WASHINGTON — Build America Bond transaction participants are debating whether they need to do more to track BAB prices to avoid running afoul of statutory premium restrictions and jeopardizing the issuer’s subsidy payments or to respond to an Internal Revenue Service compliance check.
Bond attorneys last week said a lack of clarity on American Recovery and Reinvestment Act provisions relating to BAB premiums, coupled with a heightened IRS interest in the initial pricing of BABs, has led to an increased focus on pricing. But no consensus has emerged so far on what, if anything, should be done, they said.
“[There’s] a lot of uncertainty in the bond counsel community as to what obligation the IRS is apparently looking to impose on issuers and bond counsel,” said Robert Eidnier, a partner with Squire, Sanders & Dempsey LLP. “In the absence of specific rules, I do think that bond counsel is really struggling with it and figuring out where the market is going to end up with this.”
“Certainly we have concerns that the uncertainty may affect market liquidity,” said Leslie Norwood, associate vice president and general counsel of the Securities Industry and Financial Markets Association. “It’s important to get some more clarity on the rules about issue price for BABs, and particularly we’re looking at whether … this is causing restrictions amongst purchasers of BABs.” SIFMA is hosting a conference on BABs here Thursday.
“It’s pretty serious,” said Bill Daly, senior vice president for government relations at the Regional Bond Dealers Association. “Theoretically ... the IRS could say after the fact, 'Here’s what we think the issue price is ... and therefore these don’t really qualify as BABs and so ... you don’t get your 35% check.’ ”
Issue price also is a major topic of discussion among BAB issuers, according to one who did not want to be identified.
The February 2009 ARRA, which created BABs, included a provision stating they could not be sold at more than a de minimis amount of premium. The provision referred to a section of the tax code that defines de minimis as 1/4 of 1% of the stated redemption price at maturity for the bond, multiplied by whichever comes first: the number of complete years to the maturity date for the bonds or the first optional redemption date for the bond.
The premium limit was put in place to ensure that issuers do not artificially inflate the interest rates of their BABs to obtain larger subsidy payments, according to market participants. The Treasury makes direct payments to BAB issuers equaling 35% of their interest costs.
If issuers sell their BABs at more than a de mimimis amount of premium they run the risk of becoming ineligible to receive the subsidy payments — hence the concern about issue price.
A key point of the debate is whether or not BAB issuers can rely on the same rules for determining issue price that they would for traditional tax-exempt bonds.
Traditionally, issue price for bonds is set once 10% of the bonds are sold to the public. The issue price rule, in Section 1.148-1(b) of the tax rules, states: “Generally, the issue price of bonds that are publicly offered is the first price at which a substantial amount of the bonds is sold to the public. Ten percent is a substantial amount.”
However, the Recovery Act is not explicit about whether these tax-exempt bond rules for issue price apply to BABs and the IRS has been silent on that point. IRS officials could not be reached for comment.
Part of the confusion about the issue stems from the fact that while the stimulus law makes clear that BAB issuers should comply with tax-exempt bond rules, the provision containing the de minimis premium restriction refers to another section of the tax code.
“There’s nothing formal that has been published by Treasury and IRS to clarify that,” said David Caprera, a partner at Kutak Rock LLP. However, he noted that generally the Treasury and IRS have indicated BABs should adhere to tax-exempt bond rules, such as those restricting arbitrage.
“We’re told, 'Go use the same rules,’ ” he said. “It’s logical to use the tax-exempt bond rules regarding issue price in determining whether you meet the issue price rules for BABs. But there is no black-letter law that would tell you, 'This is how you would go about doing it.’ ”
Further driving concern over issue price is the compliance check questionnaire the IRS is sending to every BAB issuer. The first two questions on the document deal with bond pricing.
One asks issuers if they have written procedures in place to make sure their BABs are not issued with more than a de minimis amount of premium. It asks the issuers to describe the procedures in detail and to provide a copy of them, as well as the date they were implemented.
If an issuer has no such procedures it must explain what guidelines are in place to address the issue. “We’ve been hearing about it more informally for a number of months, but now we’re seeing it reflected in the questionnaire,” said Squire Sanders’ Eidnier.
The second question — which was the subject of controversy at the National Association of Bond Lawyers’ Tax and Securities Law Institute in February — asks if issuers or their consultants “other than the underwriter or initial purchaser” of the BABs are reviewing secondary-market trading activity between the sale date and issue date. If they are reviewing the data, the IRS asks whether are there any indications the BABs traded at a price greater than the issue price before the issue date.
