May 4-6, 2016 | Swissotel Chicago | Chicago, IL 2016 BOND LAW SEMINAR … · 2016-04-26 · the breakout sessions provide an opportunity for you to focus the trifecta of municipal

FUNDAMENTALS OF MUNICIPAL BOND LAW SEMINAR20

16May 4-6, 2016 | Swissotel Chicago | Chicago, IL

Your training has begun!Program Book & Lecture Materials

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Training Schedule 1 Training Center Floor Plan 3 Welcome to the Seminar! 5Seminar Chairs 6Seminar Faculty 62016 Frederic L. Ballard, Jr., Memorial Scholarship Program 9 RUN For FUNdamentals 11 Seminar Highlights 12Things to Know 13Mobile App 14Sponsors 15Upcoming NABL Events 18

Basic Training General Session MaterialsBasic Structuring & Financial Aspects of a Municipal Bond Transaction 27 General Securities Law 89 General Tax Law - Part I & II 149

Training Session Materials01. Arbitrage & Rebate 17902. Refunding & Reissuance 20103. Avoiding Private Activity 23504. Qualified 501(c)(3) Bonds 26305. Qualified Small Issue & Exempt Facility Bonds 28506. IRS Issues & Enforcement 31507. Underwriting: Behind the Scenes 35708. Practical Due Diligence/Drafting the Disclosure Document 37509. The Role of Underwriter’s Counsel 39510. Bank Loans/Direct Purchases 42511. Conduit Issues & Issuers 44112. State Law Issues 45513. Document & Default Administration - The Trustee’s Perspective 47714. Leases & Other Non-Traditional Financings 49115. Demystifying DTC 54116. Engagement Letters & Opinions (Ethics Credit) 55517. Conflicts of Interest & Ethical Issues (Ethics Credit) 573

TABLE OF CONTENTS

Start - End Event LocationWednesday, May 4, 2016

11:00am - 6:00pm Check-in Desk Open Zurich Foyer1:00pm - 6:00pm Exhibits Open Zurich Foyer1:30pm - 1:50pm Introduction & Welcome Messages Zurich Ballroom2:00pm - 4:00pm Basic Training General Session: Basic Structuring &

Financial Aspects of a Municipal Bond TransactionZurich Ballroom

4:00pm - 4:15pm Break Zurich Foyer4:15pm - 5:45pm Basic Training General Session:

General Securities LawZurich Ballroom

6:00pm - 7:00pm Welcome Reception Vevey Ballroom

Thursday, May 5, 20167:00am - 8:00am RUN For FUNdamentals - Registration opens at 6:45am

in the lobby. *Additional registration requiredLobby

8:00am - 5:30pm Check-in Desk Open Zurich Foyer8:00am - 5:30pm Exhibits Open Zurich Foyer8:00am - 9:00am Continental Breakfast Vevey Ballroom9:00am - 10:30am Basic Training General Session:

General Tax Law Part IZurich ABCD

10:30am - 10:45am Break Zurich Foyer10:45am - 12:15pm Basic Training General Session:

General Tax Law Part IIZurich ABCD

12:20pm - 1:10pm Interactive Luncheon: Featuring NABL President Ken Artin and the NABL Diversity Committee

Vevey Ballroom

Training Session 11:15pm - 2:30pm

04. Qualified 501(c) 3 Bonds Zurich AB 05. Qualified Small Issue & Exempt Facility Bonds Zurich C07. Underwriting: Behind the Scenes Zurich D08. Practical Due Diligence/Drafting the Disclosure Document

Zurich EF

12. State Law Issues Zurich G2:30pm - 2:45pm Break Zurich Foyer


01. Arbitrage & Rebate Zurich AB02. Refunding & Reissuance Zurich D08. Practical Due Diligence/Drafting the Disclosure Document

Zurich EF

09. The Role of Underwriter’s Counsel Zurich G10. Bank Loans/Direct Purchases Zurich C

TRAINING SCHEDULE

2016 Fundamentals of Municipal Bond Law Seminar Page: 1

Start - End Event LocationThursday, May 5, 2016

4:00pm - 4:15pm Break Zurich Foyer


03. Avoiding Private Activity Zurich D06. IRS Issues & Enforcement Zurich EF12. State Law Issues Zurich G13. Document & Default Administration –The Trustee’s Perspective

Zurich C

17. Conflicts of Interest & Ethical Issues(ethics credit)

Zurich AB

5:30pm - 6:30pm Networking Reception Vevey Ballroom

Friday, May 6, 20167:15am - 1:00pm Information Desk Open Zurich Foyer

7:15am - 11:15am Exhibits Open Zurich Foyer7:15am - 8:15am Continental Breakfast Vevey Ballroom

Training Session 4 8:15am - 9:30am

02. Refunding & Reissuance Zurich D04. Qualified 501(c) 3 Bonds Zurich C07. Underwriting: Behind the Scenes Zurich EF14. Leases & Other Non-Traditional Financings Zurich AB16. Engagement Letters & Opinions (ethics credit) Zurich G

9:30am - 9:45am Break Zurich Foyer

Training Session 59:45am - 11:00am

01. Arbitrage & Rebate Zurich AB03. Avoiding Private Activity Zurich G09. The Role of Underwriter’s Counsel Zurich C10. Bank Loans/Direct Purchases Zurich EF11. Conduit Issues & Issuers Zurich D

11:00am - 11:15am Break Zurich Foyer

Training Session 6 11:15am - 12:30pm

05. Qualified Small Issue & Exempt Facility Bonds Zurich AB06. IRS Issues & Enforcement Zurich EF15. Demystifying DTC Zurich D16. Engagement Letters & Opinions (ethics credit) Zurich G17. Conflicts of Interest & Ethical Issues(ethics credit)

Zurich C

TRAINING SCHEDULE


TRAINING CENTER FLOOR PLAN

swissotelchicagomeetings.com | 312.268.8215323 East Wacker Drive, Chicago, IL 60601-9722

REGISTRATION

EVENT CENTRE

2ND FLOOR EVENT CENTRE

1ST FLOOR EVENT CENTRE

First Floor Map Swiss�tel Chicago

April 17-19, 2013 | Swissôtel Chicago | Chicago, IL


13

First Floor

swissotelchicagomeetings.com | 312.268.8215323 East Wacker Drive, Chicago, IL 60601-9722

REGISTRATION

EVENT CENTRE

2ND FLOOR EVENT CENTRE

1ST FLOOR EVENT CENTRE

Second Floor Map Swiss�tel Chicago

April 17-19, 2013 | Swissôtel Chicago | Chicago, IL


13

Second Floor


I would like to welcome each of you to the 2016 NABL Fundamentals of Municipal Bond Law Seminar! The training program for 2016 is designed to give you a broad, practical understanding of municipal bond law, and the breakout sessions provide an opportunity for you to focus the trifecta of municipal bond issues - tax, securi-ties, and state/general municipal law. Seminar topics incorporate new developments we see in public finance and panel materials have been updated to provide you with the most up to date, timely, and relevant training information. This year the Basic Structuring General Session will walk each of you through a trans-action from beginning to end so you can see how the various parties participate in the process. Further, the re-worked two-part General Tax Law session will provide an in-depth explanation of the federal tax laws applicable to municipal bonds. We are excited to introduce a new panel which will provide an in-depth overview of The Depository Trust Company – an important participant in the municipal securities market. Also, the IRS Issues and Enforcement Panel and the securities law panels will bring “hot” topics to the table. In addition to our education program you will have a chance to stretch your legs by participating in the second annual 5K Fun run or walk on Thursday morning along Chicago’s scenic Lakefront Trail! I encourage you all to participate in this fun event and get the day started off right!

The real strength of the Fundamentals Seminar is our faculty. Our incredible team represents a tremendous resource that I encourage you to take advantage of to enhance your NABL experience. They practice in firms of all sizes from across the country, with experience as diverse as their geography. You will have access to law-yers with different focuses, each of whom will welcome the chance to discuss bond matters with you inside and outside of class (I promise they will be thrilled!).

One of the best things about this Seminar is the opportunity to network and get to know your colleagues from around the country. Most of the attendees are relatively new to the field of public finance, and the Seminar fea-tures a number of events designed to encourage you to interact with and get to know other practitioners. The Seminar will feature a Welcome Reception on Wednesday evening, a roundtable discussion led by the NABL Diversity Committee on Thursday afternoon, and a Networking Reception on Thursday evening. I strongly en-courage you to take advantage of these events to get to know your colleagues. Do not be surprised if some of the contacts you make become long term friends – I know they have for me and many of the faculty.

I want to thank the NABL Board of Directors and staff for their support of this Seminar. They have truly made the training program you are going to experience over the next few days a reality and we are lucky to have such a dedicated group. The NABL Staff will be visible throughout the Seminar, so please reach out to them if you have any questions about the Seminar or NABL as a whole. I need to also express my incredible gratitude to my Vice-Chair Jeff Qualkinbush, for all of his support, ideas, hard work, assistance, and humor throughout the planning process.

I congratulate you on your interest in the field of municipal finance. As one of many attorneys that has dedicated my practice to this area of law, I can tell you that it is very rewarding, and there is a sense of camaraderie among its professionals that makes this practice truly unique and special.

