CHICAGO — Bond lawyers need to tell federal tax regulators what aspects of the proposed issue price rules are unworkable and then recommend alternatives or fixes, a Treasury Department official said Wednesday in Chicago.
“We very much encourage comments on the proposed regulations but we’d like the comments to specifically focus on how they are unworkable and what fixes we could make,” Vicky Tsilas, Treasury associate tax legislative counsel, said at the National Association of Bond Lawyers’ Bond Attorneys’ Workshop after a contentious discussion about the proposals.
The proposed rules would dramatically change market practices, bond lawyers and Treasury and Internal Revenue Service officials speaking on a “Hot Topics” tax panel all agreed.
Current rules say that the issue price for each maturity of bonds publicly offered is the first price at which a substantial amount of the bonds is reasonably expected to be sold to the public, with substantial defined as 10%. Bonds sold to underwriters or wholesalers do not count toward the 10%.
Under those rules, the issue price is typically determined based on reasonable expectations when the bonds are priced, before the closing. The underwriter typically signs a certificate stating the issue price, which the issuer relies upon and reports to the IRS.
However, IRS and Treasury officials have become concerned in recent years, based on the Municipal Securities Rulemaking Board’s EMMA data, that some bonds are being flipped, or almost simultaneously traded up between underwriters and either other dealers or institutional investors. As a result, retail investors end up paying the highest prices for the bonds, leaving the regulators to suggest the issue price should be higher.
A higher issue price would mean a lower bond yield so the issuer’s investments would have to be at a lower yield to comply with arbitrage requirements. It also would mean that, in the case of direct-pay bonds such as Build America Bonds, that the subsidy payments Treasury makes to the issuer should be lower.
In the proposed rules, which were published on Sept. 16, the Treasury would eliminate the reasonable expectations standard and instead base the determination of issue price on actual sales of the bonds. The proposed rules state: “The issue price of tax-exempt bonds issued for money is the first price at which a substantial amount of the bonds is sold to the public.”
The Treasury has proposed a safe harbor under which the issue price is the price at which the first 25% of the bonds is sold to the public. The public is defined to mean anyone other than the underwriter, an underwriting syndicate member, or a dealer that “purchases bonds for the purpose of effecting the original distribution.”
Bond lawyers and issuers worry that under the proposed rules, they might not know what the issue price is for days or even weeks after the bonds are issued.
“You may have entire maturities, maybe whole deals where there is no issue price” known for awhile, Michael Larsen, a lawyer with Parker Poe Adams & Bernstein LLP who moderated the panel, told Tsilas.
Bond lawyers and issuers also are upset that Treasury and IRS officials appear to want them to spend a lot of time after the bonds are issued to try to determine what the actual sales prices were. One lawyer said during the session that his engagement as bond counsel ends after the bonds are issued and does not cover making queries about the issue price.
Bond lawyers asked Treasury and IRS officials how they are supposed to know when 25% of the bonds are sold to the public.
Steve Chamberlin, acting director of the tax-exempt bond office said issuers and bond counsel could look at the prices posted on EMMA to see if there are any indications of that they were traded up. But he admitted that, while “EMMA is a fantastic resource,” it cannot be used to definitively determine the issue price because it contains information about reported trades, not actual sales. The data may contain errors. Also it is not always clear what the sequence of the trades was, since contingent commitments for purchases, which may have occurred days earlier, are reported the first day of issuance after the bond purchase agreement is signed. Bonds are not considered officially sold or bought until after the bond purchase agreement is signed.
Chamberlin said IRS officials look at the data on EMMA “to identify if there could be a problem, but we don’t look at EMMA to reach conclusions.”
Issuers who see higher prices on EMMA, should not simply rely on the issue price certified to by the underwriter, he said. “At this point, you need to go and ask what really happened. You need to be talking, probably to the underwriter or members of the syndicate, to find out what was the structure of the market ... How was it decided what orders to fill? Were dealers permitted to buy the bonds [instead of] the public.”
But several NABL members were angry at the suggestion that they cannot simply rely on underwriter certificates as to the issue price. They said they do not have the expertise to gauge what happened with the pricing.
Some NABL members worried that underwriters will not be willing to share their pricing information with the issuer. Chamberlin said after the session that one of the problems is that a dealer’s underwriting desk makes the certification as to the issue price, while a separate selling desk is in charge of actual sales. But one NABL member said the two desks are always talking to each other during a primary offering.
Several bond lawyers suggested during the session that federal regulators’ concerns about issue price should be directed at underwriters not issuers and bond counsel. If underwriters are being unscrupulous trading up bonds and knowingly certifying a false issue price, they should be charged with fraud in a securities law enforcement action, they said.
“One could argue that these regulations, they’re reactionary, they’re designed to address what I hope is a very small subset of all negotiated underwritings where they may be an unscrupulous underwriter at the table,” said Larsen.
But Tsilas said there have long been concerns about issue price from a tax standpoint and that market participants have asked the Treasury to provide clearer guidance or rules.
Larsen and other bond lawyers worried the proposed rules could hurt issuers and the federal government, “incentivizing” underwriters to increase yields on bonds to ensure they will sell 25% of them to the public. The rules could be creating “a less efficient market” and one that raises borrowing costs for issuers, one lawyer said.
Another bone of contention is that the proposed rules would apply to competitive as well as negotiated deals. Competitively sold bonds should not be a problem because the bonds typically are sold to the underwriter willing to pay the most for the bonds.
“We understand that enforcement does not really have a problem with competitive deals,” Tsilas said. But the issue price rules are rooted in original discount rules, which do not distinguish between bonds sold through competitive and negotiated transactions, she said.
One bond lawyer said after the session that market participants can take solace in the fact that it usually takes the Treasury years to finalize rules, even those that are not controversial.