That question appears to be exploring whether “flipping” is occurring with BABs. Flipping occurs when dealers or institutional investors purchase bonds and then immediately resell them to retail investors at higher prices.
The practice is believed to hurt issuers because they don’t get the highest prices and lowest coupons for their bonds. Flipping also raises questions about whether underwriters are complying with the issue price rules.
Flipping first created a storm of controversy in the tax-exempt bond sector when academics from Carnegie Mellon University’s Tepper School of Business focused on the practice in a paper on trading and prices in the new-issue market in 2005. The compliance checks seem to be the first time the IRS has formally queried whether issuers are tracking the pricing of their bonds.
At the NABL conference, bond lawyers pressed IRS officials about whether issuers would be subject to an audit if they disclosed on the questionnaire that they are not following the pricing or trading of their BABs.
Steve Chamberlin, senior manager of compliance and management in the IRS’ office of tax-exempt bonds, told the lawyers that his agency had not yet determined how they would select BABs for audit, but said some audits would specifically focus on issue price.
The second question is “definitely a concern,” the issuer official said.
“What are you supposed to do with this information after you see it?” he said. “There’s an implication there that somehow issuers are supposed to control the pricing of this after the pricing date.”
However, the de minimis premium restriction appears to be causing more heartburn for market participants because if issuers exceed it they could lose their subsidy payments from the federal government.
“It obviously is a hot topic in the BAB area, and the stakes of having a problem with the issue price is significant,” said Richard Chirls, a partner at Orrick, Herrington & Sutcliffe LLP. “If you exceed the premium limitation, the issuer is at risk of losing the entire subsidy.”
Attorneys said it would be helpful if the IRS agreed to allow issuers to lose only a portion of their subsidy relative to how much they violated the premium restriction, but it is unclear if the agency’s officials would or could even do that because the restriction is statutory.
Bond lawyers had a range of views about what they should do, if anything, to monitor the pricing of BABs.
For some bond lawyers, it’s business as usual, believing that they can apply the tax-exempt bond rules on issue price to BABs. Caprera said the tax-exempt rules are sufficient to guide behavior pertaining to BAB pricing, but he wouldn’t mind a little clarification from the IRS.
“We think it’s the right thing to do, but it’s nice to have it in print,” he said.
Normally, issuers turn to underwriters for certification of issue price, but the IRS has asked them if someone other than the underwriter is monitoring trading.
“We are looking to ensure that someone involved with the transaction is reviewing the trading information on the bonds between the sale date and the issue date,” Eidnier said. “Frankly, we are looking to financial advisers to be the primary professionals in the transaction who are taking the lead on this question.”
However, he said some FAs might be reluctant to provide certification on the pricing and that the underwriter remains the transaction participant best situated to speak to the appropriateness of pricing.
In some cases, attorneys are also taking it upon themselves to review trading on the Municipal Securities Rulemaking Board’s Electronic Municipal Market Access system.
“We want to be sure that someone involved in the transaction is reviewing that information,” Eidnier said. “If no one else is willing to do it, we do it.”
Others are going much further and are either trying to prohibit the resale of BABs above a pre-determined price prior to the issue date, or waiting to determine the issue price of the bonds until 50%, rather than 10%, of the bonds have been sold, according to several lawyers.
Gary Anderson, a shareholder with Gilmore & Bell PC in Kansas City, Mo., said his law firm typically tries to make sure there is a ceiling on the reoffering price of BABs. The firm was bond counsel for a competitive sale of $710,000 of BABs for DeSoto, Kan., earlier this month.
The terms of the sale included a requirement that the bonds be sold at no more than 102.50%, to ensure the premium restriction was not exceeded.
“We’ve been doing this really since day one with Build America Bonds,” Anderson said. “Since the IRS has a significant percentage of the money that issuers are counting on to pay interest — 35% for BABs and 45% for [recovery zone economic development bonds] — there is always a risk that at some point the IRS could use its position to pressure an issuer into settling a tax controversy.”
“One of the things that we’ve been preaching to our clients is that these BABs and [recovery zone economic development bonds], you know, it really changes the relationship with the issuer and the IRS, because previously if the IRS had a problem with your issue, they’d initiate an audit and there would be an ongoing conversation,” he added.
“Now the leverage has changed ... if the IRS thinks there is something wrong, they can say 'Oh, by the way, we’re going to suspend your payments.’ ”