So, get ready to suit up, hit the field, and have some fun! Are you ready!?

Deanna GregorySeminar Chair

WELCOME TO THE SEMINAR!


Deanna L.S. Gregory, ChairPacifica Law Group LLP

Seattle, WA

Jeffery J. Qualkinbush, Vice-ChairBarnes & Thornburg LLP

Indianapolis, IN

Angela W. AdolphKean Miller LLPBaton Rouge, LA

Alison J. BengePacifica Law Group LLP

Seattle, WA

M. Jason AkersFoley & Judell, L.L.P.

New Orleans, LA

Paul H. BillowWomble Carlyle Sandridge & Rice, LLP

Raleigh, NC

Kenneth R. Artin

Bryant Miller Olive P.A.Orlando, FL

Ryan K. CallenderSquire Patton Boggs (US) LLP

Cleveland, OH

2016 SEMINAR CHAIRS

SEMINAR FACULTY


David J. FernandezBuchanan Ingersoll & Rooney P.C.

New York, NY

Samuel (Rod) KanterBradley Arant Boult Cummings LLP

Birmingham, AL

Kimberly J. MinWhiteford, Taylor & Preston L.L.P.

Baltimore, MD

Matthew O. GrayButler Snow LLP

Denver, CO

Christopher B. LanghartMcManimon, Scotland & Baumann, LLC

Roseland, NJ

Kris A. MoussetteHinckley, Allen & Snyder LLP

Boston, MA

Perry E. Israel

Law Office of Perry IsraelSacramento, CA

Kathleen MilesThe PNC Financial Services Group, Inc.

Washington, DC

Harrie (Hal) C. PatrickHarris Beach PLLC

Albany, NY


Bradley D. PattersonBallard Spahr LLPSalt Lake City, UT

Aviva M. RothOrrick, Herrington & Sutcliffe LLP

Washington, DC

Don E. WilbonJ. P. MorganChicago, IL

Lois RadischThe Depository Trust & Clearing

CorporationNew York, NY

Linda B. SchakelBallard Spahr LLPWashington, DC

S. Douglas WilliamsMaynard Cooper & Gale P.C.

Birmingham, AL

Eric RockholdBank of America Merrill Lynch

Chicago, IL

Stephen E. WeylHinckley, Allen & Snyder LLP

Boston, MA

Carla A. YoungNixon Peabody LLP

Washington, DC


Now in its fifth year, NABL is pleased to announce that five applicants for the 2016 Frederic L. Ballard, Jr. Memorial Scholarship Program have been selected as recipients. Each of the recipients received a waiver of the enrollment fee to the Seminar, complimentary hotel lodging and reimbursement of travel expenses.

The 2016 Scholarship Recipients are:► Jennifer Binger, Stanford Law School

► Joshua Bonney, Elon University Law School

► Madison Coburn, University of Mississippi

► Christa Freeman, Howard University

► Nicole Perez, Rutgers University

The Frederic L. Ballard, Jr. Memorial Scholarship Program


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Thursday, May 5 at 7:00am – 8:00am (Please report to the Swissotel Lobby to check in at 6:45am.)

Begin the day with a challenge by taking a scenic, guided run with your colleagues on Chicago’s Lake Front Trail. The run is 3.1 miles and will not be timed. Beverages will be served. Check-in will be from 6:45am-7:00am in the lobby, and the run will begin promptly at 7:00am. There is a $20 registration fee for this event. If you haven’t registered yet, on-site registration is available until Wednesday at 6:00pm.

2nd ANNUAL RUN FOR FUNdamentals

RUN FOR FUNdamentalsMAY 5, 2016 | CHICAGO, IL


SEMINAR HIGHLIGHTSBasic Training General SessionsThe Fundamentals of Municipal Bond Law Seminar offers three Basic Training General Sessions, each designed to provide attendees with a strong understanding of the key components of a municipal bond practice. First, the Basic Structuring and Financial Aspects of a Municipal Bond Transaction session will provide attendees with a solid foundation of practical skills and techniques needed to understand the basic structural elements, documents and financial aspects of a municipal bond transaction. Second, the General Securities Law session will provide an overview of the applicable federal securities laws with which every municipal bond practitioner should be familiar. Third, the two-part General Tax Law session will provide an in-depth explanation of the federal tax laws applicable to municipal bonds.

Training Sessions In addition to three Basic Training General Sessions, the Seminar offers attendees the option to attend six (6) train-ing sessions. Attendees can select from seventeen (17) training session topics designed to build upon the materi-als taught in the Basic Training General Sessions.

Networking Events Cool down after a long day of training by attending one of the Seminar’s evening networking receptions. The net-working receptions are a great way for you to have a cock-tail with colleagues old and new and network with Seminar faculty members. A Welcome Reception on Wednesday, May 4, and a Networking Reception on Thursday, May 5, will be held for all attendees and faculty. This year’s faculty includes the current NABL President, along with several Board members, Committee Chairs and other esteemed legal colleagues. Throughout the Seminar, attendees will have direct access to the faculty and are encouraged to ask questions.

2nd Annual RUN For FUNdamentals Thursday, May 5 (7:00am – 8:00am) Meeting Location: Swissotel LobbyBegin the day with a challenge by taking a scenic, guided run with your colleagues on Chicago’s Lake Front Trail. The run is 3.1 miles and will not be timed. Beverages will be served. Check-in will be from 6:45am-7:00am in the lobby, and the run will begin promptly at 7:00am. There

is a $20 registration fee for this event. If you haven’t reg-istered yet, on-site registration is available until Wednes-day at 6:00pm.

Interactive Luncheon: Featuring NABL President Ken Artin and the NABL Diversity CommitteeThursday, May 5 (12:20pm-1:10pm) Thursday’s luncheon, sponsored by Sidley Austin LLP, will include an interactive lunch discussion regarding diversity and inclusion for all, featuring NABL President Ken Artin and the NABL Diversity Committee. This lun-cheon will have live polling via the Seminar Mobile App. Make sure you bring your smart phone or tablet to take part in this lively discussion. Participants will also hear from NABL President, Ken Artin, about the new initiative geared to help young lawyers become more involved with the association.

Use the App to Answer Polling Questions► Load the Seminar mobile app on your device.

► Select “Agenda.” Select “Session By Day.” Select the “Luncheon”.

► Select a polling question.

► Select your answer.

► Select “Finish.” Select “Exit Poll.” (You may need to scroll down to see the “Finish” button if the question is long.)

► Attendees do not need to be logged in to answer polling questions.

Sponsored by:


Training EquipmentAll registrants will receive a printed program book contain-ing an outline for each session as well as an electronic form of NABL’s reference volume, Fundamentals of Mu-nicipal Bond Law, containing valuable reference material on tax, securities and other laws applicable to municipal finance. A printed version of the book is available for the discounted price. Registrants may also request a compli-mentary copy of their choice of the LexisNexis Federal Taxation of Municipal Bonds Deskbook (valued at $212) or Federal Securities Laws of Municipal Bonds Deskbook (valued at $127) on-site at the Lexis Nexis exhibit table.

Continuing Legal Education (CLE) The Seminar is expected to offer CLE credit up to a total of 14 hours in states with a 60-minute CLE hour and up to a total of 16.8 hours in states with a 50-minute CLE hour. Included in the total hours are two 75-minute sessions for which ethics/professionalism credit for will be sought. Few programs offer this much CLE credit through sessions geared specifically toward the municipal finance lawyer. NABL will apply for CLE credits from those states that have mandatory CLE requirements. Attendees should be sure to include applicable MCLE states and identify-ing numbers on the registration forms. The requisite CLE forms will be available at the Seminar.

Mobile AppDownload the Seminar Mobile app for a full Institute ex-perience. The Mobile App will allow you to find other attendees, set your schedule, view and download session outlines and PowerPoints, and stay in the know about event updates during the Seminar. For a more interac-tive Seminar experience, When you first run the app, it will take a little longer to set itself up. The time this takes depends on the device and your connection, so we rec-ommend you allocate a few extra minutes when you first launch the app.

3 Ways to Download the App:1) Go to the Google Play or App Store on you phone or tablet. Search “NABL Events” and download the app.

2) Go to this link https://crowd.cc/fund16.

3) Or simply scan the QR code below based on the plat-form of choice.

Complimentary WiFiComplimentary wireless internet is included in your guest-room rate. To access the wireless internet in the meet-ing rooms, connect to the PSAV_EVENT_SOLUTIONS network and enter code NABL2016 when prompted (the code is case sensitive).

Fitness CenterYour group rate includes complimentary access to the Swissotel’s Penthouse Fitness Center and pool, with pan-oramic 42nd-floor views.

Business Center The full-service UPS Store in the Swissotel Chicago operates Monday-Friday from 7am-7pm.

ParkingOvernight valet parking is $70 at the Swissotel Chicago.

Airport ShuttleFor information regarding shuttle transportation to the airport, please visit www.airportexpress.com.

THINGS TO KNOWWednesday, 5/4

11:00am – 6:00pm

Thursday, 5/58:00am – 5:30pm

Friday, 5/67:15am – 1:00pm

NABL Check-in DeskThe Check-in Desk will operate during the following dates and times at the Zurich Foyer:


http://crowd.cc/fund16

Download the Seminar Mobile App Now!

