WASHINGTON — Four major municipal market groups are urging the Treasury Department to issue guidance confirming that the existing regulatory framework on issue price for tax-exempt bonds also applies to Build America Bonds and stating that if issuers follow certain long-standing practices, they can be confident they are complying with the rules in this area.
The groups stressed there is an “urgent need” for such guidance in a letter sent late Friday to John Cross 3d, the Treasury’s associate tax legislative counsel.
The groups also provided the Treasury with an analysis of market data they said confirms that the “trading up” of bonds occurs in all markets, and is actually more extreme in the corporate market than in the BAB market. The letter does not use the term “flipping,” but trading up means the same thing: when bonds are issued at one price and then immediately traded at a higher price.
The letter is a follow-up to a meeting held last month between Treasury officials and representatives of the four groups —the Government Finance Officers Association, the National Association of Bond Lawyers, the Regional Bond Dealers Association, and the Securities Industry and Financial Markets Association.
Uncertainty surrounding issue price has gripped the BAB market in recent months, since the Internal Revenue Service began asking BAB issuers if they were following the pricing of their bonds — something issuers traditionally have not done.
That line of inquiry has led to concern among muni market participants that the IRS might require issuers to rely on the actual trading of their BABs to determine issue price, instead of allowing them to rely on underwriter certifications that there was a bona fide public offering of the bonds at the initial offering price and that it is reasonable for the issuer to expect a substantial amount of the bonds will be sold to the public at that price. This traditionally has been the way issue price has been established for tax-exempt bonds.
The controversy peaked after an IRS official said during a teleconference sponsored by NABL that the service could audit up to 50% of BAB issues. The IRS has since backed down from the remark, saying the actual number of audits is likely to be much smaller. But concerns about audits have driven the need for explicit guidance to assure issuers they are compliant.
“Issuers and others in the marketplace continue to struggle with matters surrounding the questions of issue price,” the groups wrote in the letter. “The best way to alleviate these concerns and difficulties created for the market is to clarify the existing regulatory framework for tax-exempt bonds and apply this directly to [BABs].”
Issue price is particularly significant for BABs because of a tax law requirement that the bonds 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, which currently equals 35% of their interest costs.
Requiring issuers to track actual sales of the bonds would place “an unreasonable burden on issuers by subjecting tax compliance to the randomness of subsequent market movements and causing uncertainty and second-guessing after a legal commitment has been executed,” the groups argued.
Specifically, they are asking for explicit guidance on two points — what constitutes a bona fide public offering, and what constitutes reasonable expectations. Tax rules state that the issue price of bonds for which a bona fide public offering is made is determined on the sale date based on reasonable expectations regarding the initial public offering price. On both questions, the groups are effectively asking the Treasury to affirm long-standing market practices as compliant with the tax rules.
“We tried to impress on them that the normal way that bonds are offered and have been offered for years is in fact a bona fide public offering,” said William Daly, RBDA senior vice president of government relations. “Because of statements that have been made, people have gotten nervous … that the normal practice is somehow not good enough.”
“What we’re saying is, 'Look, we just need to be real clear as to how reasonable expectations work and what is good evidence of reasonable expectations,’ ” said Perry Israel, who has his own firm in Sacramento and is chair of NABL’s tax committee. “We think that good evidence of reasonable expectations includes, for example, a final pricing wire.”
The group called on the Treasury to establish safe harbors. They recommended that information contained in a final pricing wire or bond purchase agreement, supported by evidence of underwriter negotiations with bondholders, should establish a reasonable basis for issue price for negotiated deals.
If normal market practices are followed for competitive deals — such as issuing a public notice that the bonds are available, collecting competitive bids, and awarding the bonds to the bid representing the lowest interest cost — then that should “de facto establish the issue price is the reoffering price/yield on the bonds.” Subsequent sales at different prices should be irrelevant and not affect the price set by market forces at the time of initial sale, the groups said.
Given that the areas in need of clarification apply to both BABs and tax-exempts, the groups said the forthcoming rules should apply to all municipal securities, including BABs.
“BABs have brought attention to this issue, but certainly we would like clarity with regards to all municipal securities,” said Leslie Norwood, managing director, associate general counsel, and co-head of municipal securities at SIFMA.
In addition, if a violation of the tax law is discovered by the IRS, the penalty should be made to fit the violation, rather than simply endangering the subsidy payment on the entire issue, the groups told the Treasury.
They said that even if the department disagrees with them, it is crucial that officials make clear what exactly it expects from issuers.
“If there is some discomfort, we want to hear from the IRS what that discomfort is, pinpoint it for us,” Daly said. “There’s a real need here for certainty from the IRS.”
The letter was accompanied by a study done by SIFMA that indicated that price fluctuations in the BAB market are less severe than in the corporate taxable bond market, and that BABs trade in a similar fashion to tax-exempt bonds. The group looked at over 1300 deals done between April 2009 and May 2010.
The study found that negotiated BABs experienced the smallest price movements from initial pricing to first settlement, moving an average of 0.161 points, followed by competitive BABs, which moved an average of 0.386 points. On the other hand, corporate bonds during that time experienced much larger price swings, averaging 1.078 points between initial pricing and first settlement.
In comparison, traditional tax-exempt bonds experienced similar trading patterns. Negotiated deals had an average of 0.298 points in price movements, while prices for competitive deals changed an average of 0.623 points over the same timeframe.
“This is a natural function of the new issuance of securities,” Norwood said. “There’s nothing abnormal going on here, and actually the trading up is much tighter than in the corporate market.”
Treasury officials could not be reached for comment on the letter.