a book building process to investors without an ISPO. A fastidious examination of the provisions of Section 224(3)(a) of the ISA creates an impression that deductions from the statutory allocation (ISPO) should only crystallize when there is a default by the Sub-national in liquidating the bonds from other sources of repayment. In practice, this isn’t entirely correct. In fact, for most Sub-national bonds (if not all) that have hit the Nigerian capital market in the recent past, the ISPO is the only or major source of repayment. In other words, deductions from the statutory allocation of the State kick-off immediately the offer hits the market and in some cases, even before the offer hits the market.

In addition, the Resolutions of the State Government’s Executive Council and Legislative Assembly authorising the issuance of the bonds and published in the Official Gazette of the State and the Feasibility Reports on the projects to be funded by the proceeds of the bond issue are part of the documents that are sine qua non for the SEC’s approval to be obtained. Moreover, the funding from the bond issuance exercise and utilization of same should be captured in the provisions of the state’s yearly budget during the bond’s tenor.”

Noteworthy must be the fact that this particular bond was not approved by the SEC as it was not presented to it. The transaction was considered a private initiative and is equally permissible.

This is where it gets interesting and opens the doors for governance issues around risks, pricing in defaults from ratings and the window for an unwilling issuer to distort the market intent.

More importantly, and as we briefly show below, the role/status of trustees as gatekeepers become crucial i.e. to be able to:

1. recognize the place of guarantee on the Lagos State Govt revenue by being able to distinguish between the use of FAAC vs. IGR as protection for investors; and

2. The sanctity of contracts or recourse in the case of a contract dispute; if the bond was ‘condition precedent’ on a contract.

Matters Arising

The most important asset traded in financial markets is trust. A financial transaction is priced and agreed on the basis of trust concerning the underlying quality of the asset.

To establish that quality and to ensure a credible metric by which an asset can be traded, especially if the Issuer of the asset lacks a credible borrowing history, a Credit Rating Agency serves as an assessor of the default risk of a debt instrument such as the MWMCL Fixed Rate Note. Agusto’s ‘A+’ Rating of the Offer made the MWMCL Note eligible for Institutional Investors such as Pension Funds to invest in.

It naturally therefore brings to the fore, a number of critical market governance issues:

Can the Rating Agencies’ assessment of the default risk of primary debt Issues offered in markets be trusted? What is the true value of an ‘A+’ rating? This has been an issue that has dogged capital markets around the world since the collapse of major global financial markets in 2007/2008 when sub-prime mortgage assets in the United States were wrongly valued and ratings firms found their careful calculations thrown into the garbage can of serial mortgage defaults. Rating firm calculations do quite poorly in predicting the likelihood of default, but because Issuing houses use the rates of these Agencies to establish safety thresholds for Debt Issuers there is a systematic tendency for such Debt Issues to be underpriced. Default Risk and debt pricing are related but not the same thing. This is becoming increasingly clear as issues of default risk are attended to by market operators without any safety nets (in the absence of guarantees).

Does the 15.75% coupon on the Note adequately reflect the inherent risk of default of the 4 ¹/₂ year Fixed Interest Note? With the recent payment default on the Note, the answer would clearly be ‘No’.

How does the recent payment default affect the pricing of the Note in secondary markets? Since the coupon on the Municipality Note is not adjustable, secondary market transactions on the Note will take place at steep discounts to reflect the Notes newly established default risk. The bonds’ required rate of return would be closer to 23% than its coupon of 15.75%..

Who is the primary Obligor to the Offer since the Issuer is a Private Limited Company but the Lagos State Government has agreed to use its internally generated revenue (IGR) to support the Offers Sinking Fund by way of monthly deductions to the credit of the Fund? This is a grey area of the Note. The Municipality Note takes its default risk rating of A+ from the state government and not the limited liability company that issued the Note (as is clearly inferred by the Agusto Credit Rating report).

