The Securities and Exchange Commission and the Internal Revenue Service have published guidance on auction rate bonds, particularly with respect to transactions in which an issuer purchases its own bonds. The SEC published a no-action letter March 14 on issuer purchases under securities laws relating to "market manipulation." Subsequently, SEC staff met with industry representatives to "clarify" the letter, as reported by the Securities Industry and Financial Markets Association (SIFMA) in a Clarification Memo dated April 8 and available on SIFMA's Web site. On March 25, the IRS published Notice 2008-41, with new rules on "reissuance" of auction rate bonds in various contexts, including issuer purchases. This discussion summarizes these two authorities for our clients and friends facing market difficulties with auction rate bonds.

SEC Letter

The SEC letter, written by the Commission staff under the title "Municipal Auction Rate Securities," relates to issuer purchases of auction rate bonds on which they are obligated. It responds to the fact that in some auctions, there have not been sufficient bidders to clear the auction, so the auction rate bonds have repriced at a "no auction" penalty rate. There had been concern in parts of the market that an obligor's participation in the auction of bonds on which it is obligated may manipulate the market for those bonds in a way that violates federal securities laws and that a broker-dealer's participation in an auction on behalf of an obligor would violate any consent order it may have with the SEC on auction bonds. The SEC letter attempts to provide guidance when an obligor enters its auction market.

First, the bond documents (indenture, auction agreement and broker-dealer agreement, for example) may limit an obligor's ability to enter the auctions for its bonds. These documents may require amendment.

Second, the official statement or other offering document for the bonds may have statements to the effect that the obligor will not enter its auctions. If so, the offering document must be amended or supplemented.

Third, the SEC staff believes that notice to the market is essential. The SEC staff letter suggests the notice include:

  • Disclosure that the obligor intends to enter the auction for its bonds. The staff suggests at least two business days' advance notice.

  • Disclosure of the amount of the auction rate securities that will be the subject of the bid and the bid interest rate. The April 8 memo indicates that the bid information can be by reference to an index, such as the SIFMA municipal swap index.

  • Provisions made by the obligor to permit other holders to sell the bonds to the obligor if less than all of the auction bonds are purchased by the obligor.

  • Information about the preceding auction and the auction in which the obligor participates (rates, number and aggregate dollar amount of bids, participating dealer information).

  • Steps that would be taken to avoid a rate that would be less than a "below market-clearing interest rate."

The staff letter states that the disclosures should be made to nationally recognized municipal securities information repositories (most auction bond obligors have continuing disclosure agreements in place that could be useful) and to the "financial press," and should be posted on the obligor's and participating dealer's Web sites.

Obligations issued by conduit issuers for a non-governmental obligor are not considered extinguished for tax purposes when acquired by the obligor. Different tax rules apply to obligations of governmental issuers. State law should be consulted to be sure that the obligor's bond acquisition does not extinguish the debt represented by the bonds.

Most auction broker-dealers have adopted guidelines and procedures to implement the SEC staff guidance. Also, while the admonition to avoid a "below market rate" in the obligor bid is inherently (and intentionally) imprecise, the April 8 memo quotes SEC staff as viewing the SIFMA index as a safe harbor for this purpose.

IRS Notice 2008-41 in a Nutshell

Notice 2008-41 provides generally that auction rate bonds (ARBs) will be treated as a form of qualified tender bonds (QTBs) and so have the benefit of essentially the same rules as tender option bonds (TOBs), an earlier form of QTB approved in the original 1988 reissuance guidance in Notice 88-130. ARBs and TOBs are financially similar in that both of them bear interest at floating rates that are reset by a market process at periodic intervals, unless and until they are "converted" to a fixed rate to maturity. They are legally similar in that, as a result of Notice 2008-41 and its immediate predecessor Notice 2008-27, both are protected from reissuance treatment in their ordinary rate-setting procedures and in a number of extraordinary circumstances as well. This protection is important in many cases: Depending on the precise context, a reissuance can have various tax consequences, from the need to file a new report with the IRS to technical changes in applicable substantive requirements for tax exemption.

