As you have heard, and as we noted last week, Treasury and the IRS recently released final regulations that tell issuers how to calculate the “issue price” of tax-advantaged bonds that are issued for money. The regulations don’t take effect until June 7, 2017, so we can spend some time luxuriating in their nuances and preparing for the new order of things until the appointed hour arrives. As ever, though the new regulations seem to carve out some discrete rules, interesting [sic] questions lurk in the margins.

 The overall flow of the new regulations appears to go as follows:^[1]

1. Private placements. Is the bond sold in a private placement?

   1. If so, then the issue price of the bond is the price paid by that buyer.

   2. If not, go to 2.

2. True Competitive Sales. Is the bond sold by an underwriter to the public in a competitive sale?

   1. If so, and if the sale process meets certain bidding and certification requirements, then the issue price is the reasonably expected initial offering price to the public as of the sale date.

   2. If not, go to 3.

3. The General Rule. If the bond was not privately placed, and was not sold in a competitive sale, was at least 10% of the bond actually sold by an underwriter to the public?

   1. If yes, then the issue price of the bond is the first price at which 10% was sold to the public.

   2. If not, then go to 4.^[2]

4. The Hold-the-Offering-Price Rule. If the bond was not privately placed or sold in a competitive sale, and at least 10% of the bond was not actually sold to the public, then the initial offering price to the public on the sale date is the issue price, so long as the underwriter provides all the certifications and agreements required by the “hold-the-offering-price” rules.

 Some questions and guesses as to answers, starting at the top and working our way down.

1. The definition of private placement – what do we do about “bought deals”?

 The new regulations provide a nice, neat rule for “private placements.” The new rule says: “If a bond is issued for money in a private placement to a single buyer that is not an underwriter or a related party . . . to an underwriter, the issue price of the bond is the price paid by that buyer.” The regulations don’t define the term “private placement.” The Preamble does say that “bank loans” are an example of private placements, and that private placements “in the municipal bond industry typically do not involve underwriters.” The regulations do define the term “underwriter” – it means any person who has a contract with the issuer (or with the lead underwriter) to “participate in the initial sale of the bonds to the public.”

Recently, the municipal bond market has seen an uptick in so-called “bought deals,” where a large bank that typically serves as an underwriter instead finds it more advantageous to purchase bonds and hold them for some time before potentially selling them. Similarly, occasionally in smaller transactions a bank purchaser will purchase an issue of bonds with the intent not to market to the public or to hold the bonds, but to sell the bonds to its retail customers.  How would the issue price of a bond in these situations be determined?

It appears that the answer lies in the definition of “underwriter,” which requires a contract with an issuer or a lead underwriter that relates to the “initial sale of the bonds to the public.” So long as the initial sale of the bonds in a “bought deal” does not involve a contract for a “sale of the bonds to the public,” then arguably the price paid for the bond in the bought deal should be the issue price. However, some caution is probably warranted, to be sure that the bank purchaser in the bought deal does not have an existing arrangement to sell the bonds to its customers or to third parties prior to the issue date. In other words, care should be taken to distinguish a “bought deal” from the situation where a bank purchaser buys the bonds with an intent to sell to its customers (in which case the price paid by the customers should be the relevant price for determining issue price). To protect the integrity of the price, some consideration should be given to requiring the purchaser to hold the bonds for some period of time that is sufficient to expose the purchaser to the risk that the market will move, so that it is in substance truly a purchaser and holder of the bond, rather than an intermediary.

2. What happens in a “competitive sale” where the underwriter doesn’t get three bids?

The final regulations also provide a clean rule for competitive sales. Treasury and the IRS responded to numerous comments both to the original 2013 proposed issue price regulations and the later 2015 proposed regulations that competitive sales did not raise the same concerns regarding the “true” issue price of an issue of bonds, because the bond market introduces enough competition to ensure that the price that the underwriter bids  incorporates an accurate reflection of the price of the bonds (taking into account the underwriter’s compensation). For a bond sold in a competitive sale that meets certain requirements set forth in the new issue price regulations, then the reasonably expected initial offering price to the public as of the sale date is the issue price. One of the requirements to use this rule is that the issuer receives at least 3 bids from at least 3 underwriters.

What happens if the issuer receives fewer than 3 bids?

This three-bid requirement is familiar to those that toil in the intricacies of the arbitrage regulations.  It’s borrowed from the element of the safe harbor for establishing the fair market value of guaranteed investment contracts and investments purchased for a yield restricted defeasance escrow that the bond issuer who will use bond proceeds to purchase such investments receive at least three bids from providers of these investments.   Failure to receive three bids means that the safe harbor cannot be satisfied, but failure to satisfy the safe harbor does not mean that the fair market value of a guaranteed investment contract or investment to be held in a yield restricted defeasance escrow cannot be established.  In the absence of the safe harbor, an issuer can look to all the facts and circumstances (for example, prevailing market conditions that mandate 200 – 300 basis points of negative arbitrage on every advance refunding escrow created since 2008) to ascertain the fair market value of such investments.

