EXHIBIT 10.6
HEALTH CARE REIT, INC.
INTEREST RATE & CURRENCY RISK MANAGEMENT POLICY
ADOPTED ON MAY 6, 2004
I. GENERAL OVERVIEW
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The following interest rate risk management policy establishes the objectives,
policies, procedures, and practices for Health Care REIT, Inc., subsidiaries,
partnerships and other related companies (the "Company") to manage its interest
rate and currency risk position. The Board of Directors and senior management
establish the risk vision for the organization. Further, it is the
responsibility of the Board and senior management to establish an effective set
of policies for the purpose of using derivatives (also referred to as "hedges")
consistent with the Company's underlying strategy, commercial objectives, level
of risk tolerance, and financial capacity and flexibility. Management will
implement practices and procedures consistent with the Company's policies, and
these practices and procedures will be subject to review on an ongoing basis by
the audit committee of the Board of Directors.
II. HEDGING OBJECTIVE
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The Company manages interest rate risk based on the varying circumstances of
note offerings, revolving credit agreements, and other debt in order to manage
otherwise unpredictable costs and hedges accordingly. In addition, the Company
manages to an appropriate mix of fixed and floating rate debt. Examples include
sometimes swapping or capping rates, hedging portions of the total amount of
debt, or hedging a period of months and not always hedging to maturity, and at
other times locking rates to fix interest costs. The Company may fix rates on
transactions prior to the issuance of debt taking into account factors that
influence the hedging decision, including the degree of certainty, timing and
amount, the material benefit of the hedge, the actual level of rates, the
budgeted debt service, and the state of the financial markets.
The Company will generally pursue interest rate and currency risk mitigation
strategies that result in the least amount of reported earnings volatility under
Generally Accepted Accounting Principles (GAAP) while still meeting strategic
economic objectives and maintaining adequate liquidity and flexibility.
III. HEDGING STRATEGY AND PRODUCTS
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The Company engages in a number of business activities that by nature are
vulnerable to interest rate risk. The Company's hedging strategy is intended to
take advantage of opportunities to reduce, to the extent possible, unpredictable
cash flows, or to mitigate its exposure to changes in fair value. Examples of
business operations whereby the Company is exposed to interest rate risk include
the following:
- - Medium and long-term financing
- - Revolving lines of credit
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When the Company is engaged in business opportunities in foreign countries, the
Company is exposed to foreign exchange risk. To avoid risk of changes in foreign
currencies relative to the Company's functional currency, the US dollar, the
Company will pursue various hedging strategies to mitigate that risk.
The Company may use a variety of commonly used derivative products that are
considered plain vanilla derivatives, and are instruments used by a majority of
real estate companies and other companies to manage interest rate and foreign
currency risk. Included among these are derivatives that help achieve the
appropriate mix of floating and fixed rate debt. The Company expressly prohibits
the use of exotic derivative instruments and using derivative instruments for
speculative purposes. The Company utilizes the following products:
- - Swaps (including options and forwards)
- - Caps (including options and forwards)
- - Collars (including options and forwards)
- - Treasury locks
- - Foreign currency (spot, options, forwards and swaps)
IV. BOARD, EXECUTIVE COMMITTEE AND SENIOR MANAGEMENT INVOLVEMENT IN MANAGING
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INTEREST RATE RISK AND CURRENCY RISK
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The roles for the members of the Board of Directors and Senior Management in
relation to risk control of derivatives are described below.
The Board of Directors approves:
- - The types of derivative contracts that may be used by the Company to hedge
interest rate and foreign currency risk
- - The use of any derivatives for other than cash flow, fair value and foreign
currency hedging purposes (if applicable)
- - Any hedging transaction in excess of $50 million for durations of greater
than six months
- - General parameters for credit-worthiness of counterparties
The Board of Directors delegates the following responsibilities to senior
management:
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- - Identifying specific financing risks for which it may be desirable to hedge
and defines precisely the hedging objective, and
- - Working in consultation with the independent risk management consultant to
structure a derivative transaction to meet the defined objective.