You can also scan this code with a QR Reader on your device.


NABL thanks all of our sponsors for their support.

Interested in sponsoring other NABL events? Contact Susan Zelner at [email protected] or call 202-503-3300.

Gold Level Sponsor

Media Sponsor

Bronze Level Sponsor

Gold Level Sponsor


Platinum Level Sponsor


Platinum Level Sponsor

Silver Level Sponsor Silver Level Sponsor

SPONSORS


Sidley is proud to support the National Association of Bond Lawyers as the 2016 Diversity Sponsor.

Clifford Gerber Partner

555 California Street Suite 2000 San Francisco, California 94104 +1 415 772 1246

Find out how we are fostering inclusiveness in our law firm’s culture at

sidley.com/diversity

sidley.com

AMERICA • ASIA PACIFIC • EUROPE

Sidley and Sidley Austin refer to Sidley Austin LLP and affiliated partnerships as explained at www.sidley.com/disclaimer. MN-3202



201641st Annual Bond Attorneys' Workshop

October 19-21, 2016Fairmont Chicago | Chicago, IL

201715th Annual Tax & Securities Law Institute

Members-Only EventMarch 9-10, 2017

The Omni Shoreham | Washington, DC

Fundamentals of Municipal Bond Law SeminarApril 19-21, 2017

Sheraton Downtown Denver | Denver, CO

42nd Annual Bond Attorneys' WorkshopOctober 4-6, 2017

Fairmont Chicago | Chicago, IL

201816th Annual Tax & Securities Law Institute

Members-Only EventFebruary 21-23, 2018

JW Marriott Phoenix Desert Ridge | Phoenix, AZ

Fundamentals of Municipal Bond Law SeminarApril 25-27, 2018

The Westin Charlotte | Charlotte, NC

43rd Annual Bond Attorneys' WorkshopSeptember 26-28, 2018

Fairmont Chicago | Chicago, IL

Stay on top of your game by continue your training.

UPCOMING NABL EVENTS


BAW41st Bond

Attorneys’ WorkshopOctober 19-21, 2016 Fairmont Chicago | Chicago, IL

Save the DateVisit www.nabl.org for more details

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A L B A N Y B O S TO N C O N C O R D H A R T F O R D N E W YO R K P R O V I D E N C E

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Lewis Roca Rothgerber Christie is proud to support the National Association of Bond Lawyers

Bryant Barber602 262 5375 direct201 East Washington StreetSuite 1200Phoenix, AZ 85004

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Thank you to The Bond Buyer for being the official media sponsor.

Daily editions of The Bond Buyer will be available for attendees during the Seminar by the Registration Desk.


NOTICE

Because opinions with respect to the interpretation of state and federal laws relating to municipal obligations fre-quently differ, the National Association of Bond Lawyers has given the authors and editors of this work the opportu-nity to express their individual legal interpretations and opinions. The interpretations and opinions are not intended to reflect any position of NABL, or the law firms, branches of government, or organizations with which the authors and editors are associated, unless they have been specifically adopted by such organizations. For educational purposes, the authors and editors may have employed hyperbole or offered suggested interpretations for the pur-pose of stimulating discussion. Neither the authors and editors of this volume nor NABL take responsibility as to the completeness and accuracy of the materials contained herein, and accordingly readers must conduct independent research of original sources of authority. This volume is provided to further legal education and research and is not intended to provide legal advice or counsel as to any particular situation. If you discover any errors or omissions, please direct your comments to the Chair of the Seminar for consideration in future volumes.

NATIONAL ASSOCIATION OF BOND LAWYERS601 13th Street, NW

Suite 800 South Washington, DC 20005

Copyright is not claimed for those portions hereof prepared by any official or employee of the United States of America in the course of his or her official duties.

©Copyright 2016 National Association of Bond Lawyers



Basic Training General Session Materials



NATIONAL ASSOCIATION OF BOND LAWYERS FUNDAMENTALS OF MUNICIPAL BOND LAW SEMINAR

May 4-6, 2016 – Chicago, IL

Basic Training General Session: Basic Structuring &Financial Aspects of a Municipal Bond Transaction

Faculty:M. Jason Akers Foley & Judell, L.L.P. - New Orleans, LA Angela W. Adolph Kean Miller LLP - Baton Rouge, LA Paul H. Billow Womble Carlyle Sandridge & Rice, LLP - Raleigh, NC S. Douglas Williams, Jr. Maynard Cooper & Gale P.C. - Birmingham, AL

This session provides an overview of the basic structuring and financial aspects of municipal finance transactions. It covers concepts that are relevant to the structure of a deal, such as the decision to borrow, the source of payment, the scope, timing, and marketing of the borrowing and various aspects of the municipal bond market. It also covers basic financial concepts relevant to an understanding of such transactions. In doing so, this session will address the following questions:

A. What are the basic “structures” of most typical municipal finance transactions?

B. What are the basic documents that implement these structures (i.e., what documents are required for typical municipal finance transactions)? In addition, what are the more important parts of these documents?

C. What are the primary economic terms of a municipal finance transaction?

D. What are the financial aspects of a transaction and how do these drive the structure of a transaction?

PART I: BASIC STRUCTURING & DOCUMENTATION

I. WHAT IS A MUNICIPAL BOND AND WHY ISSUE THEM?

A. At its most basic level, a municipal bond is a debt instrument issued by a governmental issuer.

B. Debt Instrument. A public entity issues a bond to borrow money. A bond is simply the evidence of the debt, in the same way that a promissory note is evidence of the obligation to repay an ordinary loan. A bond typically specifies:

1. An obligation to pay,

2. a stated amount (the “principal”),


3. at a given time (the “maturity”), and

4. with interest at a stated rate.

There are many variations on the structure and security for bonds, including bonds that are payable from all funds of the issuer and those that are payable from only a specified source of funds), bonds that have one maturity date or those with multiple maturity dates, and bonds with fixed interest rates and those with variable interest rates.

C. Municipal bonds are issued by, or on behalf of, a governmental issuer. The issuer can be nearly any governmental entity, such as a state, county, city or an authority created by any of these pursuant to applicable law. There are two primary types of bonds issued:

1. Governmental Bonds - issued to provide funding for governmental projects. For example, water and sewer bonds or general obligation bonds.

2. Conduit Bonds - issued in order to loan the bond proceeds to a third party authorized by law to use municipal bond proceeds. For example, municipal bonds issued to provide funds for a tax-exempt hospital to build a new cancer wing.

D. Why Use Municipal Bonds?

1. The most common reason a governmental entity issues municipal bonds is to finance costs associated with capital projects (or to refinance bonds previously issued to finance capital projects). In most states, governmental issuers cannot borrow money without following required statutory procedures (i.e., the bond process).

2. Traditional tax-exempt municipal bonds benefit from a federal income tax-exemption on the interest earned on the bond. Investors will buy tax-exempt municipal bonds at a lower interest rate than a taxable bond because they will not have to pay federal income tax on interest on the tax-exempt bond. The issuer will, therefore, have a lower interest rate to pay on its debt.

For example, if the taxable rate on bonds is 7% and an investor has a 33% marginal tax rate, then the investor will make the same amount of interest with a 7% taxable bond as with a 4.69% tax-exempt bond. The calculation is 7% multiplied by 0.67 (1 minus the marginal tax rate), which equals 4.69%. An issuer would much rather pay 4.69% on $10,000,000 than 7%. In the first year alone, the issuer would save $231,000 in this example.


E. A brief, overview and detour . . . Tax Credit and Direct Subsidy Bonds.

1. Alternative financing methods designed to provide issuers with zero or extremely low cost financing for certain targeted assets or programs

2. Instead of interest, a tax credit bondholder receives a federal income tax credit based on a % specified by the IRS. Holders of direct subsidy bonds receive interest, but a federal subsidy is paid to the issuer to off-set interest costs.

3 Tax credit bonds were first introduced in 1997 and expanded as part of the 2009 Stimulus (ARRA).

4. The Stimulus Act also created Build America Bonds, which are Direct Subsidy Bonds, and allowed issuers to elect to issue some Tax Credit Bonds as Direct Subsidy Bonds instead.

5. Most provisions for Tax Credit Bonds and Direct Subsidy Bonds expired December 31, 2010, but lately proposed tax legislation often includes some form of direct subsidy bond provision.

F. Certain risks inherent to bonds in general:

1. Interest Rate Risk

2. Default Risk (Credit Risk)

3. Reinvestment Rate Risk

4. Inflation Risk

5. Call Risk

6. Maturity Risk

7. Liquidity Risk

8. Other Risks

II. LOCAL GOVERNMENTS AND BORROWINGS

A. The Decision to Finance/Borrow

1. General. Every municipal bond transaction involves a public issuer’s need to borrow money to finance “something.” Conceptually, the process of issuing bonds is the process of borrowing money (a loan from the bondholders to the public issuer or a private borrower borrowing “through” the governmental entity). The buyers of bonds are thus


investors, both individual and institutional, who loan money to the governmental issuer (or through the governmental issuer to conduit borrowers) by means of their purchase of the bonds.

Strategic planning for debt issuance, in light of the issuer’s capital outlay/improvement program, should be addressed with a view to giving the issuer the ability to access the market when it expects to need funds, while avoiding an unnecessarily high number of transactions (with resulting high issuance costs) in a short period of time. The key here is when the issuer receives money vs. when the issuer needs money (capital/debt markets allow entities to “smooth out” their production and consumption of “excess” cash over time).

