Recent Developments Regarding Issuer Responsibility for Reviewing Initial Offering Prices of Bonds
BY JEREMY SPECTOR
Following the advent of Build America Bonds (BABs) in 2009 and securities law rulemaking that has resulted in the posting of virtually instantaneous trading data on the EMMA website (msrb.emma.org) hosted by the Municipal Securities Rulemaking Board (MSRB), the IRS has repeatedly expressed concerns about how initial offering prices (a/k/a “issue prices”) on municipal bonds are determined on the primary market and whether certifications of such prices for tax purposes are correct.
Why the concern? Why has this concern been exacerbated in recent years? Why hasn’t the IRS addressed its concern by publishing new regulations?
The “issue price” determines the yield, for tax purposes, on the bonds. The lower the issue price for bonds bearing a stated interest rate, the higher the yield. IRS regulations specify that the issue price for tax-exempt bonds is, for each maturity, the first price at which ten percent of bonds is sold to parties other than underwriters. For a bona fide public offering of all of the bonds, issue price can be established based on reasonable expectations on the sale date. Typically, issuers rely upon issue price certifications provided at closing by the underwriters.
An erroneous issue price can cause the US Treasury to lose tax revenues. In the case of tax-exempt bonds, an erroneously low issue price may create an erroneously high bond yield and result in the issuer retaining impermissible arbitrage on taxable investments made with tax-exempt bond proceeds. In the case of BABs, a requirement of the federal subsidy is that the issue price cannot be higher by more than a de minimis amount than the par amount of the bonds. Accordingly, a determination by the IRS that the “issue price” was erroneously calculated could cause loss of tax-exempt status in the case of tax-exempt bonds and loss of subsidy in the case of BABs.
The IRS’s concerns with issue price first surfaced in the context of 32 BAB audits. Two factors account for the concern. First, a correct issue price is particularly critical in the context of BABs, because of Code Section 54AA(d)(2)(C)’s limitation on the amount of premium. Second, the relatively recent availability of live trade data on EMMA has made it increasingly feasible to spot what may appear to be discrepancies between issue price certifications delivered by underwriters upon issuance of bonds and the prices at which bonds are traded shortly after, and sometimes shortly before, such certifications are delivered.
In some of the BAB audits, the IRS observed suspicious trading activity which it still appears to be investigating. The suspicious activity included situations where (1) a portion of a maturity is sold at the initial offering price and another portion is sold at higher prices; (2) a portion of a maturity remains unsold by the underwriter with the rest sold at prices above the initial offering price; and (3) dealers purchase all or a portion of a maturity and quickly resell at higher prices in what appears to be the primary market. A common theme seems to be a trend of increasing prices when the public buys on the secondary market, sometimes on the same day the bond purchase agreement is signed by the underwriter.
In response to its concerns the IRS has launched two compliance check initiatives to educate issuers and learn more about how issuers “due diligence” the issue price on their bonds. In addition, the IRS has reached an agreement with the MSRB, announced on October 24 (see the MSRB press release), to allow the IRS access to the MSRB’s internal regulatory website, with its up-to-date trade data, and to other information available to enforcement agencies (such as FINRA) that the MSRB works with to regulate the municipal market. The IRS’s agreement with the MSRB regarding such access includes an acknowledgment that the MSRB’s regulatory website is designed to help administer the securities laws and not the tax laws and that its market data may be incomplete for federal tax purposes. For example, the data reported to the MSRB does not always distinguish between sales to dealers and sales to the “public.”
So far, the IRS seems to have learned that most issuers rely on the issue price certificate provided by the underwriters to establish issue price without further due diligence. The IRS’s compliance check initiatives contain questions relating to procedures an issuer uses to review available trading data to confirm compliance with federal tax requirements. These questions appear to encourage issuers to look behind the issue price certificate and to use publicly available municipal market data, such as data available on EMMA, to spot problems. In light of this increased scrutiny by the IRS of trade data, issuers, out of an abundance of caution, are well advised to review trading data on EMMA and to raise any questions with their underwriters and bond counsel whenever such data shows a quick uptrend on and immediately after the sale date and before the bond closing. Downtrends in issue price would tend to indicate that an issuer received excellent pricing on the sale date, a scenario the IRS is unlikely to question.
At this time, there is confusion about how much and what type of diligence an issuer must do on issue price, as well as on the facts about which sales are meaningful for purposes of issue price determinations. The bond community is still waiting for the IRS to solve these issue price conundrums by writing more manageable regulations which will help issuers more easily identify the line between the primary and secondary market and any requirements for testing issue price certifications.