The favorable treatment for ARBs began in February 2008 with Notice 2008-27, which for the first time allowed ARBs to be treated as QTBs. Notice 2008-41 carries the favorable treatment of ARBs a step further, allowing an issuer of ARBs to purchase them and hold them for up to 180 days without causing the purchase to be treated as a retirement of the bonds and any subsequent remarketing to be treated as a reissuance. The 180-day rule is temporary; an issuer can use it only for purchases through September 30, 2008. Nonetheless, it can be extremely helpful now as issuers work through the morass of failed auctions and high rates.

Besides adding the 180-day rule, Notice 2008-41 differs from Notice 2008-27 in numerous revisions of technical language. Notice 2008-41 simplifies "Example 2," concerning bond exchanges, and includes a new example for "serialization" of bonds issued originally with a mandatory sinking fund schedule.

How Notice 2008-41 Works

Notice 2008-41 allows QTBs to have periodic resets of their interest rate or to have changes in the rate "mode" (e.g., a change from a short-term mode of auctions every 35 days or tenders every week, to a fixed rate to maturity), without causing the bonds to be constructively retired and "reissued." The original reissuance notice, Notice 88-130, applied to TOBs, a popular financial product at the time. It did not seem readily applicable to ARBs when they too became popular, hence the need for the 2008 Notices.

Notice 2008-41 is structured as a set of favorable rules for QTBs, which it defines to include ARBs, as well as TOBs and certain other floatingrate bonds based on indexes. TOBs set the floating rate through periodic remarketings of bonds tendered for purchase pursuant to tender rights granted to the holder in the bonds' terms. ARBs differ from TOBs in that ARB rates are set by periodic auctions, with no holder right to force a purchase if there are no buyers.

Changes from one interest rate mode to another provided in the bond documents will not create a reissuance under Notice 2008-41 and the prior Notices. In contrast, transactions in which the documents are amended will cause a reissuance if they change the bond yield by more than the greater of (a) 25 basis points or (b) 5% of the pre-change yield (see Treas. Reg. § 1.1001-3). A reissuance can also result from amendments that defer the payment of principal or cause other major changes in the payment terms or security for the bonds, as set forth in Treas. Reg. § 1.1001-3.

In general, if an issuer purchases its own bonds, the bonds will be treated as retired under the doctrine of "extinguishment." Notices 2008-27 and 2008-41 created limited exceptions to this doctrine, as did Notice 88-130 on a smaller scale. As stated in Notice 2008-41, the primary exception to the extinguishment doctrine applies for a 90-day period for best efforts to remarket after an issuer's purchase of TOBs pursuant to a holder's exercise of the periodic tender rights for rate resetting or special tender rights that apply if the interest rate mode is changed, including a fixed-rate conversion. With ARBs, there is no tender right in connection with the periodic resets. The 90-day rule applies, however, if the issuer purchases ARBs pursuant to a holder’s exercise of special tender rights for mode changes or conversions.

The 180-day rule is a temporary extension of the 90-day rule in response to current market conditions. To qualify for the 180-day rule, the purchase must be made before October 1, 2008. The 180-day rule is separately stated for ARBs, clarifying that an issuer can purchase ARBs and hold them for up to 180 days without the purchase having to occur pursuant to a holder’s exercise of a tender right, if the purchase occurs before October 1, 2008.

In discussing an issuer's purchase of its bonds, Notice 2008-41 makes clear that, as under the prior Notices, a bank that purchases tendered bonds pursuant to a letter of credit or standby bond purchase agreement can hold them beyond the 90- and 180-day limits provided in the Notice. Similarly, the 90- and 180-day limits do not apply to purchases by a conduit borrower other than a "governmental issuer." The definition of governmental issuer limits them to governmental units that borrow bond proceeds from the issuer by giving the issuer a debt instrument that qualifies as tax-exempt in its own right, complete with a separate Form 8038-G in addition to the bond issuer’s own 8038-G.

