Post Issuance Bond Compliance

Illinois Association of School Business Officials

Kyle HardingAnjali Vij

May 16, 2012 3196205

Presentation Outline

• Federal Tax Issues– Overview of IRS Enforcement– Investment of Bond Proceeds -- Arbitrage Rebate– Use of Bond Proceeds -- Private Use

• Securities Law Issues– Continuing Disclosure/Rule 15c2-12

• Post Issuance Compliance Tools– Record-Keeping Policy– Compliance Checklist

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Federal Tax Issues • Various consequences of non-compliance with tax rules:

– Interest treated as taxable

– Loss of BAB/RZEDB subsidy, if applicable

– Additional arbitrage rebate may be owed (non-paid or underpaid rebate amounts, plus interest)

– Penalties

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Tax Issues – Overview of IRS Enforcement

• Increased enforcement by the IRS• As of February 2011, the IRS was examining 23 Build America Bond

issues

• The IRS provided a “Government Bond Financing Compliance Check Questionnaire” to approximately 200 governmental issuers that issued bonds in 2005 to track recordkeeping and post-compliance policies

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Tax Issues – Overview of IRS Enforcement (continued)

• Focus on Advance Refundings: in May, 2011, the IRS sent 269 questionnaires to governmental entities that issued advance refunding bonds between July 1, 2009 and June 30, 2010

– Questionnaire covers: • Debt management policies and procedures for determining when to

advance refund a bond issue• Qualification requirements applicable to advance refundings• Arbitrage requirements applicable to advance refundings• Procedures related to the determination of issue price• Record retention procedures• Procedures related to the timely identification and correction of tax

violations• IRS will conduct more than 100 audits of advance refunding bonds (Robert Henn,

manager of the IRS’ tax-exempt bond office, at the SIFMA and MSRB’s municipal regulation seminar on 9/26/11)

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Investment of Bond Proceeds –Arbitrage Rebate Rules

• Arbitrage: Spread between (i) the interest due on tax-exempt bonds and (ii) the earnings on the investment of such tax-exempt bond proceeds in higher yielding securities.

• Rebate: Issuer must pay (or rebate) arbitrage profits to federal government.

• Anything above bond yield gets paid to the US Treasury, unless you meet one or more exceptions:– Small issuer exception– Spend-down exceptions

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Arbitrage Rebate Exceptions• 6-Month Exception - no rebate payment required if all proceeds of the

issue are spent within 6 months of the issue date. • 18-Month Spend-down Exception

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PeriodSpend-down Requirement

6 months 15%

12 months 60%

18 months 100%

Arbitrage Rebate Exceptions (continued)

• Two-Year Construction Spend-down Exception– At least 75% of the proceeds must be spent on construction expenditures

• Certain refunding issues– Small Issuer Exception applied to the refunded obligations.– Average maturity of the refunding obligations is not later than the average

maturity date of the refunded obligations.– No refunding obligation has a maturity date later than 30 years of the issue

date of the original obligation.

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PeriodSpend-down Requirement

6 months 10%

12 months 45%

18 months 75%

24 months 100%

Arbitrage Rebate

• Arbitrage post-issuance compliance tips:– Obtain computation of bond yield and establish procedure to track

investment returns– Monitor compliance with temporary period expectations for

expenditure of bond proceeds– Monitor compliance with 6-month, 18-month or 2-year spending

exceptions to rebate, if relevant– Arrange for timely computation of rebate liability and, if rebate is

payable, for timely filing of Form 8038-T and rebate payment– May engage outside arbitrage rebate consultants to do

computations

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Use of Bond Proceeds Private Activity Bonds• General Rule for Tax Exempt Financing:

– Interest on any State or local government bond is not included in the gross income of the holder thereof for Federal income tax purposes

• Exception to General Rule:– Tax exemption does not apply to any “private activity bond”, with

limited exceptions• Private Activity Bond

– Any bond that meets (i) the “private business use test” AND (ii) the “private payment or security test”