Further, in a letter dated 20th April 2017, and signed by the Director of Treasury Operations and Permanent Secretary/Accountant General of the Government of Lagos State; and addressed to Municipality Waste Management Contractors Limited, it was stated that:

“Pursuant to the Lagos State Executive Council Resolution (Ref. No.SSG/CO/S.126/VOL.XVI/60) passed on the Provision of a Guarantee for the above mentioned contract, and following the execution of State wide Residential and General Waste Collection Agreement between Visionscape Sanitation Solutions Limited, and the Lagos State Government, and under which Agreement the LASG is required to issue to the Contractor a guarantee, I am directed to convey the approval for an Irrevocable Standing Payment Order (ISPO) in respect of the above referenced Contract Agreement.”

The letter goes on to read : “Consequent upon the above, this office would implement the monthly remittance of the gross sum of Seven Hundred and Thirteen Million, Seven Hundred Thousand Naira Only (NGN713,700,000) as a first line charge from the revenue account of Lagos State Government which is to commence in June 2017 and terminate in June 2027.”

The information memorandum (issued in lieu of a prospectus for private placements) sent out to prospective investors had included an excerpt from Agusto & Co (as indicated above) that relied on this comfort/guarantee wherein it stated that:
“We estimate that the duly executed ISPO on Lagos State’s revenue account constitutes sufficient security for the issue as the remittances…will be adequate to cover the cumulative obligations (coupon payments and principal repayments) of the Series 1 Note 1.03 times.”

What has been the role of the Securities and Exchange Commission (SEC) in mitigating payment defaults in state government-sponsored debt issues? The MWMCL Municipality Note Fixed Rate Debt Issue never mentioned the SEC in its Information Memorandum. It need not if it is as admitted, an Issue by way of a Private Placement . However, given the involvement of a sovereign entity like a state and the size of the transaction, market experts will have to provide some guidance on how such should be packaged in future. It would appear though that in this case, investor protection is a function of the investment grade rating that approximates the risk of default; and where the investment rating of the state Government was used; it assumes the risk of default; not the company who had no credit history at the time of consummating the transaction.

The short period between the opening and closing of the Offer indicates a likely SEDA (standby equity distribution agreement) by institutional investors.

How will the distortion in the repayment cash flow be addressed and at what cost? Since the Note’s coupon is fixed and is not adjustable, the Note’s price will apparently be allowed to fall. This seems to be the only logical outcome.

AMORTISATION SCHEDULE
Period	Beginning Balance	Payment	Interest	Principal	Ending Balance
0					4,850,000,000
1	4,850,000,000	772,355,741	381,937,500	390,418,241	4,459,581,759
2	4,459,581,759	772,355,741	351,192,064	421,163,678	4,038,418,081
3	4,038,418,081	772,355,741	318,025,424	454,330,317	3,584,087,764
4	3,584,087,764	772,355,741	282,246,911	490,108,830	3,093,978,934
5	3,093,978,934	772,355,741	243,650,841	528,704,900	2,565,274,034
6	2,565,274,034	772,355,741	202,015,330	570,340,411	1,994,933,623
7	1,994,933,623	772,355,741	157,101,023	615,254,718	1,379,678,905
8	1,379,678,905	772,355,741	108,649,714	663,706,027	715,972,877
9	715,972,877	772,355,741	56,382,864	715,972,877	0

Source: Supplemental Information Memorandum, Municipality Waste Management Contractors Ltd

Why use the states IGR to support the Note Issue rather than the states FAAC? Normally if the Note was supported by the states Federation Account Allocation Committee (FAAC) monthly payments it would have become a first line charge from the Finance Ministry and Federal Debt Management Office (DMO). This would, arguably, have made it more difficult for the state to default on Note payments, but it would also have made it more difficult for the transaction to have been concluded in the first place. The use of IGR which (for Lagos State) is three (3) times its FAAC revenue appeared sensible; and the natural intent thus becomes the focus – that of an able and unwilling payer caught in the governance limitations of politics (a new factor in transaction risk evaluation for the state).