The issuer purchase rule is illustrated by a new example (5) in which the documents provide that tenders are financed by a bank but the tendered bonds are held by the issuer (and pledged as security for the issuer’s reimbursement obligation to the bank). In this situation the issuer has 90 days (or 180 days for pre-October 1 purchases) to remarket the bonds. As previously, there is no time limit if the bank, rather than the issuer, holds the bonds after the purchase.

Notice 2008-41 makes other significant points on issuer purchases:

  • If bonds are retired without a "link" to another borrowing (i.e., using funds that are "equity" and not proceeds of debt), it may not be possible to issue new debt at a later date and treat it as a refunding. The Notice does not discuss the possibility that the debt could be issued under the rules for reimbursement bonds (Treas. Reg. § 1.150-2) and treated as "linked" to the prior bonds because of a reimbursement of the equity that retired the prior bonds. However, an argument to establish "linkage" through the reimbursement rules would seem questionable under a provision in the reimbursement rules providing, generally, that an expenditure of equity to pay principal or interest on a prior obligation will not qualify for reimbursement (Treas. Reg. § 1.150-2(g)(1)).

  • A conduit borrower may purchase ARBs "to facilitate liquidity under adverse market conditions" without disqualifying the bonds from treatment as being issued pursuant to a "governmental program" under Treas. Reg. § 1.148-1(b). Loans under a governmental program generally qualify for a special arbitrage limit allowing them to yield up to 1.5% above the bond yield, instead of the general limit of .125%. The governmental program definition requires the bond documents to prohibit any obligor from purchasing bonds in an amount related to the loan to that obligor. The provision in the Notice relates only to ARBs.

Both these points have been the subject of considerable discussion among lawyers.

Besides permitting issuers to purchase their own bonds, Notice 2008-41 also permits them to waive "caps" (limits) on the bonds' interest rate, again through October 1, 2008. To qualify for a cap waiver, both the waiver agreement and the waiver period must fall within the period November 1, 2007, to October 1, 2008. The cap waiver rules are a response to requests from ARB issuers who wanted to waive rate caps to maintain good relations with bondholders who were being forced to below-market rates by caps, but were unable to sell their bonds without a successful auction.

How The Rules Got This Way and What They Really Mean

The following discussion describes various other aspects of Notice 2008-41.

QTB remarketings

The general rule since Notice 88-130 has been that QTB remarketings must be at a price equal to principal amount. Notice 2008-27 created a small but helpful exception, allowing the remarketing with a fixed rate to maturity to be at a discount or premium. Notice 2008-41 provides that a premium on remarketing fixed-rate bonds be considered sales proceeds for purposes of the arbitrage rules, decreasing the bond yield. The notice does not address the status of the premium for purposes of the private activity bond rules.

Authorization of fixed-rate remarketings at a premium will benefit issuers because of the potential rate savings available from use of a premium. However, the indentures for outstanding bonds will be unlikely to permit remarketing at any price other than principal amount, in compliance with the QTB rules under Notice 88-130. Therefore, converting outstanding QTBs to fixed rate will probably require an indenture amendment to permit a premium remarketing. The reduction in yield attributable to the premium remarketing may be large enough to trigger a reissuance under Treas. Reg. § 1.1001-3, which treats a yield change as significant if it exceeds 25 basis points (or, if greater, 5% of the pre-change yield).

