WASHINGTON - The National Association of Bond Lawyers is urging the Treasury Department to clarify that multi-modal auction-rate securities can be treated as qualified tender bonds to avoid reissuance problems when they are converted to another interest rate mode - a move more issuers are pursuing as insurers face rating downgrades.
NABL made the plea in a letter sent to the Treasury late Monday that said the Internal Revenue Service needs to update its definition of qualified tender bonds. As the subprime mortgage crisis has resulted in actual or threatened rating downgrades for several major bond insurers, many issuers are considering converting their auction-rate bonds, which typically are insured, to other interest rate modes in an attempt to avoid higher interest costs.
However, there are questions in the muni community over whether such conversions would result in reissuance of the bonds or whether auction-rate bonds that are part of a multi-modal structure could be treated as qualified tender bonds, which are not be subject to IRS tax restrictions on reissued bonds.
Much of the confusion stems from IRS Notice 88-130, which protects qualified tender bonds from being treated as reissued. Bond lawyers need clarification from Treasury regarding how auction-rate bonds fit into that notice, said Scott Lilienthal, a partner at Hogan & Hartson LLP and one of the authors of the NABL letter.
A qualified tender bond is one in which the holder must tender the bonds at par at one or more tender dates. Technically, auction-rate securities may never be tendered unless there is a change in mode.
"Auction-rate bonds have become much more popular since Notice 88-130 was issued. It's not clear whether they were even contemplated in forming the notice," Lilienthal said. "What we're asking for is that auction-rate bonds be treated similarly to other short-term interest rate bonds."
Linda Schakel, a partner with Ballard Spahr Andrews & Ingersoll LLP added that similar questions have existed since auction-rate bonds became popular several years ago, but the current struggles facing bond insurers has exacerbated the need for clarification.
"This notion of whether an auction-rate bond is a qualified tender bond has been hanging out there for several years, since auction-rate securities became much more common in the municipal market," she said. "Basically the problem was that the definition of a qualified tender bond was a very specific definition ... and now with the insurance problems, they [Treasury] need to make changes, so this just kind of heightened the concern."
Schakel said due to the recent popularity of auction-rate bonds, the IRS' definition of qualified tenders, which it established in 1988 with Notice 88-130, is in need of an update.
"All [the proposed clarifications are] doing is just broadening the definition," she said.
If auction-rate securities are not found to be qualified tender bonds, they would be reissued when converted to another mode and subject to new restrictions. Under the tax rules if the terms of a debt instrument are significantly modified, the bonds are deemed to be reissued and subject to new requirements.
For example, the issuer would need to redetermine and pay arbitrage rebate on the bonds within 60 days. And in some cases, a reissuance might mean the borrower must hold a public hearing and seek public approval under the Tax Equity and Fiscal Responsibility Act. Furthermore, bondholders might have to recognize taxable gains or losses from a reissuance.
NABL sent the Treasury a draft revenue ruling that would resolve this problem by updating Notice 88-130 and including auction-rate bonds in the definition of qualified tender bonds.
Lilienthal said he does not know when Treasury will respond to NABL's request, but that the letter and proposed revenue ruling were drafted narrowly to encourage a quick response from federal officials.
"The need is pretty immediate," he said.
However, even with some uncertainty remaining, Lilienthal said he does not expect issuers to delay conversions to wait for Treasury.
"I don't know if people will be waiting because in large part it's driven by the economics of wanting to get to a lower rate," he said. "I'm not sure if the tax issue is holding things up, it's really just a matter of making things more complicated." q