CHICAGO — Bond lawyers are beginning to require that underwriters sit down with members of the issuer’s finance team to discuss how they determined the issue price for the bonds, an IRS official said at a seminar held here on Wednesday.
The Internal Revenue Service believes these kinds of discussions are a good idea, Allyson Dodd, the agency’s acting tax-exempt bond field manager, said at a regulation seminar co-sponsored by the Securities Industry and Financial Markets Association and the Municipal Securities Rulemaking Board.
The discussion between the underwriter and the issuer’s finance team should happen “immediately after the sale to explain each trade in the primary market distribution which was not at the issue price,” Dodd said.
“The reasoning here is that a discussion helps the issuer evaluate both the effectiveness of the pricing economically as well as identifying if there are any potential concerns about the correct establishment of issue price for tax purposes,” she told an audience of about 50 market participants.
Issue price is key to determining the bond yield for tax purposes, in the case of tax-exempt bonds, and subsidy amounts, in the case of Build America Bonds and other direct-pay debt.
The determination of bond yield has a bearing on whether a tax-exempt bond issuer is meeting arbitrage requirements and whether a BAB issuer is receiving the correct amount of subsidy payment from the Treasury.
Under IRS rules, the issue price for each maturity of bonds is the first price at which a substantial amount of them are sold to the public, with 10% considered to be a substantial amount. However, the rule only applies if all of the bonds of a specific maturity are offered to the public at that price. The public “does not include bond houses, brokers, or similar persons or organizations acting in the capacity of underwriters or wholesalers,” the rules state.
Moderator Leslie Norwood, managing director and associate general counsel with SIFMA, asked Dodd if the IRS is aware that the Municipal Market Rulemaking Board’s online EMMA system is designed for price reporting purposes and not necessarily for IRS compliance purposes.
Dodd replied that that is not her understanding. “The data available is simply one tool that we use in analyzing the correctness of the establishment of the issue price,” she said.
“We do look at those trades and look at pricing anomalies and try to get an understanding of that process,” Dodd said. “What we are basically looking for are indications of red flags that require further investigation and scrutiny. We are really trying to stay away from making conclusions based on that data alone.”
The IRS’ tax-exempt bond office continues to explore ways to “evaluate potential mispricing of the initial offering of bond issues,” she said, and the TEB team is primarily concerned with the process that produced the issue price and not necessarily the pricing outcome itself.
When IRS agents look at EMMA data, they look for instances where the bonds were not fully placed, there are upward pricing trends, or simultaneous trades showing less than 100% at the initial public offering and premium trades occurred subsequently. They also look for apparent dealer prioritization over the public and the dealers involved in the trades.
If the service still has questions following their analysis, they will contact the issuer about the underwriting process.
Some of the questions the IRS may ask issuers include:
• What certifications or explanations did they receive from the underwriter?
• Did they have a financial advisor?
• What explanations did the financial advisor give?
• Did they follow the Government Finance Officers Association best practices for negotiated sales?
“Asking what actually happened is key because conclusions cannot be made without understanding the process that led to the outcome,” Dodd said. “We’ve often been told that underwriters don’t take on excessive risk and that underwriters rarely if ever have failed. So if an underwriter certifies to an issuer that it will offer all of the bonds of each maturity to the public at the initial offering price and does not actually place the bonds, then what happened?”
The TEB’s focus in terms of scrutiny of issue price is primarily with negotiated sales and not competitive sales, according to Dodd.
“It is our understanding that any of the pricing anomalies that we think we might observe will likely be in respect to negotiated deals,” she said.
She suggested that an issuer can monitor issue-price compliance through presale discussions with the underwriter and by developing an understanding of how the issue price is to be established, how all of the bonds are being offered to the public, and what documentation will be available to review.
Dodd also recommended that issuers review comparable and recently sold issues to evaluate the effectiveness of pricing and have access to all relevant information related to the bond issue, including information regarding the primary offering purchasers of the bonds.
“A lack of access to such supporting documentation undermines the reasonableness of the underwriter’s certification,” Dodd said.
If an underwriter certifies to an issuer that they will offer all of the bonds of each maturity to the public at the initial offering price and they do not actually place the bonds, the IRS wants to know why that happened.
Specifically, the service is interested if the markets moved against the bonds, if the bonds were repriced, or if there was a change in issuance plans and if it was discussed with the issuer and bond counsel, Dodd said.
In addition to the issue price, Dodd discussed a variety of ongoing IRS initiatives including its focus on arbitrage compliance, promoting post-issuance compliance and financial restructurings.
The TEB office will host a free webinar in September on financial restructurings to help state and local governments that have been under financial pressure better understand unintended tax consequences that can be triggered by a reissuance of their obligations.