- - Executing the hedging transaction using the services of independent
interest rate and currency risk management consultants,
- - Preparing timely memoranda necessary to document hedges for both GAAP and
income tax reporting purposes,
- - Monitoring the fair values of the derivatives in the hedging portfolio,
- - Communicating the appropriate periodic valuation information received from
the independent interest rate and currency risk management consultants,
- - Reviewing the effectiveness of each hedge during the entire period of time
the hedge contract is in effect,
- - Engagement of independent interest rate and currency risk management
consultants,
- - Engaging tax consultants to review and opine on hedging strategy, and
- - Keeping the Board of Directors informed as to all the above activities.
V. HEDGING WITHIN PARAMETERS FOR REIT QUALIFICATION
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The Company is eligible to undertake only certain permissible hedging strategies
in the context of the REIT qualification requirements. In many cases, the tax
accounting rules for hedges may yield different income and expense amounts than
that recognized under GAAP.
For example, a hedge may constitute a bona fide hedge for tax purposes, such
that hedge income is accrued as an offsetting interest expense is incurred.
However, the accounting rules may be different under SFAS No. 133 (as amended
and interpreted) -- the derivative transaction may be subject to mark to market
treatment such that gains and losses become recognized in earnings.
In addition, in certain instances, cash flows realized from a hedge may
constitute non-qualified income for REIT qualification purposes. In these cases,
assurances must be provided that potential income from a hedge cannot exceed
five percent of a REIT's gross income. The Company will properly and timely
identify hedges for tax purposes in order to ensure appropriate tax accounting.
VI. ACCEPTABLE COUNTERPARTY
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The Company has established criteria for suitable counterparties in relation to
various specific types of risk (credit risk, reputation risk, market risk).
Acceptable Counterparty - Credit Risk
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The counterparty must have a credit rating of no lower than `A-' from Standard &
Poor's, Moody's, and/or Fitch or other nationally recognized rating agency. The
Company works with a pre-approved list of a limited number of financial
institutions.
Acceptable Counterparty - Reputation Risk
Lenders will meet the credit risk requirements above and are chosen from:
- - Lenders that currently participate in the Company's revolving credit
facility,
- - Lenders that the Company has done business with in the past and had
a good working relationship with,
- - Lenders that third-party advisors recommend based on their experience with
similar type transactions.
VII. CREDIT ISSUES
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The Company will consider using the following methods to control credit
exposure.
- - Collateral agreements: provision for security in the case of default.
- - Netting agreements: provision setting off total amounts of reciprocal
obligations.
- - Credit guarantees: third party usually with superior credit rating
guarantees principal balance.
- - Credit triggers: outstanding contracts can be terminated if the
counterparty's credit rating falls below a certain predetermined level.
- - Mutual termination options: permit either counterparty to terminate
unconditionally on a specified date before maturity.
VIII. TRANSACTION PROCESS, AUTHORIZATION, PROCEDURES AND CONTROLS
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The Company follows a structured internal control process that involves the
following authorization and procedures. Included in the process are required
approvals for the use of derivative instruments, including specifying the level
of Company staff authorized to engage in derivative transactions and for those
who are permitted to be involved in entering into, negotiating, approving,
executing, and reviewing the accounting and transaction documentation.
The following outlines the procedures and controls for recording and monitoring
the use of all derivatives transactions, including specifically how:
- - the underlying assets and component risks of derivative instruments should
be analyzed,
- - records will be maintained and how frequently they will be updated,
- - counterparties will be pre-qualified and approved for derivatives
transactions,
- - the risk management function will proactively supervise derivatives
exposures, and
- - the risk managers will exercise their control over approved limits.
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The Company has adopted SFAS No. 133 (as amended and interpreted), the
accounting standard governing derivatives that must be adopted by all public
companies and other companies that issue financial reports prepared in
accordance with generally accepted accounting principles. Only certain
qualifying hedges can follow the accounting under SFAS No. 133, which is
typically desirable compared to the mark to market consequences of not
qualifying under SFAS No. 133.