Interest rates, terms and costs of issuance can also influence the decision to finance. The issuer and/or borrower should weigh all of the financing costs against the benefit to be gained from the financing in deciding how to proceed. Further, consideration should be given to the relevant public support for the project and to the possibility that political controversy or litigation may arise from the financing.

2. Types of Municipal Borrowings

a. to finance new projects - often building projects, new roads, new plants, new schools, new hospitals;

b. to finance cash flow needs - “working capital” financings are subject to both state and federal tax law limitations; and

c. to refinance outstanding debt (“refundings”). Usually done because the issuer can receive lower interest rates and save money; e.g., by paying off outstanding 5% debt with new 3% debt. This is a “high-to-low” refunding. An issuer may also do a “low-to-high” refunding, if there is a non-economic reason to eliminate the old debt and related documents, such as a burdensome covenant that the issuer needs to escape. Under tax law there are two types of refundings - current refundings where the old debt is paid off within 90 days and advanced refundings where the new bond proceeds are placed into escrow to pay the old debt off in more than 90 days. You will hear more about current and advanced refundings later in this session and in future sessions and why the distinction matters.

B. Debt Affordability Standards and Debt Policies

1. General. Debt financing through the issuance of bonds generally should not be considered an additional source of operating revenue. Debt is merely a way of spreading out the cost of a capital improvement or public program over time. In some cases (as with general obligation bonds or


land-secured financings), the statutes permitting the issuance of debt also permit the levying of taxes or assessments to pay debt service. Issuers should be careful to gauge the effect of ongoing debt service on their budgets and fiscal priorities over time. Capital decisions are essentially long term in nature and, once made, often “set in stone” an issuer’s strategy or financing plan.

2. Debt affordability standards. Debt affordability standards (sometimes referred to in the sense of “debt capacity”) help evaluate when, why and how much debt should be issued. These standards can lead to a debt affordability plan that keeps debt levels within acceptable ranges. A debt affordability plan will typically include a set of target ratios for debt, which might be based upon assessed valuation of property, revenues, population, system users, or other factors relevant to specific types of issues. These ratios may be varied depending on factors such as volatility of revenue streams, concentration of tax or revenue base, community policies and preferences regarding debt and the overall need for capital investment. Due to these factors, as well as the public policy issues that are inherent in the decision to borrow, there is no “one size fits all” model.

3. Debt issuance policy. In addition to debt affordability standards, some issuers maintain a formal debt policy. A debt policy (1) establishes parameters for issuing and managing debt, (2) provides guidance to decision makers so as not to exceed the debt affordability standards, (3) directs staff on objectives to be achieved both pre- and post-issuance, (4) promotes objectivity in decision-making and limits the role of political influence, and (5) facilitates the process by considering and making important policy decisions in advance of an actual financing. A debt policy should address issues such as (1) the types of debt that will be issued, (2) structural features with respect to the debt (e.g., maximum term, criteria for use of credit enhancement), (3) method(s) of sale of debt (i.e., circumstances under which negotiated or competitive sales will be used), (4) refundings, (5) selection of professionals and consultants, (6) disclosure practices, (7) arbitrage rebate and continuing disclosure compliance, and (8) investment of bond proceeds.

Debt policies may assist in maintaining and improving an issuer’s general creditworthiness, together with its credit rating and/or the rating accorded its various debt obligations. The elements of a debt policy will vary for each issuer, and should reflect the scope of activities the issuer is likely to undertake in the debt financing arena. In addition, it is important that the debt policy reflect community standards and attitudes about debt.

C. The Role of Investors

1. General - investors are important! The principal concerns of a lender (here, think investor) are whether the loan will be repaid and how much it


will earn from the transaction. Issuers must consider the needs of investors for different structural features of a bond issue. To be successful, a bond financing program must not only meet the financial needs and limitations of the issuer but also those of the investor -- by providing an attractive opportunity to potential investors, who have many choices of investment vehicles. Thus, the ultimate investor not only provides the money but also determines many of the features of the financing.

The relative demand by investors for bonds having different characteristics may influence the structure of a financing. For example, in a market where short-term, high credit quality bonds are in high demand, it may be to an issuer’s advantage to issue variable rate put bonds rather than long-term, fixed rate bonds. As another example, in periods of relatively high interest rates, investors may demand that bonds not be redeemable prior to maturity (or be redeemable only after an extended period of time) to assure investors that they will enjoy the benefit of the high interest rate and not risk having to reinvest at a time when market rates may be lower.

2. Institutional and Retail Investors. Municipal bond investors are of two general types. Some sales of bonds are made to large investors (such as mutual funds and insurance companies) commonly known as institutional investors. Other sales are made to individual investors, commonly known as retail investors (a.k.a., “Mom and Pops”). Generally, however, bond investors in traditional tax-exempt bonds have the ability to take advantage of the exemption from federal (or state) income taxes customarily available for interest on tax-exempt municipal bonds. Changes in the composition of the municipal bond market have often resulted from changes in federal tax law, that have made tax-exempt interest less attractive to certain segments of the market.

Historically, banks have been major purchasers of tax-exempt municipal bonds. While changes in the tax code in the 1980s restricted their ability to deduct all or some of the interest paid on their own obligations (such as deposits) attributable to the carrying of tax-exempt bonds, banks are still attracted to the relative safety of municipal bonds.

Similarly, changes in federal tax law adversely affected the attractiveness of traditional tax-exempt municipal bonds to certain property and casualty insurance companies and to corporations and individuals with alternative minimum tax liability. Entities such as pension funds and certain other tax-exempt entities are generally not attracted to such municipal bonds due to their inability to take advantage of the tax exemption (since their income is already tax-exempt).


3. Suitability. In addition to the tax status of a bond, other criteria that serve as primary determinants of the attractiveness of a particular bond to a particular investor include the credit quality of the bond (credit rating), its term to maturity, its risk of redemption and its potential for sale in the secondary market. Broker-dealers offering bonds to investors must match up the sophistication, risk tolerance and economic situation of a potential investor with the structural features, liquidity and credit quality of the bonds being offered. Securities laws require that broker-dealers take these factors into account when offering and selling bonds. Issuers should also know what suitability considerations a broker-dealer will use in selling the issuer’s bonds. See, e.g., MSRB Rules G-17 and G-19.

D. Structural Issues and Considerations

The issuer’s principal concerns are the long and short term “cost” of the borrowed money - e.g., what is its “all in” interest cost. The debt service structure, term and security of the issue are perhaps the most important of the determinants as to the cost of the borrowing. The issuer is also concerned about the limitations a transaction may impose in the form of covenants and legal constraints on the issuer’s future activities.

1. Debt Service Structure – “Debt service” is the term given to the principal and interest payments due on the bonds, and the schedule upon which a series of bonds will pay principal and interest to the investors is typically called a “debt service schedule” or “amortization schedule.” The debt service structure is important to both the issuer and the investors. The issuer wants to make sure that it owes principal and interest payments on a schedule that will allow it to make the payments. The investor wants to know when and how much it will get paid in determining whether an investment is appropriate for the investor.

a. In a New Money Issue - Short-term operating needs generally are financed with cash or short-term borrowings (e.g., “tax anticipation notes”), while a capital asset, such as a sewage treatment facility or a fire station, generally is financed with longer maturity debt. The debt service structure is often tied to the life of the assets being financed. A primary consideration in any financing plan is the relationship between the term of the financing and the life of the asset being financed. Most types of public buildings and infrastructure are financed over 20-30 years (cf. residential mortgages -- 15-30 years). Compare to equipment (a fire truck), which generally has a much shorter useful economic life and would be financed over an intermediate term of 3-15 years. In a new money financing, an issuer may be able to issue additional bonds to pay the costs of interest in the first few years. For example, if a tax-exempt organization was building a new hospital and wanted to have the revenues from the new hospital to help pay


debt service, the hospital could borrow bond proceeds to pay interest on the bonds until the hospital was open and generating revenues.

b. In a Refunding Issue - The debt service will be influenced by whether the issuer wants to realize its savings up front, at the end or on a level basis. If an issuer refunds $10,000,000 in bonds that had a $1,000,000 in principal coming due each year for 10 years, the issuer could use the same debt service structure on the new bonds and have some savings each year. Or the issuer could have no principal due until year 5 and then pay $2,000,000 a year for the last 5 years. By paying interest only in the first 5 years, the issuer dramatically lowers payments in the early years. As a rule of thumb, issues generally seek to realize not less than a 3% net present value savings on the interest cost of a refunding issue as a threshold savings rate.

c. Wrap Around of Existing Debt - When planning debt service payments on a bond issue, the issuer has to look at the debt it already has outstanding. Many issuers like to have level debt service – and thereby owe approximately the same amount of principal and interest each year. In order to achieve level debt service, an issuer might structure debt service on the new issue so that total debt service on the new bond issue plus existing debt service is level.

2. Security for the issue - in any issue, a number of factors will affect the final structure of the issue. In most cases, however, the source of revenue pledged by the issuer to the repayment of the debt has the most impact. For a further discussion of the various types of bonds common today, see Section IV of this outline (“BOND STRUCTURES, ROLES AND RESPONSIBILITIES OF PRINCIPAL PARTICIPANTS; BASIC DOCUMENTS”).

