On June 7, 2017, new IRS regulations that change the way state and local governments issue tax-exempt bonds went into effect. The new rules change the way municipal issuers determine the issue price of tax-exempt bonds they issue, and amend existing IRS regulations under section 148 of the Internal Revenue Code. The new rules have produced immediate changes to many common documents used by municipal issuers and their advisors in municipal bond transactions.

The new rules amend section 1.148-1 of the Code of Federal Regulations, 26 C.F.R. §1.148-1, by adding new subsection (f) to include a new definition for issue price. Previously, the definition of issue price was contained in subsection 1.148-1(b), and provided that issue price carried the meaning given that term in sections 1273 and 1274 of the Code, and that “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.” A “substantial amount” was defined to mean ten percent.

The prior regulations also contained a special rule under which the issue price of a series of bonds for which a “bona fide public offering” was made was determined as of the bonds’ sale date, based on the reasonable expectations of the underwriter regarding the initial offering price. In practice, the “bona fide public offering” rule was routinely used to establish the issue price of a series of bonds as of the sale date (which generally occurs days, if not weeks, before the “issue date” or closing on a bond transaction).

Out of a concern over alleged abuses by underwriters in the determination of issue price, the IRS embarked on a years-long process to reform the way issue price was determined. Regulations on this topic were first published in 2015, with substantial changes being made to the proposal until the final regulations that went into effect on June 7th were issued. The new regulations’ definition of issue price maintains some of the key concepts contained in the prior regulations, while making numerous changes that will drastically change the way issue price is determined in most tax-exempt bond transactions.

Under the new regulations, the general rule remains the same: issue price is as defined in sections 1273 and 1274 of the Code, and generally means the first price at which a substantial amount (i.e., ten percent) of the bonds is sold to the public. However, the new regulations scrap the “bona fide public offering” special rule and introduce two new special rules: the “Hold-the-Offering-Price” rule and the “Competitive Sale” rule. The new regulations also introduce a special definition for issue price in the context of private placements to a single buyer, specifying that in such cases, the issue price is the price paid by the buyer.

Issuers have flexibility in choosing which rule to apply to determine issue price. Furthermore, the new regulations provide that the issue price of bonds in an issue that do not have the same credit and payment terms is determined separately. This means that the issuer may not be required to apply the same rule to every single bond in the issue.

The “Hold-the-Offering-Price” Rule

An issuer may elect to apply the “Hold-the-Offering-Price” rule to establish the issue price for the bonds. If the rule’s requirements are met, the issuer may use the initial offering price of the bonds as the issue price.

In order to take advantage of this rule, the underwriter (or underwriters) that is purchasing the bonds from the issuer must agree in writing that it will neither offer nor sell the bonds 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 on the earlier of (1) the close of the fifth business day after the sale date; and (2) the date on which the underwriter sells 10% of the bonds to the public at a price that is no higher than the initial offering price. Additionally, the underwriter must execute a certificate prior to closing that it offered the bonds to the public for purchase at the initial offering price on or before the sale date, and include in the certificate sufficient supporting documentation (such as a pricing wire) to that effect.

Many practitioners have questioned what the consequences will be should the underwriter violate its pledge to “hold the offering price” on a particular series of bonds. The new regulations do not specify the consequences; however, in the Preamble to the regulations, the IRS has stated that “a failure to meet a specific eligibility requirement of a rule for determining issue price, such as an underwriter’s breach of its hold-the-offering-price agreement …, will result in a failure to establish issue price under that rule and a redetermination of issue price under a different rule.” 81 Fed. Reg. 89002-03 (Dec. 9, 2016) (emphasis added).

While the Preamble is not part of the regulation, and consequently does not carry with it the force of law, it does offer insight into the IRS’ position on this issue. A “redetermination of issue price” may have negative tax consequences to the issuer – and potentially beyond those tied explicitly to matters of arbitrage and rebate, on which Section 148 speaks. Therefore, issuers should seek confirmation from their underwriters that the pledge has not been violated, and may consider requesting a certification to that effect in the issue price certificate.

The “Competitive Sale” Rule

An issuer also may elect to apply the “Competitive Sale” rule to establish issue price. To qualify for this rule, the issuer must sell the bonds to the underwriter that is the winner of a competitive bidding process. The bidding process must contain specified written terms, and, at a minimum, meet the following requirements:

• A Notice of Sale must be disseminated in a manner that is reasonably designed to reach potential underwriters;
• All bidders must have an equal opportunity to bid, within the meaning of section 1.148-5(d)(6)(iii)(A)(6) of the regulations (i.e., no “last look”);
• The issuer receives bids from at least three underwriters with established industry reputations in the municipal bond industry; and
• The issuer awards the sale to the bidder who submits a firm offer to purchase the bonds at the highest price (or lowest interest cost).

An issuer that intends to use the “Competitive Sale” rule should have a backup plan in place in the event the bidding process produces a result that fails to comply with the requirements of the special rule (e.g., less than three underwriters participate). The issuer can avoid headaches by including in its bidding documents a requirement that the responding bidders also agree to take any necessary steps to establish issue price under the new regulations, for instance by applying the “Hold-the-Offering-Price” rule in the event the requirements of the “Competitive Sale” rule are not met.

Final Thoughts

As noted above, issuers may elect to apply different rules in determining the issue price for different bonds, so long as the bonds have different credit and payment terms. As an example, a single issue could have an issue price that is based in part on actual sales data (for bonds where the general rule is met), and in part on initial offering prices (for bonds where the “Hold-the-Offering-Price” rule is met).  We are already seeing Bond Purchase Agreements and form issue price certificates that have been prepared with such instances in mind.

Thankfully, you don’t have to start from scratch in preparing a transaction’s documents in compliance with the new regulations. The National Association of Bond Lawyers and the Securities Industry and Financial Markets Association each have issued model documents to use in tax-exempt bond transactions to which the new rules apply. The NABL and SIFMA forms offer an excellent starting point when working on a transaction under the new rules, although care should be taken to ensure that the forms’ language is consistent with the specifics of the transaction being undertaken.

Reprinted with permission from the June 8, 2017 edition of The Legal Intelligencer © 2017 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.