In order to qualify for hedge accounting under Statement of Financial Accounting
Standard No. 133, Accounting for Derivative Instruments and Hedging Activities
(SFAS 133), the hedging relationship, risk management objective, and strategy
for undertaking the hedge will be documented at the inception of each individual
hedge. The Company's Chief Financial Officer or Treasurer will document the
following information in a Hedge Designation Memo:
1. Identification of hedging instrument
2. Description of hedged item or transaction
3. Nature of risk being hedged
4. Benchmark interest rate being hedged in a hedge of interest rate risk (the
same benchmark interest rate should be used as the risk being hedged). Note
that if the benchmark interest rates are not the same, an entity may be
able to designate the overall changes in cash flows or fair value as the
hedged risk instead of interest rate risk.
5. Foreign currency risk being hedged in a hedge of currency risk.
6. Method to be used for assessing effectiveness of hedging derivative in
achieving offsetting changes in cash flows or fair value attributable to
the risk being hedged; this method must be used throughout the hedge
period.
The following procedures will be followed for each new derivative:
1. The Treasurer will make a determination whether the derivative must be
reviewed with tax counsel and auditors prior to entering into the
derivative.
2. The Treasurer determines that the instrument meets the Company's hedging
policies and objectives and makes a recommendation to the Chief Financial
Officer.
3. The Chief Financial Officer approves the derivative transaction, if it is
not a transaction that requires approval by the Board of Directors.
4. The Chief Financial Officer and Treasurer engage in the derivative
transaction through its Third Party Advisors (TPA). The TPA completes a
negotiated transaction or conducts an auction among counterparties chosen
that meet the Acceptable Counterparty requirements. The Hedge Designation
Memo is generated as necessary.
5. The Chief Financial Officer and Treasurer sign the derivative transaction
confirmation. Copies of such transaction are forwarded to:
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- - Auditor(s)
- - Tax Counsel
- - Outside Counsel
- - Financial Institution/Counterparty
- - Third Party Advisor
The following procedures and controls are followed to monitor the Company's
derivatives:
- - Derivatives are monitored at least quarterly. The Company maintains a
report listing all derivative agreements, including those with effective
dates in the future, and their terms. The report is issued to the Treasurer
from the Company's Third Party Advisors.
- - Hedge designation memos are reviewed quarterly and, if necessary, updates
are made and included in the SFAS 133 documentation binder.
- - Each quarter, the Chief Financial Officer and Treasurer obtain valuations
from their Third Party Advisor, and review their reasonableness.
- - Each quarter, the Chief Financial Officer and Treasurer assesses the
effectiveness of existing hedges.
- Effectiveness of each derivative designated as a hedge will be
assessed for effectiveness using the method specified in the related
designation memo.
- Each hedge must sustain an effectiveness level within an 80% - 125%
correlation in order to continue to qualify for SFAS 133 accounting
treatment as a hedge.
- - The Chief Financial Officer, Treasurer and the Company's auditors will
approve a report stating their conclusions as to effectiveness.
- - The accounting department records the adjustments to mark the derivatives
to market each quarter and any necessary entries to Other Comprehensive
Income or to the P&L in accordance with SFAS 133.
The accounting processes and related internal controls that the Company
considers in an effort to meet its risk management objectives involves
consideration of the following key elements:
Control Environment - The control environment considers the integrity, ethical
values, and competence of personnel, as well as management's philosophy and
operating style
Risk Assessment - Risk assessment refers to the identification and analysis of
risks relevant to achieving objectives that form a basis for the overall risk
management.
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Control Activities - The control activities represent the policies and
procedures that are implemented to ensure management's objectives are met.
Information and Communication - The information and communication element refers
to the nature, quality of information, systems requirements and types of reports
that are necessary to meet the Company's objectives.
Monitoring - The monitoring element addresses the ongoing assessment of the
quality and effectiveness of the control system.