3. Other structuring (covenant) considerations. These are most often seen in revenue bond financings and generally stem from or relate to the security for the transaction and the type of project/asset that is financed:

a. limitations on additional debt borrowings;

b. rate covenants;

c. flow of funds;

d. maintenance covenants;

e. limitation on asset dispositions;


f. tax restrictions on use of project;

g. default / remedy provisions (e.g., acceleration); and

h. rating requirements for liquidity and cred enhancement or sureties (including downgrade requirements).

4. Methods of Sale - municipal bonds can be sold in one of three ways:

a. Competitive Sale - The issuer sets the general terms and maturities for the bonds and asks that underwriters and banks/sophisticated investors submit their best interest cost on the bonds. The issuer selects the best submission, generally based on the lowest overall interest cost. Hence, the underwriter or bank/sophisticated investor is picked at the time of sale and other working group members (bond counsel, financial advisor, issuer finance staff) help set the structure.

b. Negotiated Sale - The issuer selects an underwriter or small group of underwriters based on their skills and negotiates the terms and conditions of the relationship with one or more of such underwriters. An RFP process may be used. The underwriter is selected at the beginning of the process and assists in structuring and marketing decisions. Negotiated sale is common for revenue bonds, conduit bonds and refundings.

c. Private Sale/Bank Placement – The issuer sells the bonds directly to a bank or a small group of sophisticated investors, usually financial institutions.

III. LEGAL CONTEXT AND CONTRACT LAW

A. The determinants of an issue’s structure and the documents that put together that structure are a function of (1) the basic bond/loan/debt terms, plus (2) tax requirements, plus (3) securities requirements, plus (4) state law requirements. The four basic components that determine the legal documents and agreements of a bond transaction and their contents are:

1. the economic terms or substance of the transaction, as set forth in agreements between the parties -- primarily a matter of contract law (who are the parties? What are the economic/legal relationships between them?);

2. tax law requirements relating to the eligibility of the debt for tax-exempt status;


3. securities law requirements governing disclosure, and the offering/sale/purchase of the debt; and

4. state law doctrines and requirements pertaining to the authorization/issuance of the debt.

The common law of contract is the starting point. Tax, securities and state law are doctrines that limit the basic contract points between the parties or otherwise must be embodied in the contracts among the parties.

B. Contracts

1. The basic premise of a contract is that it is an enforceable promise.

2. Common law is the traditional source of contract law, although statutes have become increasingly important (e.g., the Uniform Commercial Code, the Statute of Frauds).

3. The general order of documents is as it has always been - purpose, agreements, signatures. A well-crafted document can be diagrammed like a sentence - “We (the parties) agree to do X upon conditions Y.”

The function of a contract is to set forth the parties’ obligations clearly and to establish the conditions under which such obligations must be performed. The important elements include:

a. Parties (clearly identified);

b. Promises (clearly stated mutual obligations); and

c. Consideration (mutual benefits).

(Some definitions of a contract specify: offer, acceptance and consideration. Note the importance of your states’ contract law).

4. Contracts also are the means to allocate risks among the parties. Important risk allocation provisions include:

a. conditions;

b. insurance;

c. indemnification;

d. limitations on liability; and

e. representations and warranties.


5. Lawyerly attention to detail has added, over centuries, an initial listing of the parties, the use of defined terms and separation of text into articles and sections.

6. Still, the essence of every good legal document is the same - and similar in its essentials to the Magna Carta.

7. Remember, also, the uniqueness of governmental contracts (in general) and of governmental debt in particular.

C. How to decide what is needed for a municipal finance transaction.

1. Identify all parties and their relationships.

2. Identify how the money flows and the security for the transaction.

3. Diagram the transaction. For example a basic corporate debt transaction has two boxes. One box for the lender who loans proceeds to the borrower - the second box. In exchange for the proceeds, the borrower promises to repay the money and usually evidences the promise with a note. In a basic municipal bond transaction there are also two boxes. One for the bondholders who buy the bonds and thereby pay money to the issuer - the second box. In exchange for the money, the issuer promises to repay the money and evidences this promise to pay debt service with a bond.

IV. BOND STRUCTURES, ROLES AND RESPONSIBILITIES OF PRINCIPAL PARTICIPANTS; BASIC DOCUMENTS

A. General Obligation Bonds

1. Characteristics (varies from state to state):

a. generally backed by the issuer’s full faith and credit;

b. generally supported by the issuer’s ability to levy and collect taxes (particularly property/ad valorem taxes);

- limited tax pledge vs. unlimited tax pledge;

c. generally, requires voter approval; and.

d. potential concerns regarding treatment as general unsecured debt in municipal bankruptcy proceedings.


2. Participants:

a. The Issuer as the “Central Actor.” The issuer is the legal entity that is borrowing the money by issuing bonds and is customarily the central actor in the process. The financing is being accomplished by, and for, the issuer and, even in the case of a financing for a nongovernmental/conduit borrower, should be designed to serve the objectives of the issuer.

b. Investors (the “Lenders”); Underwriters (the “Market-Makers”):

1. Investor. The ultimate investor in a bond financing not only provides the money being lent, but also determines in many ways the features of the financing. A bond financing structure must meet not only the needs of the issuer, but also the needs of the investor. Target investors in a bond financing may have considerable influence in determining the features and structure of the bonds (e.g., redemption provisions).

2. Underwriter. An underwriter purchases bonds from an issuer with the intent to resell the bonds to the ultimate investors. In effect, the underwriter acts to match those that need money/capital (the issuers) with those that have money and are seeking to put their money to use or to invest it. In a classic sense, the underwriters are the financial middlemen.

c. Paying Agent. An issuer customarily selects one or more commercial banks or trust companies to perform one or more of several administrative duties relating to a bond issue. Although historically an issuer may have received, held and disbursed the bond proceeds itself, and collected, held and paid debt service on the bonds with the revenues pledged as security for the bonds, today, relatively few issuers have the banking capabilities and relationships necessary to perform those services themselves. Recently, the longstanding exclusion of tax-exempt interest from the information reporting requirements of Section 6049 was eliminated, and thus issuers, as payors of tax-exempt interest, must file information returns with the Internal Revenue Service and furnish similar statements to the payees. Most issuers do not have the operating systems to perform this required backup withholding.

Most general obligation transactions use a paying agent. A paying agent (or fiscal agent) is not a trustee, but merely acts as agent of the issuer to perform functions necessary to comply with the


requirements of the documents - in this case, to pay debt service to the bondholders.

In some cases, particularly with book-entry only bonds held through The Depository Trust Company (“DTC”), the issuer (or a financial officer of the issuer) will serve as paying agent in lieu of a commercial bank or trust company, since only a single debt service payment needs to be to DTC, and DTC distributes the debt service payments electronically to the ultimate beneficial owners of the bonds. For instance, this is common practice in North Carolina.

d. Municipal/Financial Advisor. Acts as an advisor to the issuer in connection with the financing, including matters relating to structuring, security, manner of sale, procurement of bond ratings and other financial matters. Serves in a fiduciary capacity to the issuer/conduit borrower.

e. Counsel to all of the various parties described above.

3. Principal Documents and Contents

a. Bond Order/Ordinance/Resolution - This is the basic document authorizing the borrowing through the sale and issuance of bonds, establishing the terms of the bonds (payment dates, maturities, redemption provisions, securities depository, registration, transfer and exchange, etc.) and the security for the transaction - such as the pledge of the issuer’s full faith and credit and/or taxing power. It might also:

1. approve the manner of sale of the bonds and the disclosure document;

2. set forth continuing disclosure undertakings;

3. describe the investment of proceeds/deposit and use of funds;

4. provide some general tax-related (arbitrage and private activity bond) covenants;

5. approve related financing agreements (e.g. indenture, line of credit agreement, credit enhancement); and

6. set out delegation authority and parameters for accepting bids or otherwise conducting the sale of bonds.


4. Bond Sale Documents

a. Bond Purchase Agreement - in a negotiated sale, provides for the sale of the bonds to the underwriter (or their placement by the placement agent for private placements, when it’s referred to as a Placement Agreement) and specifies discount, interest rates, terms for payment of purchase price. Contains representations and warranties, conditions precedent to underwriter’s obligation to purchase bonds at closing (and the “outs” allowing the underwriter to terminate the purchase); specifies documents to be delivered at closing; states who will pay what expenses/costs. etc.

Parties: Issuer, Underwriter, Nongovernmental/conduit borrower (in such financings).

b. Notice of Sale/Bid Form - similar function (provides for the sale of the bonds to the underwriter/purchaser in a competitive sale). Sets out the terms for conducting the sale and award of the bonds in a competitive bid process. Not a negotiated document. When accepted by the issuer, this forms the purchase contract for the sale of the bonds. Primarily used in general obligation or other more “plain vanilla” transactions where there is little or no need for the underwriter/purchaser to “tell a story” to the bond investors/credit committee.