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Use of Bond Proceeds Private Activity Bonds• “Private business use” occurs when more than 5% of bond proceeds

finance a public facility that is used by nongovernmental trade or business– Examples of private use:

• Sale, transfer or lease of property to private user• Management of property by private user under a management

contract• “Private payment or security” occurs when more than 5% of bond

proceeds are secured by an interest or derived from payments related to a “private business use” in bond-financed property– Example of private payment:

• Payments of lease rentals to the issuer by a private operator

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Use of Bond ProceedsPrivate Activity Bonds

(continued)

• Private Activity post-issuance compliance tips:

– Allocate bond proceeds and funds from other sources to ensure that bond proceeds are used for qualifying costs

– Map out what outstanding bond issue financed which facilities and in what amounts; Monitor private use of bond-financed facilities to ensure compliance with applicable percentage limitations

– Identify in advance any new sale, lease or license, management contract, or other arrangement involving private use

– Promptly consult with bond counsel as to any possible private use–– remedial actions may need to be taken

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Securities Law Landscape• Formerly, municipal securities largely unregulated • Dodd-Frank expands SEC’s municipal securities authority

– Enforcement budget to increase 100% over next 5 years– 30 muni securities attorneys, spread across virtually all SEC regions– “Whistleblower bounty program”

• Enforcement Actions– As of August 2011, 72 entities and individuals charged with

municipal securities violations• $743 million paid by financial institutions to settle SEC actions

– Enforcement action against New Jersey• Relates specifically to disclosure of pension obligations• Action appears based on negligence, not fraud

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Securities Law Issues—Goals of the SEC• Enhance timeliness of Information

– Ensure that investors get the information they need prior to the sale• Regulate the Form and Substance of Disclosures

– Conform documents and periodic reports to a form that investors are accustomed to seeing for other securities

– Standardize the information that must be disclosed• Mandate use of Governmental GAAP Standards

– Provide an independent funding mechanism for GASB• Corporate Style Registration? SEC Review of Disclosure Documents?• The Bond Buyer article from 9/27/11: SEC Commissioner Elisse Walter

wants to see the SEC undertake a “longer-term deeper dive study” of the muni market

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Continuing Disclosure Undertaking• Rule 15c2-12

– Requires an underwriter to enter into an agreement with issuers to provide certain financial information and event disclosures to the market

• Filings must be made electronically at the EMMA (Electronic Municipal Market Access) portal [www.emma.msrb.org]

• Word-searchable PDF format

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Continuing Disclosure Undertaking (continued)

• Over $10,000,000 (“Full”)– Annual financial information– Audited financial statements– Reportable events

• Over $1,000,000 but less than $10,000,000 (“Limited”)– Audited financial statements– Reportable events

• Less than $1,000,000– No continuing disclosure

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Continuing Disclosure Undertaking Reportable Events (continued)

To be filed within 10 business days after the occurrence of the event

•Principal and interest payment delinquencies

•Non-payment related defaults, if material

•Unscheduled draws on debt service reserves reflecting financial difficulties

•Unscheduled draws on credit enhancements reflecting financial difficulties

•Substitution of credit or liquidity providers, or their failure to perform

•Adverse tax opinions, the issuance by the Internal Revenue Service of proposed or final determinations of taxability, Notices of Proposed Issue (IRS Form 5701-TEB) or other material notices or determinations with respect to the tax status of the security, or other material events affecting the tax status of the security

•Modifications to the rights of security holders, if material

•Bond calls, if material, and tender offers

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Continuing Disclosure UndertakingReportable Events (continued)

• Defeasances• Release, substitution or sale of property securing repayment of the

securities, if material• Rating changes

• Bankruptcy, insolvency, receivership or similar event of the Issuer

• The consummation of a merger, consolidation, or acquisition involving the Issuer or the sale of all or substantially all of the assets of the Issuer, other than in the ordinary course of business, the entry into a definitive agreement to undertake such an action or the termination of a definitive agreement relating to any such actions, other than pursuant to its terms, if material