Specific items to consider as part of establishing a strong accounting process
and control are the following:
- - An active and effective board of directors that is responsible for the
approval of the Company's overall risk management strategies
- - Senior management should assume the following responsibilities:
- Ensure that derivatives used are consistent with the Company's risk
management objectives
- Authorize and approve the use of derivatives products
- Clearly communicate objectives and expectations for derivative
activities to individuals responsible for executing such trades
- - Ensure that employees or advisors involved in derivative activities have
the necessary skills and experience
- - Prepare and update periodically an approved counterparty list, which may
include types of products, maximum/minimum exposures, credit rating, credit
limits, collateral requirements (both initially and on an ongoing basis),
etc.
- - Segregation of duties between individuals responsible for making investment
and credit decisions, custody of assets, disbursing and receiving funds,
record keeping, confirmation of positions, and the individuals responsible
for reconciliations.
- - Ensure that the standard disbursements/receipts controls are in place.
- - Preparation and timely review by Senior Management of a report that matches
"open derivative positions" to hedged items.
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APPENDIX
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The following is a description of derivatives products referenced in Section
III, herein, and are typically used by U.S. real estate companies:
1. Forward-Rate Agreement, Rate Lock, or Forward Starting Swap: Used
commonly to lock in interest rates for a future financing or
refinancing. A forward contract specifies a reference interest rate
and an agreed upon interest rate on an assumed deposit of a specified
maturity at a specified future date (settlement date). The term of the
assumed deposit may begin at a subsequent date (e.g., the contract
period may be for six months, commencing in three months). At the
settlement date, the seller of the forward contract pays the buyer if
interest calculated at the reference rate is higher than that
calculated at the agreed upon rate; conversely, the buyer pays the
seller if interest calculated at the agreed upon rate is higher than
that calculated at the reference rate. Reference rates are typically
the US Treasury rate or LIBOR swap rate. By using a forward contract,
the Company can fix the Treasury portion or LIBOR swap rate portion of
an anticipated transaction.
[DIAGRAM]
Loan Rate
| |
| |
| |
Effective Rate | |
| |
-------------|-----------6.2%
| |
| |
| |
| |
| | Treasury Lock Rate
Actual Rates
The above diagram illustrates the concept of a Treasury Lock hedge--the
same concept applies to forward starting swaps. As the loan rate rises,
the offsetting value of the Treasury Lock when it net settles at the
time of loan origination provides an effective interest rate of 6.2%.
The accounting for this product usually follows the cash flow hedge
model specified under SFAS No. 133, where the fair value of the rate
lock is carried on the balance sheet, with unrealized gains and losses
on the marked-to-market instrument recorded in other comprehensive
income. Accumulated gains and losses are recognized in earnings during
the same period in which the forecasted debt cost is charged to
expense.
2. Interest Rate Swap: This is a financial contract in which two parties agree
to swap streams of payments over a specified period. The payment streams
are based on an agreed-upon (or notional) principal amount. The term
notional is used because
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swap contracts generally involve no exchange of principal at either
inception or maturity. Rather, the notional amount serves as a basis for
calculation of the payment streams to be exchanged.
Interest rate swaps are the most prevalent type of swap contract. As
diagramed below, one party generally agrees to make periodic payments,
which are fixed at the outset of the swap contract. The counterparty agrees
to make variable payments based on a market interest rate (index rate).
Swap contracts allow the Company to achieve net payments similar to those
that would be achieved if the end user actually changed the interest rate
of designated assets or liabilities (underlying cash position) from
floating to fixed rate, or vice versa. In the diagram below of the swap
terms, the Company locked in the cost of its floating rate debt to an
all-in rate of 8.10% (1.45% + 6.65%).
[DIAGRAM]
6.65%
|---------| |-----------| _________\ |--------------|
| Lender | /___________ | The | / | Swap |
|---------| \ LIBOR+1.45 | Company | /________ | Counterparty |
|-----------| \ LIBOR |--------------|
Interest rate swaps normally run to maturity, however circumstances might
eliminate the end user's need for the swap contract before maturity.
Accordingly, entities may cancel contracts, sell their position, or enter
an offsetting swap-contract and realize gains or losses, depending on the
value of the swap.