5. Offering or Disclosure Document

The Official Statement/(Limited) Offering Memorandum is the document that provides disclosure to investors and potential investors. Most financings are required to have Official Statements under SEC Rule 15c2-12. Provides disclosure to prospective investors regarding the terms of bonds, security, risk factors and financial and operating information concerning the issuer and/or conduit borrower and background information. Must comply with the “10b-5” standard. It is critical that the issuer/borrower read the entire offering document, since it bears responsibility and has liability for material misstatements and omissions (and, unlike the underwriter, does not have a “due diligence” defense). Crucial sections of the offering document are: description of the securities (e.g., redemption provisions), security and sources of payment for the bonds, risk factors, financial and operating data and litigation.

6. Continuing Disclosure Agreement

Continuing Disclosure Agreement - The continuing disclosure agreement contains the undertakings of the issuer (and/or any obligated persons) to provide ongoing disclosure in the form of annual financial information (financial statements and operating data) and event notices pursuant to


SEC Rule 15c2-12. The undertakings are made for the benefit of, and are enforceable by, the bondholders and remain in place for the life of the issue. The continuing disclosure undertaking may be contained in a separate agreement or certificate or may be incorporated into other financing documents to which the issuer/borrower may be bound.

B. Revenue Bonds

1. Characteristics:

a. backed by a pledge of the gross or net revenues of the facility/system/enterprise that is being financed; and

b. generally, not a tax pledge (unless “double-barrel” pledge).

2. Participants:

a. Issuer.

b. Sometimes a conduit borrower (i.e., user or operator of facility) – see “Conduit Revenue Bonds” below.

c. Trustee - An issuer customarily selects one or more commercial banks or trust companies to perform one or more of several administrative duties relating to a bond issue. Although historically an issuer may have received, held and disbursed the bond proceeds itself, and collected, held and paid debt service on the bonds with the revenues pledged as security for the bonds, today, relatively few issuers have the banking capabilities and relationships necessary to perform those services themselves. In addition, investors are “comforted” by the involvement of a fiduciary acting on their behalf and holding the funds and accounts relating to the bond issue.

As a result, many bond resolutions and indentures appoint a trustee or fiscal agent to perform a number of different duties relating to the bond issue.

The duties of a trustee in a revenue bond transaction include the following:

1. establishes and holds funds and accounts, including accounts for bond proceeds and revenues, determining that the conditions for disbursement of proceeds and revenues have been met and sometimes collecting revenues and executing investments;


2. acts as bond registrar - maintains list of names and addresses of bondholders; records transfers and exchanges of bonds;

3. acts as paying agent; and

4. as trustee, protects interests of bondholders by monitoring compliance with covenants (“promises”) and acting on behalf of bondholders in an event of default (key role of trustee in a workout).

d. Lender/Underwriter; Financial Advisor; Counsel to Various Parties (same as general obligation bonds above).

3. Principal Documents and Contents

a. Trust Indenture or Trust Agreement - (cf. Bond Order/Ordinance/Resolution). Two parties: issuer and trustee. The basic security document of a bond transaction, providing the terms of the bonds, including payment dates, maturities, redemption provisions, registration, transfer and exchange, etc.. The Indenture (or Trust Agreement) sets forth the legal structure for the security for the bonds, including:

1. creation/granting of the “trust estate” (the security for the bond issue);

2. pledge of revenues and other collateral;

3. flow of funds (establishing the priority for uses of pledged revenues);

4. affirmative covenants (i.e., to maintain certain debt service coverage ratios or “rate covenant”, to maintain facilities or provide insurance) and negative covenants (covenant not to pledge facilities/revenues to other debt; covenant not to incur additional parity debt without meeting certain financial tests);

5. parity bonds/additional debt provisions;

6. default and remedy provisions;

7. defeasance provisions (to allow for refundings); and

8. trustee-related provisions.


C. Conduit Revenue Bonds

1. Characteristics - generally, financing of a facility for lease, use or operation by a “private” borrower, such as a small issue manufacturing facility, a 501(c)(3) entity or a solid waste disposal facility. Sometimes governmental facilities financed through conduit issuer that might have “pooled” finance authority or to take advantage of broader finance powers.

2. Participants:

a. Issuer.

b. Trustee.

c. Conduit Borrower -- Non-governmental conduit borrower: Various governmental issuers are authorized to issue bonds and lend the proceeds to one or more non-governmental borrowers to finance facilities the development of which is deemed to be a public purpose. Such facilities include, among others, single family housing, multifamily housing, student loan programs, nonprofit hospitals and other health care facilities, nonprofit educational facilities, pollution control facilities, solid waste facilities, power facilities, airports, seaports, marinas, certain kinds of sports facilities, and certain other types of industrial or commercial facilities. In each case, the criteria for qualification as a borrower are derived from state constitutional and statutory criteria, the issuer’s own policy requirements and, in the case of federally tax-exempt bonds, federal tax requirements. Such financings are often called conduit financings and the non-governmental borrowers are often called “conduit borrowers.” Generally, the conduit borrower and any credit enhancement provided by or on behalf of the conduit borrower are the only sources of revenues for repayment of the bonds.

In some cases, the conduit borrower will take a very active role in designing and negotiating the terms of the bonds. In others, for example in the case of single family lending programs, the conduit borrowers are not directly represented, but establish a market in which the lending program must operate. However, in all cases, the issuer is still a central actor in the financing.

d. Lender/Underwriter; Financial Advisor; Counsel to Various Parties (same as above).

3. Principal Documents and Contents:

a. Trust Indenture/Trust Agreement;


b. Loan/Financing Agreement (substitutes: Installment Sale Agreement; Facilities or Project Lease). Parties: Issuer, Non-governmental/conduit borrower (i.e., the obligor). The document under which the bond proceeds are lent or otherwise provided for the financed project, and the conduit borrower promises to repay the loan in amount sufficient to pay the principal of and interest on the bonds. Generally used in financings where the issuer is not the source of repayment of the debt.

Important provisions for review and negotiation: representations and warranties; covenants (operation and maintenance of facilities type covenants; financial covenants/additional-parity debt tests and insurance covenants); prepayment or redemption provisions; collateral/pledge/security interest provisions; title provisions; default and remedies provisions, etc.

c. Mortgage/Deed of Trust/Security Agreement – Conduit borrowers often pledge real or personal property as collateral to secure its repayment obligation. Similar to a security instrument in a bank or other secured lending transaction, so need to focus on the covenants, representations and warranties (especially as to environmental matters), and especially on the default and remedies sections, since that is what the basic purpose of the document is, as well as how it all fits in with the other finance documents.

Also, look at whether this document benefits the issuer (need to get it assigned to the trustee) or benefits the trustee directly.

V. VARIABLE RATE DEMAND BONDS (“VRDBs”)

A. Basic Concept.

Variable rate demand bonds take advantage of the yield curve and the notion that debt with a shorter maturity “costs” less than debt with a lengthier maturity. Because the yield curve generally slopes upward, borrowers prefer to borrow at lower yields required to be paid for shorter maturities. However, if the borrower has a long-term borrowing need, it would constantly re-enter the debt market with fixed rate bonds, an expensive proposition. Thus, “variable rate demand bonds” or “lower floaters” were created, where a bond bears a nominal long-term maturity date, but the holder has the right to put the bond to the borrower at a specified interval. That put option (or tender option), from the perspective of the borrower, is the same as a maturity date, and so the borrower is willing to treat the bond as a short-term bond. For example, if the bond purchaser has the right to put the bond every 7 days, and that put right is properly secured, even if the nominal maturity of the bond is 30 years, the bond purchaser will price the bond as it has a maturity of 7 days and not 30 years.


Often an issuer will need to purchase credit support from a credit enhancement/liquidity provider to stand behind the put. This is usually in the form of a letter of credit or stand-by bond purchase agreement. The cost of such credit enhancement is generally viewed as additional interest and added to the actual interest amount to determine an all-in interest cost. Also, the issuer or conduit borrower will need to hire a remarketing agent to remarket the bonds if they are put, and the cost of such remarketing agent is also calculated as part of the all-in interest cost.

The typical VRDB structure provides for the interest rate on the bonds to be reset on each put date to a market rate for the reset put period. Thus, if the put option can be exercised weekly, the interest rate on the bonds typically will be reset weekly to a market 7-day rate. Usually a remarketing agent (often the underwriter) will determine the periodic rate based on current market conditions. Pre-established market indices can be used but usually are not used because of concerns about accuracy. When the rate is reset, the current bondholders can either retain their bonds or tender them for repurchase at par. The remarketing agent remarkets to new purchasers any bonds tendered.

Contrast this structure with a dutch auction remarketing, where there is no guaranteed put, instead the bonds are only purchased if there is a willing purchaser.

B. Risks of Variable Rate Demand Bonds.

From the perspective of the borrower, VRDBs can be a great deal. From an historic perspective, over the life of the deal, payments on VRDBs are lower than payments on fixed rate debt. So why aren’t all bonds VRDB’s? Because of the (potentially large) risk of rising short-term interest rates. Example: suppose the VRDB rate is initially 2.5% (with the long-term rate 5%), but rates start moving upward. As long as the short-term rate remains at or below 5% (including costs) for the borrower, it’s still a good deal. But what happens if short-term rates plus other costs move above 5%? At that point, long-term rates might be at 8% or even higher rates and the issuer will be stuck with that higher rate for the long-term (“that 5% would sure look good now”). This explains why some issuers (especially public bodies) prefer fixed rates (the “sleep at night” factor). Also, if the yield curve inverts, the issuer could end up paying more for short-term paper than for long. VRDB’s generally can be converted (or refunded) with long-term debt instruments, so the issuer could “go long” if interest rates start to rise - but when is the right time?

