Issuers, Lawyers Set BAB Strategy Session

WASHINGTON — Municipal issuers and their bond lawyers last week were scheduling meetings to discuss whether the Internal Revenue Service’s compliance push on Build America Bonds will deter them from issuing the bonds in the future or force them to change the offering documents to protect themselves in case the IRS audits the bonds.

The meetings come as IRS officials told The Bond Buyer that they plan to audit up to 50% of all BAB issues, depending on the responses they get from issuers to compliance-check questionnaires and their review of BAB trade data and prices on the Municipal Securities Rulemaking Board’s Electronic Municipal Market Access system, as well as other information.

Officials from the IRS’ tax-exempt bond office have been urging BAB issuers or their advisers to track their BAB trades and prices on EMMA and to check whether their underwriters were accurate in certifying that all of the bonds were publicly offered at the initial offering price. Underwriters typically make such certifications to the issuers.

The price is key to determining the interest rate, and the interest rate dictates the subsidy rate of the payment the IRS makes to BAB issuers, which is currently set at 35% of interest costs.

IRS officials have expressed concern about the “upward ­trending” of prices when BABs are initially offered. When prices move up, yields move down. The officials want to ensure the Treasury subsidy payments made to issuers reflect BAB prices and are as low as possible.

The revised compliance-check questionnaire the IRS released last week asks BAB issuers if any investors who bought their bonds in the primary market paid more than the price at which the bonds were initially offered.

It also asks the issuers to provide summaries of the underwriters’ explanations for any prices paid above the initial offering price and whether any of the bonds were purchased by affiliates or affiliated accounts of the dealer.

IRS officials plan to delay sending the questionnaire to BAB issuers until later this month so they and other market participants have the opportunity to make sure they understand the questions and ask for any needed clarifications.

In addition to the compliance-check questionnaire and the promise of audits, issuers are alarmed at the growing number of issuers whose BAB payments are being offset or reduced by amounts of money they owe the federal government in non-bond related programs.

Several bond lawyers said last week that they feel misled by IRS and Treasury Department officials, who have repeatedly contended in recent months that the offsets and compliance questionnaires are not a big deal.

They also are angry that issuers who have already sold more than $100 billion of BABs since April 2009 are now faced with brand-new ground rules and requirements that could reduce or halt the subsidies they receive from the government.

Market participants contend government officials are saying one thing and doing something else.

“I think people will at least think twice about doing a BAB deal,” said one bond lawyer who did not want to be identified.

“If you are told tax-exempt bonds have a one-in-10,000 chance of being audited and BABs have a one-in-two chance of being audited, what would you do?” he asked, adding that at some point it is no longer beneficial for issuers to do BAB deals.

Another bond lawyer, who also did not want to be identified, said that when IRS officials last October were trying to work out the mechanics of sending issuers payments as they sold more and more BABs, they drew an analogy and said they were “trying to build a ship as it is being sailed.”

Continuing the analogy in light of recent events, the lawyer said, “I’m seeing some people below deck trying to drill holes in the ship” and sink it.

“I’m going to absolutely make sure that the bond purchase contract for every negotiated deal and the notice of sale for every competitive deal requires the underwriter to make a bona fide public offering of each of the maturities at the initial offering price,” the lawyer said.

Other lawyers said they have considered modifying the bond purchase agreement in a negotiated sale to permit the issuer to kill the deal if they discover the underwriter did not publicly offer all of the bonds at the initial offering price.

The offering price appears on the final official statement for the bonds. Without that contractual provision, the issuer would be liable to the underwriter if it tried to kill the deal.

But several attorneys worried about the consequences of such document changes.

“I’m concerned that the more we lay off on the underwriters — like getting them to certify there were no sales to affiliates — the more they’re going to say, 'We want higher coupons on the bonds,’ ” one of the bond lawyers said. “It will just make everything more expensive and result in higher subsidies for the government.”

Most market participants said the IRS is putting the issuer in an impossible situation.

They do not believe issuers or bond lawyers have the expertise to track BAB trades and prices on EMMA to check for pricing irregularities. Many say they don’t believe the system can or should be used for such inquiries. EMMA was designed to provide transparency for securities regulators, not be used for tax compliance, several market participants said.

An industry source said EMMA does not always reflect what is really going on in a bond sale. The source said some underwriters do not have retail salespeople and will sell BABs to affiliated firms with retail sales forces that will in turn sell the bonds to retail investors.

Those trades are reported on EMMA as interdealer trades because that is what they are to securities regulators. However, the underwriter will treat the sales as “going away trades” to customers that can count toward the 10% of sales used to determine issue price because the dealer always intended those bonds to go to retail customers.

Much of the debate about BAB prices revolves around the definition of issue price.

IRS rules state: “Generally, the issue price of bonds that are publicly offered is the first price at which a substantial amount of the bonds is sold to the public. Ten percent is a substantial amount. The public does not include bond houses, brokers, or similar persons or organizations acting in the capacity of underwriters or wholesalers.”

The rule, however, also states: “The issue price does not change if part of the issue is later sold at a different price … The issue price of bonds for which a bona fide public offering is made is determined as of the sale date based on reasonable expectations regarding the initial public offering price.”

Bond lawyers said the reason the rule keys off the sale date is because of the recognition that the market can change between the signing of the bond purchase agreement when trades are deemed by the MSRB to first officially occur and the one or two weeks later when the deal closes and the bonds are delivered.

Other market participants said the reason the rule refers to reasonable expectations is that it is difficult to pinpoint the first 10% of sales in any initial offering because the trades posted on EMMA include conditional commitments for the bonds that dealers obtained before the bond purchase agreement was signed.

Those conditional commitments are reported at the same time as the first sales after the bond purchase agreement is signed, even though they have taken place days apart.

IRS officials, however, insist that EMMA can be used as a tool for issuers to determine if their BAB issues comply with the tax laws. They say it is not unique to the municipal market that taxpayers have to obtain or look at other sources of information to substantiate their compliance with tax law requirements.

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