Worries Over Changes to 15c2-12

WASHINGTON - Bond lawyers are concerned about the Securities and Exchange Commission's proposal to require issuers to disclose when they have received an Internal Revenue Service form that asks an issuer or borrower to help it resolve tax issues related to their bonds.

They voiced their concerns Friday, as the SEC formally released proposed changes to its Rule 15c2-12 on disclosure, which will be subject to a 45-day public comment period when published in the Federal Register in a few days.

The commission's proposals would strengthen and expand 15c2-12 by adding to the list of events issuers must disclose under their continuing agreements. In addition, some new and existing events would have to be disclosed whether or not the issuer deems them to be material.

As part of the changes, the SEC is proposing that issuers disclose a broader array of events that may adversely affect a bond's tax exemption, including the receipt of a so-called IRS notice of proposed issue, or Form 5701-TEB.

Currently, the rule makes no specific reference to IRS notices and only says that issuers are required to file notices in the event of an adverse tax opinion or "events" affecting the security's tax-exempt status that they deem to be material. As a result, many issuers have determined that IRS notices are not material.

The issuers reason that they will either be able to convince the IRS that no tax-law violations have occurred or they will be able to reach a settlement with the IRS to prevent any change in the tax-exempt status of the bonds.

Bond attorneys said last week that requiring issuers to disclose the receipt of a Form 5701, which the IRS began issuing last year in lieu of preliminary adverse determination notices, may be premature, in part because the issuer has not yet had a chance to respond to the IRS' concerns at that point.

Disclosing them may needlessly harm bondholders by lowering the prices of fixed-rate bonds and raising the yields of variable-rate bonds, which typically trade at par, the lawyers said.

"This would be a far-reaching change," said Jeremy Spector, a New York-based tax controversy and public finance tax attorney at Mintz, Levin, Cohn, Ferris, Glovsky and Popeo PC, who is currently chair of the American Bar Association's tax exempt financing committee. "If the goal is to protect bondholders, perhaps a later time [in the audit process] is useful, after the issuer has had an opportunity to respond to the IRS' concerns, unless there's a targeted letter sent to an issuer which clearly indicates there's a problem."

These forms should not be required to be disclosed because many issues raised by the Form 5701 are ultimately resolved by a reasonable explanation from the issuer or the borrower or through a closing agreement, Spector said. He stressed, though, that issuers that wish to fully disclose all steps in the audit process should not be discouraged from voluntarily doing so.

Michael Bailey, a partner at Foley & Lardner LLP in Chicago, agreed that disclosing the receipt of a Form 5701-TEB could be premature because the IRS form may be merely identifying issues and questions that require explanation rather than making a proposed adverse determination that the bonds are taxable.

However, an SEC official dismissed the concerns, noting that an issuer could add further information to its event notice reflecting its intent to challenge the IRS claims. As with corporate disclosures about ongoing litigation, the issuer could indicate that it plans to defend itself against the IRS charges, the official said.

In the proposed rules issued Friday, the SEC stressed the significance of disclosing the form by citing statistics from IRS staff. The staff found that from April 2007 through July 2008 about 80% of the audits that received a preliminary determination of taxability were settled through closing agreements with the IRS. Of the cases that received a proposed determination of taxability, about 25% were settled through a closing agreement with the IRS, 37.5% received final determinations that the bonds were taxable, and about 37.5% were appealed to the IRS Office of Appeals, the SEC said.

But Spector questioned the SEC's statistics, saying the old preliminary adverse-determination letters cannot really be compared to the new Form 5701, because they generally were only issued after discussions with issuers failed.

He added, however, that his reservations about the disclosures would disappear if the muni market accepted Form 5701 as being just a routine disclosure matter. Currently, one cannot compare the taxable corporate marketplace and tax-exempt municipal bond marketplace because IRS audits in the corporate arena are more routine and bondholders do not react as adversely, he said.

Still, the SEC's proposed rule changes were welcomed by analysts last week, who have long argued that municipal disclosure standards should be improved.

Mark Stockwell, vice chairman of the National Federation of Municipal Analysts and director of municipal research at PNC Capital Advisors in Philadelphia, disputed the notion that investors would have a knee-jerk reaction to sell the bonds of an issuer that had just disclosed the receipt of a Form 5701 suggesting the bonds could become taxable.

"It is crucial for analysts to be aware of the tax audit so that they can make a determination or seek counsel over an issue like this, and based on that analysis, decide to hold or sell the bond," he said.

By comparison, Stockwell noted that while issuers must disclose changes in ratings or rating outlooks, the disclosures do not mean the bonds will necessarily be downgraded, though they have the potential to impact pricing.

More broadly, Stockwell said the NFMA welcomes all efforts to improve disclosure in the muni market, and is encouraged by SEC official's statements at their meeting Wednesday describing the changes to 15c2-12 as a first step.

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