Making Sense of Market Terms – Technical Default / Green Bond Debunked

Technical Default or Delay

A few analysts making comments on the state’s default of the March 5, 2019 Note payment that fell due had suggested that the default was merely “technical”. This is a strange contrivance.

A Fixed Income Debt Issue usually requires that the Issuing House draws up a debt amortization schedule. This schedule forms the basis of the Trustees to the Offer paying coupon and principal sums at a pre-agreed series of dates which in this instance is March 5 and September 5 of each of the years up until the maturity of the Note on September 5, 2022.

A default on a Fixed Income Debt instrument occurs when on due payment dates, the Issuer or Guarantor of an Offer cannot meet up with the payments agreed in the Offers Amortization schedule agreed to by all parties and to which investors were advised at the time of allotment of units of the Note or Bond as the case may be. This is quite different from a “technical default” which according to Investopedia is: “a deficiency in a loan agreement that arises from a failure to uphold certain aspects of the loan terms other than the regularly scheduled payments. Technical default indicates that the borrower may be in financial trouble, and can trigger an increase in a loan's interest rate, foreclosure or other negative events”.

In other words a “Technical default” is no less worrisome than a default in scheduled payments.

The safe middle is to look at this therefore as a delay; as the issuing house may have the public believe.

We aver that the concept of payment delay is alien to the Fixed Income market. One would immediately ask if the ‘potential delay’ was factored into the ‘A+’ rating of the Municipality Note? Besides, how would investors calculate Bond or Note yields in a market where yield dates are uncertain?

The NPV basis for Bond or Note pricing is basic arithmetic and does not build payment delays into the equation. The Municipality Note is not adjustable for coupons to compensate for payment delays. It would therefore be interesting to know / hear the Issuing House’s explanation of a structured payment delay

When is a Bond or Note ‘Green’?

Green Bonds or Notes are typically debt instruments raised to address issues related to the environment. Again according to Investopedia a green Bond is, “a bond specifically earmarked to be used for climate and environmental projects. These bonds are typically asset-linked and backed by the issuer's balance sheet, and are also referred to as climate bonds”.

The financial Note raised to clean Lagos under the State’s Cleaner Lagos Initiative (CLI) is a Municipality Note and NOT a Green Note.

Statistics on Green Bond Issuance in 2017 showed a total global bond value of $155bn and somewhere above $250bn by 2018. The green bond initiative is undoubtedly growing exponentially around the world. The problem with the Lagos Note is not about the concept, its fit or description but the execution of the natural intent.

Once the model built to support the sinking fund was upended; the early signals kicked in with the suspension of payments from the Lagos State Government into the sinking fund after the September 5, 2018 payments to date; a figure we estimate at slightly above N1.1bn.

Keeping the Market Safe

Nigeria’s Fixed Income Investment market is the most plausible route to speedily redress Nigeria’s infrastructure gap.

It holds a lot of promise and it is in this context that it has become uncompromisingly important for market participants from operators to regulators, investors, governments and financial media practitioners to ensure that the Fixed Income trading space remains a bastion of transparency, integrity, efficiency and trust.

According to an operator close to the Note Issue, but who requested for anonymity, “we cannot allow the Fixed Income market’s ethics get kicked about like a rubber ball. For the market to achieve its development goals it must be treated with decorum. An Issuers word must not only be law; it must be the Holy Grail”, and we agree totally.

It may be in this regards that feelers from our follow-up investigations on the MWMCL Note default situation suggest that the Lagos State Government will fund the Sinking Fund Account by Monday 11, March 2019 and that Note investors will begin to receive payments from next week.

We hold out the belief that this will be discharged as intended and that parties meet thereafter to address the fallout and take steps to get back on track.

You can follow our coverage and data records on State Bonds via Proshare MARKET’s Bond.

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