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Auction Reissuance Clarified

WASHINGTON - Municipal issuers of auction-rate bonds can convert to another interest-rate mode or remove bond insurance without a resulting reissuance of the bonds as long as those actions are permitted by the bond documents, the Treasury Department clarified in a notice released yesterday.

Notice 2008-27 comes as issuers of auction-rate bonds, which are typically insured, are considering converting to other interest-rate modes to avoid higher interest costs, as their bond insurers have experienced actual or threatened rating downgrades. In addition, auctions of these securities have been failing around the country for lack of sufficient investor interest.

Both the National Association of Bond Lawyers and the Securities Industry and Financial Markets Association this month urged the Treasury to clarify that its regulations to permit auction-rate bond conversions without resulting reissuances.

Jeremy A. Spector, a partner at Mintz, Levin, Cohn, Ferris, Glovsky, and Popeo PC in New York, praised the Treasury notice as timely and effective.

"The Treasury and IRS are to be commended for their rapid response to the meltdown in the markets for auction-rate bonds and variable-rate demand bonds precipitated by insurer downgrades and the shortage of liquidity. Notice 2008-27 is broad and expansive and clears the road for most all auction-rate bond and variable-rate demand bond restructurings to eliminate interest rate spikes and to shore up damaged credits from a tax perspective," Spector said, adding that the notice "was well thought-out and drafted in record time."

The notice resolves a debate about whether auction-rate bonds can be considered qualified tender bonds, which are not subject to reissuance restrictions. A qualified tender bond is one in which the holder must tender the bonds at par at one or more tender dates. Technically, auction-rate bonds may never be tendered unless there is a change in mode, and as a result, many bond lawyers and issuers were unsure whether or not they could be converted without being reissued.

In its notice, the Treasury noted potential problems facing issuers regarding reissuances.

"A reissuance of an issue of tax-exempt bonds may result in various negative consequences to a bond issuer, including, among other things, changes in yield for purposes of the arbitrage investment restrictions, acceleration of arbitrage rebate payment obligations, deemed terminations of integrated interest rate swaps under the qualified hedge rules for arbitrage purposes, new public approval requirements for qualified private activity bonds, and change in law risk," the Treasury said.

Under the notice, which is retroactively effective beginning Nov. 1, 2007, bonds with stipulations within their terms to permit rate conversions or the ability to exchange old bonds for new ones as a means of removing bond insurance can do so without being considered "significantly modified," which would require a reissuance. Bonds that are within a multi-modal interest rate structure also would be allowed to convert to another mode without being reissued.

The original notice regarding reissuance, which was published in 1988, was narrowly targeted, and did not address several types of interest rates, in particular auction rates, officials said. They said they hope the new notice will both clarify and expand the scope of the regulations.

"The [new] notice is meant to provide state and local governments more flexibility and more tax certainty to limit the occurrence of 'reissuances' of tax-exempt bonds for tax purposes as they consider modified financing plans to work through current market events. The notice provides more flexibility to consider additional interest rate alternatives and changes in credit enhancement," said Treasury spokesman Andrew DeSouza.

Scott Lilienthal, a partner at Hogan & Hartson LLP in Washington and one of the authors of the letter that NABL submitted to Treasury, said he believes the notice will help a lot of interested parties.

"It's going to cover the majority of the issues that people have been grappling with relating to conversions of auction-rate bonds and related modifications that are being made. I think it's going to settle a lot of the questions that have been floating around," he said.

But while Mitchell Rapaport, a partner at Nixon Peabody LLC in Washington, echoed Spector's appreciation of the timely and targeted response, he cautioned that tax code issues are not the root cause of problems in the auction-rate bond market.

"I think that generally they did a very good job putting something out very quickly to respond to tax issues that are coming up in the context of these auction-rate securities," he said. But "these auction-rate problems facing issuers and the market is not a tax-driven problem ... It's not like Treasury could have, through some guidance, made these problems go away." Rapaport was referring in part, to the fact that auctions are failing around the nation because of a lack of investor interest in auction rate bonds.

The notice also included a few more technical provisions, meant to address some specific concerns among muni market participants. One such provision is a temporary waiving of certain interest rate caps placed on specific auction-rate bonds that primarily was meant to provide relief in the student loan bond sector.

Treasury officials said that some auction-rate student loan bonds have had their rates tied to formulas that have set caps on interest rates that are too low for the bonds to be competitive in the current market. The waiver is effective from Nov. 1, 2007, to July 1, 2008.

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