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GFOA Annual Conference

BAB Fears Downplayed

ATLANTA — Municipal issuers are overreacting to recent developments surrounding the compliance program for Build America Bonds, a Treasury official said yesterday in an effort to tamp down ongoing concerns.

Meanwhile, Government Finance Officers Association members attending the group’s annual conference here pressed for price transparency for certain new bond issues whose yields are not reported immediately as well as restrictions on the ability of a dealer-financial adviser to switch roles and become the underwriter in a negotiated transaction.

John Cross 3d, the Treasury’s associate tax legislative counsel, said recent concerns — that the Internal Revenue Service may audit a large number of BAB deals or that BAB payments could be reduced or withheld by the federal government to offset money owed by the issuer — are overblown.

Although the controversy spiked last month after an IRS official said up to half of all BAB deals could be audited, Cross downplayed the concern by noting that a very high-ranking IRS official later said the agency has yet to determine how many BAB audits it will conduct.

“We are concerned about overreaction to these recent comments about an estimated 50% IRS audit rate,” Cross said. He pointed out that “Steven Miller, who is the highest ranking IRS official who’s involved in enforcement, basically the number-two guy at the IRS ... subsequent to those reports about a 50% audit rate ... issued public clarifying statements to the press to the effect that those reports were inaccurate.”

“You all should appreciate what it takes to get a statement like that made and that was intended to calm the waters on this,” Cross added.

He also discussed the “unfortunate reaction” from market participants about a questionnaire the IRS is sending out to every BAB issuer. The survey spooked issuers by asking them if they are tracking the secondary market trading and prices of their bonds, when they typically rely on underwriter certifications that the bonds were publicly offered at the initial offering price.

The issuers worried that the IRS could retroactively determine the bonds were not priced appropriately and that the initial offering price cited by the underwriter was incorrect.

The issue price is particularly significant because of a tax law requirement that BABs cannot be sold with more than a de minimis amount of premium. Issuers worry that if the premium is too high, the bonds would not qualify as BABs and the IRS could withhold the subsidy payments.

Cross pointed out that the Treasury said in recent guidance that issuers can rely on existing rules pertaining to issue price for the time being, and that any changes made to that guidance for BABs would be strictly prospective and subject to market participants’ comments.

“We’re not going to fundamentally change the rules of the road without public notice and the opportunity for people to debate what those changes would be,” he said.

Cross also noted that while issuers typically think of the IRS tax-exempt bond branch as solely charged with sniffing out and punishing noncompliance, its responsibilities have greatly expanded with the creation of BABs, and it is now charged with administering the program and disseminating the subsidy payments.

As a result, there’s been an increased interest in gathering information about the program and there is an “element of that behind some of the recent requests,” Cross said. “It’s not just enforcement.”

On offsets, Cross said issuers need to learn to live with them because the Treasury and IRS cannot modify the program to specifically accommodate BAB payments.

Any fix would have to come from Congress changing the law, which he said would be a “tough legislative challenge.”

“My admonition would be to try to reasonably try to assess this risk, which we think is a manageable risk,” he said.

Christopher Mier, managing director at Loop Capital Markets who also spoke on the panel, agreed with Cross. He said he had recently spoken to an issuer from a major city that was “irate” about an $8,900 offset, but failed to consider the savings it achieved by issuing BABs, which certainly outweighed that amount.

“I don’t think there’s any reason why you wouldn’t want to go ahead” with BABs, Mier said, after noting that the ongoing controversy could slow the development of the BAB market.

“My concern is that it will dampen the enthusiasm of some issuers who should in fact be selling their BABs,” he said

Frank Hoadley, Wisconsin’s capital finance director and chair of GFOA’s governmental debt management committee, agreed that offsets typically are a minor accounting issue that should not deter issuers from BABs. Issuers should be more concerned about “the inappropriate and excessive enforcement that is coming out of the IRS,” he said.

“The IRS seems to have lost sight that they and we as issuers serve the taxpayers,” Hoadley said. “We should not be creating excessive bureaucratic costs that are going to cost our taxpayers more money.”

Eric Johansen, debt manager for Portland, Ore., said that although he would not be concerned about the outcome if his BABs were to be audited, just going through the process with the IRS would be costly.

“It’s a very expensive situation when you do get the letter that a particular issue is coming under audit,” he said.

Meanwhile, Johansen outlined three general improvements he’d like to see to the municipal market: a prohibition on dealer role switching from FA to underwriter in negotiated transactions, a reduced reliance on negotiated sales, and better price transparency for competitive deals that are often not immediately reported with yields.

Johansen warned that the yields on too many competitive deals are reported as “NRO,” for not reoffered, meaning that the winning dealer pre-sold the securities and did not offer any of the bonds in the secondary market. 

The fact that the bonds have been sold does not eliminate the importance of the bonds to the rest of the market, Johansen argued, because the price at which an actual trade occurred is an important reference point for other deals.

Because the yields on many of these deals are not reported until the end of the day, “you can’t tell where the yield on that bond really was,” he said.

Johansen noted that about 80% of the transactions coming to market are sold on a negotiated basis, though many of the deals are highly rated, uncomplicated transactions and are tailored-made to be sold competitively.

He called on the Municipal Securities Rulemaking Board to alter its controversial Rule G-23 and prohibit a broker-dealer from serving as both the financial adviser and then the underwriter for the same municipal bond deal.

The rule allows a dealer to switch from the FA to the underwriter role in a bond transaction as long as they disclose to the issuer possible conflicts of interest and their expected compensation.

But Johansen said that role switching “is a very bad practice,” suggesting it allows dealers to take advantage of issuers. “If you hire a financial adviser, they should be your financial adviser from beginning to end,” he said.

He noted that the issue has gained traction recently, an apparent reference to calls from SEC chairman Mary Schapiro on the MSRB to alter the rule.

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