Change in bond terms or security

Notice 88-130 provided a hair-trigger reissuance doctrine when changes in a QTB’s terms were tied to a shift from a "short" interest rate mode (tender period of one year or less) to a "long" mode (e.g., fixed to maturity) or vice versa. Specifically, an amendment to the bond terms or change in the security in connection with "crossing the one-year line" produced a reissuance unless it was nondiscretionary and "automatic," such as the termination of a letter of credit by its own terms in connection with a conversion from a weekly mode to a fixed rate to maturity. If there were no amendments to the bond terms or changes in security, a conversion between modes or to a fixed rate to maturity did not produce a reissuance. In other words, the conversion itself, even if initiated at the issuer’s discretion, was not treated as a reissuance. A conversion of bonds from a short mode to a fixed rate to maturity was normally far more significant financially than changes between different short modes, and the theory of the Notice was that the test for a reissuance in this circumstance could more reasonably require strict adherence to the "road map"” set out in the bond terms, without negotiation of additional changes that made the conversion look like a "new deal."

For amendments or security changes that occurred in connection with actions other than mode changes crossing the one-year line, the general rule in the Notice was that a reissuance would result if the change in terms or security was sufficient to cause a reissuance under section 1001.

A major impetus for Notice 2008-27 was the need of issuers to restructure auction rate bonds that were secured by bond insurance policies of insurers that suffered ratings downgrades in the recent financial crisis. To address the problem, Notice 2008-27 fundamentally revised the analysis of a change in security to provide that in any circumstance, including a shift from short term to fixed rate, the change in security would produce a reissuance only if it created a "change in payment expectations." A change in payment expectations was defined as a change from adequate security to speculative, or vice versa. One example allowed a downgraded AA bond insurance policy to be replaced with a letter of credit from a AAA bank because the bonds were "investment grade" both before and after the change.

The payment expectations test was taken from the general tax regulations on modifications of "recourse" debt instruments in Treas. Reg. § 1.1001-3, by treating all tax-exempt debt as recourse debt. These welcome and liberal principles have been carried forward into Notice 2008-41.

Bond exchanges not treated as reissuance

Notice 88-130, drafted with an eye toward legitimizing regular tender operations rather than restructurings, did not address the circumstances under which new bonds could be issued in exchange for old bonds without causing a reissuance. The subsequently adopted 1996 regulations (Treas. Reg. § 1.1001-3(a)(1)) provided, generally, that a bond to be delivered by an issuer in an exchange for an outstanding bond could be considered the same continuing obligation as the outstanding bond if there were no "significant" difference between the terms of the two bonds. Thus it has been clear, since at least 1996, that an exchange of bonds with no significant difference in terms did not create a reissuance.

Notice 2008-27 built upon the treatment of exchanges in Treas. Reg. § 1.1001-3 by providing an example (Example 2) that approved a bond-for-bond exchange where there was no significant modification of bond terms. The only change in terms was to eliminate AA bond insurance where the underlying bond obligor was rated A without insurance (so the bondholders' expectation of payment did not change).

Example 2, as stated in 2008-27, held that an exchange could qualify for non-reissuance treatment if it took the form of "an acquisition of an existing debt instrument for cash by an intermediary purchaser who is not an agent of or otherwise related to the issuer from an existing bondholder, an exchange of that acquired debt instrument for a modified debt instrument between such intermediary purchaser and the issuer and a subsequent sale by that intermediary purchaser to a different bondholder."  This sentence, described by IRS officials as the "friendly investment banker" concept, produced numerous questions about the meaning of the intermediary purchaser not being an "agent" of or "related to" the issuer.

Notice 2008-41 restates Example 2 without the reference to a non-agent intermediary purchaser, in recognition that the language was confusing. As revised, the example simply refers to an exchange of bonds and confirms that an exchange without significant modification does not produce a reissuance.

Addition of new modes

An example in 2008-27 described a conversion of ARBs to fixed rate pursuant to an amendment to the ARBs' terms subsequent to their issuance. The example held that the reissuance status of the conversion should be determined by Treas. Reg. § 1.1001-3, under which there would clearly be a reissuance according to the general rule that a change in bond terms is a reissuance if the change affects yield by more than 25 basis points. Interestingly, the example seems to treat the reissuance as occurring on the date of the conversion, rather than the earlier date of the amendment. Notice 2008-41 is the same as 2008-27 in this respect, carrying forward both the rule and the example in somewhat simplified form.

