WASHINGTON -
Flipping occurs when an underwriter sells all or most of a maturity of new-issue bonds to a hedge fund, insurance company or other institutional investor and then that investor sells smaller blocks of the bonds to regional dealers that have the capability to distribute them to retail investors.
The institutional investor may sell the bonds to regional dealers almost simultaneously, the same day, or within a day or two after it purchased them from the underwriter, hence the term flipping.
Market participants have mixed views about the practice.
"Flipping has been an issue in the municipal securities industry since the day I got here," said Christopher Taylor, executive director of the Municipal Securities Rulemaking Board. "This has been a complicated question that many in the industry have tried to find a solution for and the problem has tended to evolve as markets have evolved. It ebbs and flows as the market ebbs and flows."
Richard C. Green, a professor of economics and management at Carnegie Mellon University's Tepper School of Business in Pittsburgh who wrote about the practice in a recent paper on trading and prices in the new issue market, says there's nothing wrong with flipping. He says flipping effectively takes place in the all markets. He cited as an example a manufacturer in China that sells a product to a U.S. wholesaler, that in turn, sells the product to a U.S. retailer, each taking some profit for their efforts.
Thomas Doe, president of Municipal Market Advisors Inc., in Concord, Mass., and a former MSRB board member, said he thinks the practice has grown during the last three years to fill a void that was created when individual retail investors who had been active buyers of tax-exempt munis, moved to other investments. "I can understand why this would exist," he said.
But Joseph Fichera, chief executive officer of the New York City-based financial advisory firm, Saber Partners LLC in New York City, said flipping hurts issuers because they don't get the highest prices and lowest coupons for their bonds.
"If you sold your house on Monday and then the buyer sold it again on Wednesday for a profit, you'd know that you left money on the table and that you got a bad deal," Fichera said.
"It's not good for the issuer," he said. "It makes it easy for the dealer. It minimizes the dealer's risk and allows for quick execution."
Fichera said he does not believe that all underwriters engage in flipping but that some may find it "tempting without transparency and accountability."
"Can we really blame underwriters for this, if the issuers don't hold them accountable? I don't think so," said Fichera. Issuers cannot simply rely on underwriters, they must obtain information from them and negotiate with them to ensure the sales process gets them the highest prices for their bonds.
One underwriter who did not want to the identified said, "As an underwriter, how would I know where the bonds are going to go after I sell them? As a general matter, we don't sell bonds to somebody who we are convinced is going to turn around and try to make a profit on it. We're selling them at what we think is a proper market price right off the bat."
Most underwriters in negotiated deals are going to try to find a broad range of investors, he said.
Regardless of the differing views about flipping, most tax experts said that flipping prevents a dealer from knowing whether it has complied with the IRS rule that defines new issue prices for arbitrage purposes.
In the paper on muni trading and pricing that he co-authored with colleagues, Green concluded that many underwriters were ignoring the IRS rule. The conclusion was based on a study of pricing data collected between February of 2000 and July 2003. But more recent pricing data from this year shows some dealers are continuing to sell entire maturities of new bonds at discount prices to institutional investors who are almost simultaneously selling them to other dealers.
The IRS' 10% rule is designed to ensure that a bona-fide issue price is set by the underwriter because the price for the bonds and the bond yield is key to determining whether the issuer makes any arbitrage profits over the life of the bonds.
The rule, which is in Section 1.148-1(b) of the tax rules, states: "Generally, the issue price of bonds that are publicly offered is the first price at which a substantial amount of the bonds is sold to the public. Ten percent is a substantial amount."
Underwriters typically certify to bond counsel in a new offering that they have determined a price for the new bonds based on their compliance with the 10% requirement.
But bond and tax lawyers pointed out this week that while the IRS rule says that 10% of the bonds must be sold to the public, it also states that: "The public does not include bond houses, brokers, or similar persons or organizations acting in the capacity of underwriters or wholesalers."
If flippers are acting as wholesalers rather than investors, and underwriters are selling entire maturities of new bonds to them, then the underwriters cannot possibly know the price at which the bonds are eventually finally sold to actual investors, the lawyers said.
But the underwriter asked: "How do we know who is going to be a wholesaler?"
"It's an inherently difficult question whether someone is a flipper or an investor," said John Cross, a partner at Hawkins, Delafield & Wood LLP.
"It's a factual issue" as to whether an investor is acting as a wholesaler or an investor, said David Caprera, a partner at Kutak Rock LLP in Denver.
An institutional investor that buys and holds bonds is an investor. But if the institutional investor almost simultaneously buys and sells bonds, that raises the issue of whether it is a wholesaler, some lawyers said.
Bond and tax lawyers are concerned whether the certifications they've been obtaining from underwriters on the 10% pricing rule are correct. The lawyers are even more concerned that they might be expected to look behind the certificates to see if the issue price was correctly determined.
"We've always relied on those certifications," said Caprera. "I don't even know how you'd check those. Conceivably you could ask for see the tickets that the trading desk wrote, but if the underwriter sold the bonds to a flipper, I don't know how you would go beyond that."
"I don't know how you'd monitor that," agreed Cross. "I think it's important to recognize the difficulty of policing this."
Both Cross and the underwriter said the 10% rule is an issue in competitive deals, where an underwriter does not spend much time lining up retail or other investors because it only has a one in four or five chance that it will get the deal and there is no underwriting syndicate.
"Once we own bonds from a competitive deal, our job is to just get out of them," the underwriter said.
Some underwriters have begun balking at signing the traditional certification stating they have sold 10% of new bonds at a particular price and that that price, therefore, is the issue price, according to several lawyers. Instead, these underwriters have been pushing for softer language in the certificate, perhaps stating only that they "reasonably expect" 10% of the bonds will be sold to an investor at a particular price.
"This is an area where they has been some pushback from underwriters," Cross conceded.
Caprera predicted that the tension in this area is going to grow. "There's going to be a pressure point between the underwriters and the representations that they want to make on the issue price and the issuer and the bond counsel and the representations that they think need to be made," he said.
Mark Scott - who currently heads up the IRS' tax-exempt bond office and oversees its enforcement program but is leaving the agency Nov. 10 to become a partner in the Washington office of Vinson & Elkins LLP - has said that IRS examiners have been investigating compliance with the 10% rule and may step up their efforts in this area.
Scott said this week that he expects IRS examiners to focus primarily on the underwriters regarding this issue and that the agency could impose Section 6700 penalties on an underwriter if it failed to comply with the 10% rule. Section 6700 of the tax code allows the IRS to impose monetary penalties on underwriters, bond lawyers and other municipal bond transaction participants that violate the tax laws.
If the underwriter failed to comply with the 10% rule, but was not trying to manipulate the issue price, then the issuer may have earned arbitrage that needs to be rebated, Scott said.
However, if an underwriter tried to manipulate the issue price, then the bonds would be taxable arbitrage bonds and this is the primary area of interest for the IRS, he said.
"Our focus is whether the bonds are tax-exempt," Scott said. "The key issue is whether there was some manipulation of the issue price to disguise the fact that arbitrage was earned."