By contrast, the rule for determining the issue price of tax-advantaged bonds that the subject of a competitive sale is not a safe harbor.  If each element of the competitive sale rule is not met, the issue price of the tax-advantaged bonds must be established pursuant to one of the other rules for determining the issue price of tax-advantaged bonds. In other words, if the competitive sale rule is not satisfied, we then proceed to step 3 and, if necessary, step 4 in our flow chart above – the issue price of the bond then depends on whether at least 10% was actually sold to the public at the initial offering price, or, if not, whether the issuer receives the required certifications and agreements under the Hold-the-Offering-Price rule.

3. So many underwriters . . .

 The existing regulations do not define “underwriter” but imply its meaning by negative implication: an underwriter (or similar entity) is not part of “the public,” so that it is instead part of a group whose purchases of bonds are ignored for purposes of setting the issue price. We instead look through to the price at which a person, such as an underwriter, who is not part of “the public” reasonably expects to sell at least 10% of the bonds to the public.

The new regulations invert the definitions. They define the underwriter as any person that has a written contract with the issuer (or the lead underwriter) to “participate in the initial sale of the bonds to the public” – so far, so good – and, to extend the chain one step further, any person that agrees with the syndicate to participate in the initial sale of the bonds to the public. The regulations give the example of an agreement between “a national lead underwriter and a regional firm under which the regional firm participates in the initial sale of the bonds to the public,” such as, the Preamble notes, a retail distribution contract.

Under the new regulations, to use the Hold-the-Offering-Price rule for a bond, the issuer must obtain a written agreement from each “underwriter” that it will neither offer nor sell the bond to any person at a price that is higher than the initial offering price to the public during the period starting on the sale date and ending 5 days later or, if earlier, the date on which the underwriters sold a substantial amount of the bond to the public. It remains to be seen how these parties will react to this new requirement.  The issuer must also receive, on or before the issue date of the bonds, a certification from the lead underwriter (or sole underwriter) that the bonds were offered to public at the specified initial offering price on or before the sale date (along with reasonable supporting evidence for this certification, such as a copy of the pricing wire).

In current practice, the underwriters in the syndicate enter into a bond purchase agreement with the issuer of the tax-advantaged bonds, and the lead underwriter (or sole underwriter, if there is no syndicate) signs a tax certificate relating to certain matters including the issue price (although the lead underwriter signs this certificate on behalf of the other underwriters in the syndicate).  Thus, the agreement and certification requirements of the Hold-the-Offering-Price rule have repositories into which they can be fitted in a usual deal structure involving a sole underwriter or a syndicate of underwriters.

Where this gets interesting [sic] is for bonds that find themselves in the Hold-the-Offering-Price rule where an arrangement such as a retail distribution contract in connection with the initial offering of the bonds is in place.  A dealer who contracts with a member of the underwriting syndicate to sell bonds in a retail distribution contract as part of the initial offering, but who is not itself a member of the syndicate, is not usually a party to the bond purchase agreement with the issuer.  It remains to be seen how persons who are not parties to the bond purchase agreement will react to the requirement of the Hold-the-Offering-Price rule that each “underwriter” enter into an agreement with the Issuer of the tax-advantaged bonds. How they react might depend on how the issuer can establish the “agreement” of all of the “underwriters” to hold the offering price. This is worthy topic for a later post, but those agreements could be memorialized in certificate from each “underwriter” addressed to the issuer, which could be seen as a drastic step, or perhaps could be satisfied by a certification from the lead underwriter that all other “underwriters” that are participating in the initial sale of the bonds to the public have agreed to hold the offering price for the required period.

4. Timing of the Hold-the-Offering-Price Rule.

 Much like the regulations themselves, our flowchart above has the superficial appearance of a mechanical process, that proceeds straightforward in time as of the sale date. Note, however, that if there is any chance (and isn’t there always a chance?) that the issuer will need to use the Hold-the-Offering-Price rule to establish the issue price of a bond, then the issuer will need to be prepared for that – by having certificates drafted, etc., on the sale date, because the Hold-the-Offering-Price period begins on the sale date.

5. Lack of Flexibility.

 No augury? No 20-sided die? What gives?

6. Concluding Thoughts.

It is worth noting how far the proposals to redefine “issue price” have come since Treasury initially issued the 2013 proposed regulations, which nearly prompted a food fight at the Bond Attorneys’ Workshop that year. The final result seems to strike a fair balance between achieving the goals of Treasury and the IRS without turning the applicable rules into a dog’s breakfast.  If you’ve ever sat down to breakfast with a dog, you’ll readily understand that idiom.

_{[1] If more than one of the following rules for determining issue price applies to a bond, an issuer spoiled for choice may select which rule will apply to that bond (and, before the issue date, must identify the selected rule in its books and records maintained for the bond).  In deference to the maxim that any important point must be tucked in a footnote, the following rules for determining the issue price of tax-advantaged bonds apply separately to each bond of a bond issue.  Thus, different rules for determining issue price can apply to the different bonds that comprise an issue of tax-advantaged bonds.}

_{[2] But note the timing point below.}