The accounting for interest rate swaps under SFAS No. 133 requires that the
instrument be carried at fair value on the balance sheet. For swaps used as
cash flow hedges, unrealized gains and losses are reported in other
comprehensive income with no effect recognized in earnings as long as the
characteristics of the swap and the hedged item are closely matched. For
swaps employed as fair value hedges, the swap and the hedged item are
adjusted through earnings with no net effect recognized in earnings as long
as the critical terms of the swap and the hedged item match. Some earnings
effects may occur when mismatches in the hedge and the designated hedged
item occur.
3. Option products--Collars, Caps, Swaptions, and Treasury Options are over
the counter and thereby negotiated between two parties. Option Contracts
allow the holder to buy (call) or sell (put) a specific financial
instrument at a specified price during a specified period (as in an
American option) or at a specified date (as in a European option). The
option holder does not have to exercise the option, whereas performance
under a futures or forward contract is mandatory.
At inception, the option holder typically pays a premium, which is the fee
to the writer of the option contract. The premium includes two values, the
intrinsic value and the time value. The intrinsic value of a call option is
the excess, if any, of the market
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price of the item underlying the option contract over the price specified
in the option contract (the strike or exercise price). The intrinsic value
of a put is the excess, if any, of the option contract strike price over
the market price of the item underlying the option contract. The intrinsic
value of an option cannot be less than zero. The other component of the
premium's value is the time value. The time value reflects the probability
that the price of the underlying item will move above the strike price (for
a call) or below the strike price (for a put) during the exercise period.
The advantage of holding option contracts is that they can be used to
mitigate downside price risk without totally negating upside profit
potential. This is because the loss on a purchased option contract is
limited to the amount paid for the option contract. Profit on a written
option contract is limited to the premium received, but the loss potential
is unlimited because the writer is obligated to settle at the strike price
if the option is exercised.
Different option contracts can be combined to transfer risks from one
entity to another. Examples of such option-based derivatives are caps,
floors, collars, and swaptions. The diagram below illustrates the concept.
[DIAGRAM]
/
| Cap 8% /
| -----------/
| /\
| / \
| / \
| / \
| / \ Collar
Effective Rate | / / (between 6% and 8%)
| Floor 6% / /
| ---------/ --------/
| /
| /
| /
| /
| /
| /
| /
| /
| /
Actual Rate |-----------------------------------
Interest-rate caps are contracts in which the cap writer, in return for a
premium, agrees to limit, or cap, the cap holder's risk associated with an
increase in interest rates. If rates go above a specified interest-rate
level (the strike price or the cap rate, which is 8 percent in the example
above), the cap holder is entitled to receive cash payments equal to the
excess of the market rate over the strike price multiplied by the notional
principal amount. Issuers of floating-rate liabilities often purchase caps
to protect against rising interest rates, while retaining the ability to
benefit from a decline in rates.
Because a cap is an option-based contract, the cap holder has the right,
but not the obligation, to exercise the option. If rates move down, the cap
holder has lost only the premium paid. However, because caps are not
exchange traded, they could
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expose the cap holder to credit risk if the cap writer fails to fulfill its
obligations.
Interest-rate floors are similar to interest-rate caps. Interest-rate
floors are contracts in which the floor writer, in return for a premium,
agrees to limit the risk associated with a decline in interest rates based
on a notional amount. If rates fall below an agreed upon rate (6 percent in
the example above), the floor holder will receive cash payments from the
floor writer equal to the difference between the market rate and an agreed
upon rate multiplied by the notional principal amount.
Interest-rate collars combine a cap and a floor (one held and one written).
Interest-rate collars enable an end user with a floating-rate contract to
lock into a predetermined interest-rate range, between 6 and 8 percent in
the diagram.
Swaptions are option contracts to enter an interest-rate swap contract at
some future date or to cancel an existing swap contract in the future. As
such, a swaption contract may act as a floor or a cap for an existing swap
contract, or be used as an option to enter, close out, or extend a swap
contract in the future.
For option contracts used as hedges of cash flow risk, SFAS No. 133 as
updated by Derivative Implementation Group Issue G20 allows the entire
change in fair value including time value changes of a perfectly effective
hedge to be deferred on balance sheet in other comprehensive income. Option
purchase premiums will be expensed as the hedged item affects earnings.