Maturity limit

Notice 2008-41 follows 2008-27 in stating an outside maturity limit at 40 years but not more than 120% of the average facility life of the financed facilities. The limit stated in 88-130 was 35 years. By extending the limit to 40 years, the IRS recognized that many ARB issuers had ignored the 35-year limit of 88-130 on the grounds that 88-130 did not apply to ARBs, but that these same issuers would want to use the expanded authorization for QTB restructurings under the 2008 Notices. As with 88-130 and 2008-27, the maturity limit under 2008-41 applies to each QTB in the issue and is not based on averaging between different maturities.

Modification of qualified hedges

Modification of a qualified hedge does not cause a "termination" of the hedge under Treas. Reg. § 1.148-4(h) if the modification is not reasonably expected to change the bond yield (after the hedge modification) by more than 25 basis points, and if the payments and receipts on the modified hedge are taken into account for yield purposes. This rule can be useful if an issuer has an outstanding swap with "swap insurance" of an issuer's obligation to make fixed-rate payments in exchange for variable payments. The counterparty's agreement to eliminate swap insurance if the issuer pays an increased fixed rate will not terminate the hedge.

Effective date, comments, future regulations

Issuers may rely on Notice 2008-41 for actions taken on or after November 1, 2007, and before the effective date of future regulations to implement the notice. Issuers may also continue to rely on 88-130 until the effective date of the regulations. (For example, Notice 88-130 conceivably might produce a more favorable result in the case of a "qualified corrective change" that met the standards of 88-130 but constituted a "significant modification" under 2008-41 and Treas. Reg. § 1.1001-3.)  Regulations will not be proposed without consideration of comments on Notice 2008-41 submitted by May 19, 2008.

Issuer Strategies

Issuers with outstanding auction rate or tender bonds bearing interest at unacceptable rates are able to proceed in a variety of ways. Options are numerous, but most include some or all of these primary strategies:

  • Restructure the security for the bonds to remove downgraded bond insurers under authorization in the 2008 Notices, allowing changes in security without a deemed reissuance as long as the bonds remain investment grade.

  • Convert the bonds to interest rate periods ("modes") that are more favorable, potentially with facilitating amendments to the bond terms that, depending on the circumstances, may or may not produce a reissuance under the 2008 Notices. Often a reissuance will require nothing more than filing a new Form 8038 to report the deemed new issue to the IRS.

  • Purchase the bonds from a temporary funding source and hold them for up to 180 days under Notice 2008-41, pending a refunding with new bonds that will provide more favorable rates or remarketing if the financial markets return to "normal."

No one size (or strategy) will fit all, but most plans for dealing with current interest rates in the auction or tender option market use one or more of these techniques to move to a better rate environment. The challenge, of course, is to assess the issuer’s particular situation and achieve the best possible result accordingly.

Ballard Spahr's Public Finance Group is working with issuers, borrowers, investment and commercial bankers, bond trustees and other parties in analyzing and implementing a variety of alternatives for restructuring ARBs and other outstanding bonds affected by the turbulence in the financial markets.

IRS "Circular 230" Disclaimer Note:  Under certain circumstances, a taxpayer may avoid certain penalties under the Internal Revenue Code by relying on a formal opinion of counsel that meets specific IRS regulations. Any tax advice in this communication does not constitute a formal opinion that meets the requirements of those regulations. Accordingly, the IRS regulations require us to advise you that any tax advice in this communication is not intended or written to be used, and cannot be used by you, to avoid penalties the IRS might attempt to impose on you.


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This newsletter is a periodic publication of Ballard Spahr LLP and is intended to alert the recipients to new developments in the law. It should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult your own lawyer concerning your situation and specific legal questions you have.