C. Variable Rate Bonds Without Put Options.

Variable rate bonds do not have to have a put feature; rather, their rate can simply “float” with market rates. This is attractive to the purchaser if the purchaser fears rising rates and attractive to the borrower if the borrower thinks rates will decline.


This type of bond is common in the taxable area (bonds backed by variable rate single family mortgages) but uncommon in the municipal area.

D. “Multi-Modal” VRDBs.

Some VRDBs permit interest rates to be set on the basis of more than one interest rate period (e.g., daily, weekly, monthly, commercial paper). The issuer or conduit borrower has the option to switch or convert among these periods or “modes” depending upon market outlook at the time of the adjustment.

E. Secondary Market VRDBs.

VRDBs also can be created in the secondary market by taking a fixed rate bond and selling it together with an attached put option. This is not an uncommon technique used by underwriters with respect to many types of municipal fixed rate bonds. The resulting VRDB is typically sold to a tax-exempt money market fund; the remaining “spread” (between the fixed interest rate and the variable rate plus costs) is retained by the underwriter or sold as an “inverse floater.”

F. Reissuance.

Tender rights and changing interest rate modes raise the question of whether under federal tax laws a “reissuance” of the bond has occurred. These rules can cause severe heartburn and must be carefully considered in structuring a VRDB. “Qualified tender bonds” generally avoid reissuance - basically the terms have to be set up in advance for tenders and conversions. See IRS Notice 88-130 and Treasury Regulations Section 1.1001-3 (the “reissuance regulations”), as well as subsequent IRS notices such as those following in the wake of the financial crisis which began in 2008.

VI. BRIEF OVERVIEW OF CREDIT ENHANCEMENT

A. In essence, the higher rating of the credit enhancement provider is relied on by investors instead of the underlying rating of the issuer or conduit borrower, so that the investors will demand a lower interest rate, more than compensating for the cost of the credit enhancement. Normally, credit enhancement only makes sense where the savings from the credit enhancement exceed the cost of the credit enhancement or where the credit enhancement facilitates the sale of a bond issue that would not otherwise be possible. Generally, the issuer or conduit borrower selects the credit enhancement provider with advice from the underwriter or financial advisor.

B. Credit Enhancement Provider. Credit enhancement provider and credit provider are terms describing any entity that guarantees or insures in one form or another the payment of debt service on the bonds. A credit enhancement provider may be a bank providing a letter of credit or stand-by bond purchase agreement or a bond insurer providing a bond insurance policy, a debt service reserve fund surety policy, or, in the case of certain types of bonds to finance lending programs, the


credit enhancement provider may be a savings and loan association, a mortgage insurer, a federal agency or a private guarantor. In each case, the purpose of the credit enhancement is to provide, for a fee, additional security for the bonds that improves the credit rating of the bonds and thereby lowers the borrowing costs to the issuer or conduit borrower

C. Types of Credit Enhancement Documents.

1. Reimbursement Agreement (for letters of credit). Parties: issuer or conduit borrower and letter of credit bank (and trustee in some cases). The Reimbursement Agreement appears in transactions involving a letter of credit (sometimes called a credit facility) guaranteeing payment on the bonds. It is fairly typical for the letter of credit to be a direct pay letter of credit meaning that the letter of credit is drawn upon any time that principal or interest is due on the bonds. In turn, the reimbursement agreement provides for the obligation of the issuer or conduit borrower to repay the letter of credit bank for amounts drawn under the letter of credit to pay debt service on the bonds. Terms and conditions vary depending upon the type of transaction involved. Important provisions include representations and warranties, fees payable to bank (including “increased costs” provisions), ability of bank to “participate” the credit facility to other banks, renewals and extensions of the credit facility, default and remedy provisions, including any “term-out” provisions, collateral provisions and choice of law provisions.

2. Bond Insurance Policy. For a premium (generally paid upfront from the proceeds of the bond issue), a bond insurer will insure timely payment of principal of and interest on the bonds when due. Bond insurance is typically a contingent obligation of the bond insurer – meaning that the bond insurer only pays under the policy in the event that the issuer or conduit obligor/borrower default in its payment obligation. In the event of a payment by the bond insurer, the bond insurer becomes subrogated to the rights of the bondholder that was paid from the bond insurance proceeds. The bond documents generally contain additional covenants specifically required by the bond insurer and enforceable by the bond insurer as a third-party beneficiary.

3. Debt service reserve fund surety bonds or reserve policies – These are typically issued by bond insurers for an upfront premium as an alternative to funding a debt service reserve fund with cash and investments. If, under the bond documents, a draw is required to be made on the debt service reserve fund, such payment will be made by the bond insurer. Typically there is a reimbursement agreement between the bond insurer and the issuer or conduit borrower that would require the bond insurer to be reimbursed in much the same manner as the issuer or conduit borrower would be required to replenish a draw on a cash-funded debt service reserve fund.


VII. BRIEF OVERVIEW OF DIRECT BANK PLACEMENTS (“DPs”)

A. In recent years, new banking regulatory requirements and other market conditions have resulted in a shift from the use of VRDBs – in many cases replaced by the use of direct bank placements or DPs.

B. In a DP transaction, instead of a bank charging a fee to put up a credit facility to support a publicly offered VRDB issue, the bank will simply purchase the bond as an investment for its own portfolio.

C. In doing so, the letter of credit fees (which is taxable income to the bank) is replaced by interest payments (which is tax-exempt interest assuming that it has purchased a tax-exempt bond).

D. DPs may be structured as fixed rate or variable rate bonds with interest based on a percentage (generally somewhere around 67%) of the one-month LIBOR rate plus a credit spread (which is somewhat akin to the letter of credit fee in a VRDB transaction). It is also typical to provide to the bank the right to put the bonds back to the issuer for mandatory purchase at the end of some negotiated terms (e.g. 5 years).

E. In addition to the standard bond documentation, there is generally a separate credit agreement or continuing covenants agreement between the bank purchaser and the issuer or conduit borrower setting forth additional representations and warranties, additional payment obligations and other covenants for the benefit of the bank (similar to the terms of a reimbursement agreement in a VRDB transaction).

VIII. INTEREST RATE SWAPS (AND OTHER DERIVATIVES)

A. In General.

The term “derivative” generally refers to a financial product in the form of a contract (e.g., an interest rate swap) that “derives” its economic characteristics from something else (e.g., the level of an interest rate index). Depending on the context, the definition of the term can be very broad, and would include many alternative debt instruments, such as strips, synthetic floaters and tax-exempt municipal bond funds.

B. Interest Rate Swaps.

In its usual form, an interest rate swap is a contractual arrangement in which each of the two contracting parties (the swap “counterparties”) agrees to pay to the other an amount equal to the interest on a specified dollar amount (the swap “notional amount”), which may or may not equal the amount of debt incurred by one of the counterparties. These arrangements are typically implemented concurrently with a debt transaction in order to hedge interest rate risk or to produce lower overall borrowing costs. Below is an example of how two issuers


might accomplish their investment objectives by entering into an interest rate swap:

1. Counterparty A is about to issue $1,000,000 of tax-exempt debt with a floating rate of interest, initially set at 3%. Counterparty B is the obligor on $1,000,000 of tax-exempt debt with a fixed 6% coupon.

2. A wishes to limit its risk that interest rates will rise to a level that would be uncomfortable, while B wishes to take advantage of the current low interest rate environment by “converting” part of its fixed rate debt to floating rate debt.

3. A’s investment banker (or some other swap broker) arranges to have B pay to A an amount equal to interest due on $500,000 of A’s debt. In return, A agrees to pay B an amount equal to the interest on $500,000 of B’s 6% fixed rate debt. For convenience, the payments are netted. From a cash flow standpoint, both A and B are now in the position of having $500,000 of 6% fixed rate debt and $500,000 of floating rate debt. The notional principal for the swap is $500,000.

4. In the arrangement described above, it is not necessary that either party actually be obligated on a debt instrument. Indeed, the swap is a separate contractual relationship between the counterparties, and even if executed concurrently with a bond issue, the swap does not in any way affect the contractual relationship between the issuer and the bondholders.

5. Risks inherent in a swap transaction include:

a. Basis Risk. Risk that floating rate debt payments may not match the swapped floating rate receipts.

b. Tax Risk. Risk that transaction becomes taxable and rate increases dramatically.

c. Termination Risk. Risk that issuer may have to pay substantial fee to terminate swap if necessary.

d. Counterparty Risk. Risk that the counterparty fails to pay or defaults.

C. Other Interest Rate Hedges.

Interest rate swaps generally are used to hedge interest rate risk. In addition to swaps, as described above, floating rate transactions often are accompanied by interest rate caps, floors or collars obtained from an unrelated third party. For example, an issuer familiar with interest rate hedges may, based on then existing market conditions, compare the all-in borrowing costs of a fixed rate bond issue with the all-in borrowing costs of a variable rate bond issue accompanied by an


interest rate cap, floor or collar. The basic functions of a cap, floor and collar are described below:

1. Interest Rate Caps. This is a notional principal contract in which an issuer of floating rate debt pays a cap premium (either up front or in annual installments) to purchase the cap. In return, the issuer receives a payment from the counterparty if the floating rate on the issue exceeds a specified rate (the “strike rate”).

