WASHINGTON - Market groups are pushing the Internal Revenue Service to change its proposed issue price rules to include a safe harbor for competitive deals, warning the failure to do so will disrupt market practices and hurt issuers.
The groups made their push in comments submitted to the IRS this week on the issue price rules the IRS re-proposed in June after the initial ones floated in 2013 were withdrawn because of criticism. Without a safe harbor for competitive sales, "underwriters in competitive sales will build more of a risk premium into prices they are willing to bid, or may no longer participate in competitive sales because they will have few orders prior to the bid," the Government Finance Officers Association wrote. "This will also increase yields to issuers."
Ben Watkins, director of Florida's division of bond finance wrote, "We strongly believe that the proposed regulations, if enacted as written, will cause significant disruption to existing market practices, impose significant administrative burdens on issuers, unnecessarily increasing the cost to issuers in an attempt to address perceived problems, and could even lead to increased bond yields if underwriters are forced to lower prices in order to meet these requirements."
Under existing rules, for bonds that are publicly offered, the issue price is the first price at which 10% of the bonds are reasonably expected to be sold to the public. But under the rules proposed in June by the IRS and the Treasury Department, there is no reasonable expectations standard.
For both competitive and negotiated sales, the general rule would be that the issue price is the first price at which 10% is sold to the public. If 10% of a maturity hasn't been sold by the sale date, issuers can employ an "alternative method" in which they can use the initial offering price to the public as of the sale date as the issue price if certain requirements are met. Those requirements include that the underwriters fill all orders from the public on or before the sale date at the initial offering price, and that the lead or sole underwriter provide a certification that no underwriter will fill an order from the public after the sale date and before the issue date at a higher price than the initial offering price unless the market moves after the sale date. The issuer can't know or have reason to know that the certifications are false.
GFOA in its letter argued that the rules should include a safe harbor for competitive sales that would allow issuers to use the current rules to establish issue price in those cases. Similarly, the State Debt Management Network, an affiliated network of the National Association of State Treasurers, urged Treasury and the IRS to exclude competitively sold bonds from any issue price rule based on actual sales.
"The competitive aspect of the bids and the tight range of bids in a successful competitive sale indicate that underwriters have access to a great deal of information regarding market demand and the likely clearing price for each maturity of bonds," SDMN wrote in a letter signed by the chair of its board, Virginia Treasurer Manju Ganeriwala. However, underwriters of bonds sold competitively usually do not have orders for bonds of each maturity prior to the sale, and instead they base their bids on "the reasonable expectation of orders," it added.
"We are concerned that certain aspects of these 2015 re-proposed regulations will negatively impact current processes used by states to issue debt," SDMN wrote.
Florida, which by law is required to sell bonds competitively, said that the rules should presume that the issue price for competitively sold bonds is the initial offering price at the time the bonds are awarded to the best bidder on the sale date. The elimination of the reasonable expectations standard would create uncertainty, and the alternative method would "impose … a significant burden on the issuer," the state wrote.
Bond Dealers of America said that if the regulators are going to eliminate the reasonable expectations rule, they should consider a safe harbor for competitive sales awarded after receiving at least three bids. The group noted that underwriters are immediately at risk to market movements when they buy bonds through competitive sales.
"The bid by the underwriter who bids the highest price/lowest yield should establish issue price," BDA wrote. "The bond has been priced competitively and this fact should temper the concerns the IRS has with potential violations of the arbitrage restrictions."
BDA urged Treasury and the IRS to keep the current reasonable expectations rule across-the-board, saying that standard "is essential to recognizing that the rules interact with a fluid marketplace in which capital is at risk." Instead of using an actual sales approach, "the IRS should use its available enforcement tools to ensure that abuses are not occurring and should work with the [Securities and Exchange Commission], [Financial Industry Regulatory Authority], and [Municipal Securities Rulemaking Board] to enforce the existing municipal securities regulations," the group wrote.
The National Association of Bond Lawyers did not request that Treasury and the IRS return to the reasonable expectations test for bonds sold competitively. Instead, NABL suggested that the rules should provide additional alternative methods for establishing issue price for bonds sold competitively that do not meet the 10% actual sales test on the sale date.
One alternative proposed by NABL is that the issuer use the initial offering price as the issue price in these circumstances if it employed "a bona fide bidding process similar to [one that is] currently in place for ascertaining fair market value in the pricing of guaranteed investment contracts and open-market securities deposited in advance refunding escrows." If the IRS required a minimum number of bids, it should exempt issues less than or equal to $5 million from that requirement. A second alternative would allow the issuer to use the initial offering price if at least 65% of total principal amount of the issue or 65% of the number of maturities of the issue met the general rule.
In addition, the groups commented about the IRS' "alternative method" for determining issue price in the proposal.
BDA wrote that "the risk, complexity, and uncertainty associated with this method will make it very unlikely the alternative rule is used." Underwriters may sell bonds at reduced prices to ensure they meet the general rule, which will lead to increased interest costs for issuers, BDA wrote. The group also urged Treasury and the IRS to remove the underwriter pricing documentation and due diligence requirements, which the group said are "not administrable."
SDMN agreed that the alternative method would be rarely used, arguing would be difficult for underwriters to document market changes. "It is our view that the potential difficulty of documenting market change will result in underwriters generally refusing to rely on the alternative method and defaulting to the safe harbor criteria, which … will increase costs to issuers, both in competitive and negotiated sales," the group wrote.
"The 2015 re-proposed regulations place undue responsibility on the issuer to ensure that the underwriter is complying with the regulations," SDMN wrote, adding, "We suggest eliminating enforcement responsibilities for the issuer."
NABL asked Treasury and the IRS to confirm that issuers do not have to choose between the general method and the alternative method prior to the issue date.
The group also asked the agencies to confirm that an issuer can rely on covenants underwriters make promising not to sell bonds at a price higher than the initial offering price between the sale date and the issue date absent market changes. It wants Treasury and the IRS to clarify that if an issuer receives appropriate certifications from the lead or sole underwriter about the sale of bonds on or before the sale date, the issue price won't be affected by false or inaccurate certifications.
NABL also asked the agencies to eliminate language about the issuer not knowing or having reason to know that the certifications are false and instead "focus on identifying, through examples in the regulations, the documentation that a prudent person would review and retain in its books and records to establish issue price."
SDMN and GFOA both argued that issuers need to be able to have certainty about issue price on the sale date for refunding transactions. "Issuers anticipate that the 2015 re-proposed regulations will result in more uncertainty regarding the issue price and the arbitrage yield which are critical for determining the escrow cost, the bond sizing and savings from an advance refunding," the NAST affiliate wrote.
BDA said that if the reasonable expectations standard is eliminated, the IRS should "consider amending the proposed general rule to protect issuers, especially small issuers, by using a modified actual sales approach that would allow issue price to be established by selling at least 50% of a total issuance."
