CHICAGO - Market participants on Wednesday and Thursday criticized the Treasury Department's alternative method for determining issue price under rules proposed in June, saying it is unlikely to be used very often.
"It seems to me that almost everybody who applies these [regulations] will use the general method if they can," David Cholst, a partner at Chapman & Cutler, said during the National Association of Bond Lawyers' Bond Attorneys' Workshop here. The proposed issue price rules were discussed during tax hot topics sessions at the conference.
The general proposed rule is that the issue price of a maturity is the first price at which 10% is sold to the public. The public would be anyone other than the underwriters or a related party, with underwriters defined as the underwriting syndicate and anyone who enters into a contract or other arrangement to sell the bonds with any of the syndicate members.
If 10% of a maturity hasn't been sold by the sale date, an issuer could use the "alternative method" to determine issue price. Under this method, the issuer could use as the issue price the initial offering price for bonds sold to the public as of the sale date as long as certain conditions are met. One condition is that underwriters fill all orders placed by the public and received by the underwriter on or before the sale date at the initial offering price. Another is that the lead or sole underwriter certifies that no underwriter will fill an order from the public after the sale date and before the issue date at a higher price than the initial offering price unless the market moves after the sale date. Additionally, the issuer can't know or have reason to know, after exercising due diligence, that the underwriter's certification is false.
Cholst said it would be very unusual for an issuer to think that it would get a better result using the alternative method, though it is possible. In addition, certain provisions will have to be included in the bond purchase agreement in order for an issuer to even be allowed to use the alternative method, he said.
Arthur Miller from Goldman, Sachs said market participants should not assume the issuer has to use the alternative method if it is eligible to use it. Using the alternative method would affect how the bonds are marketed, and if issue price doesn't matter, it should be kept out of the bond purchase agreement, he said.
Treasury Department associate tax legislative counsel John Cross said that the main challenge with using an actual sales test for issue price at the sale date is that sometimes there are unsold maturities. There are some circumstances in which issuers and bond lawyers want certainty about issue price on the sale date, such as if the bond issue is a refunding. The alternative method allows market participants to have that certainty.
Cross pointed out that if an issuer hasn't sold 10% of each maturity by the sale date and does not need to have absolute certainty about the issue price on the sale date, it can still use the general method. The general method is "easier to vet," he said.
Although the alternative method requires underwriters to fill all orders at the initial offering price on or before the sale date, Miller said underwriters should be able to fill orders below, as well as at, the initial offering price during that time.
Another potential problem with the alternative method is that demonstrating market movement may be "extremely hard to do," Cholst said.
Cross said the underwriter's certification that it won't sell bonds above the initial offering price until the issue date unless the market changes is the most important anti-abuse principal in the proposal. Senior policy makers at Treasury and the Internal Revenue Service were only willing to consider a sale-date rule that did not look at actual prices if it had an anti-abuse backstop. "This was the best idea we could come up with," he said.
Cross said he expects to hear from Miller, the Securities Industry and Financial Markets Association and others about the fine points of what indexes could be used to show market movement. A rating change for the issuer could also be a market move for that issuer, he said.
Vanessa Albert Lowry, a panel moderator and shareholder at Greenberg Traurig in Philadelphia, suggested market movement could be demonstrated by looking at the prices of similar bonds that were sold by the same underwriter during the same time. Cholst suggested that he might hire a third-party expert to prove there was market movement.
Miller said underwriters would be unlikely to sell bonds at higher prices than the initial offering price without some sort of safe harbor. He also said that if an issuer wants to be eligible for the alternative method, underwriters may be more likely to hold bonds and push for shorter closing periods. Also, the senior manager may try to control more what happens to unsold bonds, he added.
An audience member asked how an issuer would have reason to know that a certification was false. Cross encouraged the lawyers to describe what steps an issuer or its bond counsel could take as part of its due diligence on that. "I think it is a review of the certifications," Cross said, but he welcomes suggestions as to what makes that workable.
Cross provided some market perspective on the proposed rules. The Municipal Securities Rulemaking Board reviewed data for the whole new issue muni market for a year for Treasury. The data showed that transactions were about just as likely to meet a 10% test as they were a 25% test (the safe harbor under rules proposed in 2013), and that there was not much variation between how competitive and negotiated sales fared.
Miller said he still worries about how competitive sales would fare under the 2015 proposed issue price rules. Cross said that Treasury and the IRS did not want too many special rules in the proposal but acknowledged that competitive and negotiated sales work very differently. With negotiated deals, the bonds are sold and then the bond purchase agreement is signed. For competitive deals, the notice of sale is signed before the bonds are sold. Treasury and the IRS would entertain the idea of writing a special rule for competitive sales, Cross said.
At the sale date, about 20% to 50% of transactions would meet the 10% actual sales test, but if you go forward to about a week after the sale date or at least until the issue date, about 80% or 90% of transactions would meet the 10% actual sales test according to the MSRB data, Cross said.
Large portions of the total principal amount of transactions sell at or below the initial offering price. There doesn't seem to be "systemic problem with issue price," Cross said, though the Securities and Exchange Commission case against Edward Jones demonstrates there are still some issues. In that case, Edward Jones was a co- underwriter in the syndicate for many bond issues and sold bonds at a price other than the contractually agreed upon initial offering price. In some cases, it put the bonds into its inventory and sold them to customers at higher prices later, in others it didn't sell the new bonds at all until after secondary market trading began.
On the whole, market participants view the recently proposed regulations as an improvement over those that were proposed in 2013 and withdrawn. Lowry asked audience members during one of the sessions to raise their hands if they preferred the 2015 proposal. Most did so.
Cross encouraged the bond lawyers to provide "constructive" comments that focus on how to help make the rule work in practice.