• Appointment of a successor or additional trustee or the change of name of a trustee, if material

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Voluntary Disclosures to the MSRB

• EMMA system allows for voluntary disclosures– Financial/Operating Disclosures– Event-based Disclosures

• The MSRB encourages issuers to make these disclosures– Recent example: MSRB statement on April 3, 2012 regarding

voluntary disclosure of bank loans by state and local governments• MSRB believes this information is important for market

transparency and to promote a fair and efficient market

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Voluntary Disclosures to the MSRB (continued)

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Voluntary Disclosures to the MSRB (continued)

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Continuing Disclosure Undertaking (continued)

• Current consequences for failure to comply – Bondholder may sue for specific performance– Disclose failure in future disclosure documents

• MSRB August 2011 letter to SEC– Recommendation to amend the Rule to impose consequences for

non-compliance– More “robust” disclosures– Enforceable remedial steps

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Policies and Procedures• SEC faulted San Diego and New Jersey for lacking necessary disclosure

policies and procedures– Disclosure should not be a routine procedure of inserting new

numbers• Therefore, issuers should adopt and follow policies and procedures

related to disclosure– May involve formalization of existing procedures

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Proposed Legislation:Municipal Securities Transparency Act of 2011

• Rep. Mike Quigley has drafted legislation that would authorize the SEC to:– require issuers to disclose primary and secondary market bond

documents directly or indirectly through dealers/others;– direct the content and timing of those documents;– require issuers to supply annual financial information in a more

timely fashion and require periodic financial disclosure• Allows the SEC to temporarily suspend trading of any municipal bond if

in public interest• Does not require issuers to file disclosure documents directly with SEC

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Compliance Tools:Post Issuance Compliance Policy

• Establish written procedures that can be understood and implemented over time even as officials responsible for compliance change

• Key features:• 1) Record Retention:

– Basic records relating to the bond transaction (transcript)• Indenture, resolution, ordinance• Bond counsel opinion• Tax Compliance Certificate and Agreement• Final Official Statement• Bond purchase agreement• Investment contracts, GICs, interest rate swaps, related bids• Continuing Disclosure Undertaking or Agreement

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Post Issuance Compliance Policy (continued)

– Records to demonstrate tax compliance• investment of bond proceeds

– purchase and sale of securities, SLGS subscriptions, yield calculations for each class of investments, rebate calculations

– Account statements from bank, escrow agent or trustee• expenditure of proceeds

– Description of expenditure (capital, operating expense)– Amount– Identity of payee– Invoice or billing statement – Payment date

• use of bond-financed property by public and private sources – Leases and management contracts

• sources of payment or security for the bonds

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Post Issuance Compliance Policy (continued)

– Generally, material records should be kept as long as the bonds remain outstanding, plus 3 years after the final redemption date

• For a refunding issue, material records relating to the original new money bonds and material records related to the refunding issue should be maintained until 3 years after the final redemption of both bond issues

• General record keeping policy may need to be revised to reflect the bond record retention policy

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Post Issuance Compliance Policy (continued)

• 2) Designation of Compliance Officer

• Assign responsibility for monitoring and filings

• Include training of the responsible official or employee with regard to tax and disclosure requirements

• Internal reporting of compliance efforts

• Maintain sufficient information to help successors transition

• 3) Due diligence at regular intervals

• Principal and interest payment dates are good benchmarks

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Post Issuance Compliance Policy (continued)

• 4) Procedures reasonably expected to timely identify and timely correct noncompliance

• Integrate monitoring of tax law compliance with existing accounting systems (for example, use special coding on a ledger to review sales, leases or contracts involving bond financed property)

• Use of compliance checklist throughout the lifetime of the financing

• Voluntary Closing Agreement Program

– having written post issuance compliance procedures allows for more favorable settlement treatment from the IRS

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Chapman and Cutler LLP111 West Monroe Street

Chicago, IL 60603

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Anjali Vij

(312) 845-3472

anjvij@chapman.com

Kyle Harding

(312) 845-3278

harding@chapman.com

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