The Bond Buyer recently reported on a warning by Federal Reserve Bank of New York president and chief executive officer William Dudley ($) against borrowing to cover operational deficits.  Mr. Dudley distinguished capital borrowings from operational, or working capital, borrowings to illustrate the objective of “matching” the cost and benefits of financed facilities through long-term capital borrowings, an objective that can be frustrated by operational financings that provide cash for short-term needs.

Not explicit was the important distinction between short-term working capital borrowings, which are generally designed to eliminate the timing differences between cash receipts and operational cash disbursements within a single fiscal year, versus long-term working capital borrowings, which are intended to spread an existing operating deficit over some number of future years.  The former is a common and prudent use of short-term financing by governmental entities while the latter is the form of financing that Mr. Dudley warned against.  These two forms of working capital financings, when done on a tax-exempt basis, raise many of the same but also some very different issues under the arbitrage restrictions.  The rules are summarized below.

Applicable Regulations

Working capital financings have long been governed by the existing arbitrage regulations, primarily Treas. Reg. 1.148-1 (replacement proceeds), 1.148-2 (temporary periods) and 1.148-6 (accounting/spending rules).  While applicable to all working capital financings, these regulations are clearly aimed at the traditional short-term working capital financings (often referred to as “tax and revenue anticipation notes” or “TRANs”).   With the severe downturn in the economy in 2008, the demand for longer term working capital financings increased.  As a result of that demand and a lack of clarity in the rules for longer term working capital financings, in September 2013, Treasury issued proposed regulations (“Proposed Regulations”) that for the first time provided some guidance specifically for long-term working capital financings.  While not generally effective until issued in final form, issuers are permitted to apply these proposed regulations, in whole or in part, to bonds sold after September 15, 2013.  (The Internal Revenue Code and regulations also provide specific arbitrage rebate rules for working capital borrowings.  Those rules are not addressed in this post.)

Regulations Applicable to Both Short- and Long-term Working Capital Borrowings

The arbitrage regulations governing the sizing of working capital financings (by way of the permitted temporary period rules) and the required method of accounting for the expenditure of proceeds apply to both short- and long-term working capital financings.

Proceeds of working capital borrowings are generally permitted a 13-month temporary period of unrestricted investment, provided the proceeds are expected to be spent within that 13-month period.  Accordingly, these financings are generally sized to satisfy this expenditure requirement.  In determining when proceeds are spent for working capital expenditures, the so-called “proceeds-spent-last” accounting rule applies.  Under this rule, except for very limited types of working capital expenditures, proceeds may not be treated as spent for working capital expenditures until there are no other “available amounts” that could be used for the expenditures.

“Available amounts” is generally defined to include any amount that is available to the issuer to pay the type of working capital expenditure that is being financed, with the following two exclusions:

1. Available amounts do not include any amount that can be used for the type of expenditure being financed only with legislative or judicial action and without a legislative, judicial, or contractual requirement that the amount be reimbursed.

2. Available amounts do not include a “reasonable working capital reserve” (“Reserve”). The Reserve generally can be 5% of the sum of the issuer’s working capital expenditures plus capital expenditures paid out of current revenues during the preceding fiscal year.  Under existing regulations, the Reserve may not exceed the issuer’s average balance of available amounts during prior annual periods of at least one year.  This limit based on the issuer’s average balance would be eliminated by the Proposed Regulations, and is currently eliminated for issuers choosing to apply this Proposed Regulation (there is no downside to applying this rule).  Eliminating this second limit on the Reserve is a wise and fortunate development given both the confusion in applying the limit as well as the unfair result of imposing the most severe sizing restriction on issuers in the weakest financial position, i.e., issuers that have not been maintaining a sizable cash balance, likely because they could not afford to do so.

Short-term Working Capital Borrowings

The existing regulations limit the term of most working capital financings by providing a 2-year safe harbor term from the creation of “other replacement proceeds,” which can result from leaving tax-exempt obligations outstanding longer than necessary (at least as determined by Treasury).  This 2-year permitted term under the regulations has been shortened to 13 months under Rev. Proc. 2002-31, which can be read to effectively override the regulations’ permitting a 2-year term.   Fortunately, because of the objective of these short-term working capital borrowings – to smooth cash receipts and disbursements within a fiscal year – the term of these borrowings usually does not exceed this 13-month term.

Long-term Working Capital Borrowings

Until the Proposed Regulations were issued, the existing regulations left issuers and bond counsel on their own to determine what rules apply if the 13-month safe harbor term is not satisfied – i.e., generally the type of working capital borrowings that Mr. Dudley  warned against.  The Proposed Regulations establish the first set of rules specifically addressing long-term working capital financings.  These regulations govern the permitted term of these borrowings through the following two rules.  First, upon issuance, the issuer is required to determine the first year in which it expects to have “available amounts” to pay working capital expenditures.  Second, beginning with the earlier of the year determined under the first step above or 5 years after issuance, the issuer must (i) determine its available amounts on the first day of the fiscal year and (ii) within 90 days of that day use those available amounts either to redeem bonds or to invest in non-AMT tax-exempt investments.

While Treasury should be commended for taking this first step toward a rule providing for long-term working capital financings, substantial room for improvement of these rules exists.  For example, the Proposed Regulations require issuers to determine their available amounts on the first day of their fiscal year.  Why the first day (other than that it is a tidy accounting rule to use)?  For purposes of establishing an important benchmark of expected available amounts, use of that first day is entirely arbitrary.  If an issuer happens to have an unusually low balance on that day, it will be in the fortunate position of not having to pay down its borrowing by a significant amount (it may choose to do so, of course, but it is not required). On the other hand, if the issuer has a large available amounts balance on that day, it will have to pay down its borrowing significantly (or invest in non-AMT tax-exempts, which based on experience can be difficult to find in the market).

These random consequences should not be built into the tax regulations.  In particular, consider the issuer that has an unusually large available amounts balance on that day.  If it satisfies the Proposed Regulations by paying down its borrowing, it may then need to return to the market and borrow again for a cash flow deficit just a few months later.  It makes no sense to require an issuer to pay down a working capital borrowing in one month when in the very next month it may have a legitimate and permitted basis to borrow that amount back.  Put simply, it would make much more sense to require the issuer to pay down its borrowing in a given year based on its minimum expected available amounts balance during the year.  This would minimize the risk that issuers would be forced to borrow again in the same year.  Comments of this sort have been submitted to Treasury, and hopefully will result in improved final regulations.

Conclusion

In conclusion, when considering Mr. Dudley’s warning, it is important to distinguish between short- and long-term working capital financings.  Those short-term financings are a long-standing and effective means of matching revenues and expenditures within a fiscal year.  Long-term working capital financings, while probably no issuer’s first choice, can also be helpful in getting an issuer over an operating deficit that cannot be resolved within the year.  But of course these borrowings should be undertaken only in conjunction with a long-term plan to eliminate that deficit and repay the bonds.