2. Interest Rate Floors. This is conceptually the opposite of an interest rate cap. Here an issuer of floating rate debt sells the floor at a specified floor or strike rate. The issuer receives an upfront payment from the counterparty, in exchange for which the issuer agrees to pay an amount equal to the excess, if any, of the strike rate over the floating rate on the bonds.

3. Interest Rate Collar. This is essentially a combination of an interest rate cap and an interest rate floor. It can be structured at no cost to the issuer in certain cases.

Like swaps, interest rate caps, floors and collars are separate agreements between the counterparties that do not alter the underlying contract between the issuer and bondholders.

D. Other Derivative Products.

1. Forwards. A contract in which one party agrees to purchase something (e.g., a security) in the future for a specified amount. For example, an issuer that cannot advance refund an issue could use a forward purchase agreement to “sell” a current refunding issue significantly before its actual issuance, thus locking in a favorable interest rate.

2. Options. This is a contract in which one party pays for the right --but not the obligation--to purchase (a call option) or sell (a put option) a security in the future for a specified price.

3. Sale of Call Right. This is a contract in which the issuer receives an up-front payment from the existing bondholders in exchange for a waiver of the call feature. The payment is an amount equal to the difference between the current price of the bond priced to the call date and the current price of the bond priced to maturity. For arbitrage rebate purposes, payment of the call waiver causes a recomputation of bond yield as if the bond were reissued.


IX. DEPOSITORY TRUST CORPORATION

A. DTC (“Cede & Co.”) is typically the only registered Bondholder to the Trustee.

B. DTC Participants are registered and typically are underwriting and investment firms.

C. See outline and materials relating to “Demystifying DTC & Other Issues Related to Closing.”

X. REFUNDING BONDS

A. What is a Refunding?

1. A refunding involves the issuance of new bonds, the proceeds of which are used to pay debt service (principal, interest and call premium, if any) on other bonds. If the refunded bonds are not immediately retired upon issuance of the refunding bonds, the refunding bond proceeds usually are placed in a defeasance escrow to provide for the payment of the refunded bonds.

2. If a defeasance escrow is established, the proceeds of the refunding bonds must be deposited into an escrow fund and invested at a yield sufficient for the escrowed amounts, plus investment earnings thereon, to pay all debt service on the refunded bonds through their call or retirement date. When a defeasance escrow is established, the refunded bonds are defeased. This means that bondholders no longer have the right to seek payment from the issuer or from the original security for the bonds and must look solely to the escrow for repayment.

B. Defeasance.

1. What is a Defeasance?

a. A defeasance involves (i) a formal release of all security pledged under a resolution or indenture (for the benefit of the bondholder) as security for particular bonds in exchange for (ii) a pledge of cash or securities sufficient to repay those bonds. A defeasance can be accomplished with an issuer’s cash, with refunding bond proceeds, or with proceeds of other indebtedness.

b. The specific procedures required to defease bonds are established by State law and by terms of the resolution or indenture.


c. An issuer sometimes must enter into a separate escrow agreement in order to establish a defeasance escrow, rather than doing so under the terms of the resolution or indenture.

d. Most resolutions and indentures require, as a condition to defeasance, that the issuer obtain a legal opinion to the effect that (i) the tax-exemption on the bonds being refunded will not be adversely affected by the defeasance, and (i) all requirements for defeasance under the resolution or indenture have been satisfied.

e. If the refunded bonds (or prior issue) cannot be legally defeased or if the defeasance requirements in the resolution or indenture cannot be fully satisfied, the prior issue may nonetheless be defeased on an economic basis if sufficient securities or cash are deposited in an escrow to retire the bond. This will enable the issuer or borrower to remove the debt from its balance sheet but will not release the lien of the resolution or indenture.

f. The cash flow generated by a defeasance escrow must be verified (usually by a certified public accountant) as to mathematical accuracy and sufficiency to defease the prior bonds.

g. State law, the applicable resolution or indenture, or both, typically limit the types of investments that can be used in a defeasance escrow. Permitted investments typically include cash, U.S. Treasuries, or SLGS (State and Local Government Series of Treasury Obligations created specifically for issues of tax exempt bonds). Regulations for the purchase of SLGS are found at 31 CFR Part 34, Department of the Treasury Circular, Public Debt Series 3-72.

2. Types of Defeasance.

a. Net Defeasance -- The net cash refunding defeasance is the most common type of refunding. The proceeds of refunding bonds are placed into an escrow and invested at a yield not in excess of the yield on the refunding bonds. The proceeds of the refunding bonds, plus earnings thereon, are sufficient to pay the principal, interest and call premium, if any, on the outstanding prior issue as and when due. Issuance costs and administrative costs must be paid from refunding bond proceeds, from the escrow’s cash flow, or from separate funds of the issuer or borrower.

b. Full Cash Defeasance – This type of defeasance is also known as a gross defeasance or gross refunding. A full cash defeasance generally is undertaken only if a defeasance of the refunded bonds is


required and the prior resolution or indenture requires an initial deposit to the escrow in an amount equal to the full amount of the principal, interest and call premium on the prior bonds, disregarding any interest that may be earned on the refunding escrow. This method is not used frequently anymore because complex investment and issuance rules limit the benefits of such a transaction. Typically used only if required by applicable documents or local law or in a current refunding context and SLGS are not available to be purchased.

c. Defeasance without a refunding -- Bonds may be defeased without being refunded with new bonds. Instead, an issuer can use its cash to defease the bonds. If the bonds are not yet callable, the issuer can defease the bonds by establishing a defeasance escrow.

3. Verification of Amounts. An independent verification report is usually required to be delivered in order to have a legal defeasance. Such report will state that the proceeds of the refunding bonds, plus earnings thereon, are sufficient to pay the principal of and interest and call premium, if any, on the outstanding prior issue when due and payable, and will also reflect the yields on the bonds as well as the yield on the investments.

4. Variable Rate Bonds. If the bonds bear interest at a floating interest rate, the bond documents will most likely require that the amount set aside in the escrow be funded at an amount necessary to pay principal, premium and interest at the maximum interest rate.

C. Tax Law Considerations

1. Current Refundings - refunding bonds issued within 90 days prior to the date the refunded issue is retired.

2. Advance Refundings - refunding bonds issued more than 90 days prior to the date the refunded issue is retired.

a. New money bonds issued after 1985 may only be advance refunded once.

b. New money bonds issued prior to 1986 may be advance refunded twice (although all advance refundings if an original new money issued prior to March 15, 1986, will be treated as only one advance refunding for the two-refunding limit).

c. Only governmental or 501(c)(3) bonds are eligible to be current or advance refunded. Private activity bonds can be only current refunded.


3. Proceeds of the refunding bonds are subject to yield restriction based on the yield on the refunding issue.

4. Under tax law, the issuer must redeem refunded bonds if the advance refunding creates present value debt service savings (first call date rule to limit the amount of the tax-exempt bonds in the market):

a. For refunded bonds issued before 1986, at the first call date at 103% or lower; or

b. For refunded bonds issued after 1985, at the first call date.

D. Other Considerations

1. Refundings for Debt Service Savings – New bonds are issued at lower interest rates than the refunded issue, thereby reducing debt service and providing savings to the issuer.

2. Refundings for Other Reasons – New bonds may be issued to refund an outstanding issue for reasons other than debt service savings (e.g., in order to restructure an issue, to pay off an issue that contains overly restrictive covenants, or to extend or restructure debt service).

3. Mechanics – It is important to review the requirements of the resolution or indenture for the bonds being refunded to determine the applicable restrictions, if any, upon redemption (e.g., notice requirements, conditions to redemption, redemption date restrictions, etc.).

XI. ECONOMICS TO CONSIDER IN A REFUNDING

A. Debt Service Savings.

1. Usually, the higher the interest rate on the refunded bonds relative to today’s market, the greater the savings.

2. The earlier the call date on the refunded bonds, the greater the savings.


B. Redemption Provisions

1. Optional call provisions with respect to the bonds being refunded will govern whether you have a current or advance refunding (by determining whether or not the refunded bonds can be called for redemption within 90 days after the issuance of the refunding bonds). An example of a call provision is set forth below.

Optional Redemption. The Bonds maturing on April 1, 2024 or thereafter, will be callable for redemption in full on or after April 1, 2023, at the redemption prices, expressed as a percentage of the principal amount of the Bonds redeemed, as set forth below, together with accrued interest to the date fixed for redemption:

Redemption Period Redemption Price

April 1, 2023 to March 31, 2024 100.50% April 1, 2024 and thereafter 100.00%

Based on this language, for example, refunding bonds issued on March 1, 2024 could be used to current refund these Bonds at 100.00%; refunding bonds issued on March 1, 2023 could be used to current refund these Bonds but only with a redemption price of 100.50%; and refunding bonds issued on June 30, 2022 could be used only to advance refund these Bonds with the redemption occurring on April 1, 2023 at a redemption price of 100.50%.

2. The longer the period between the call date of the refunded bonds and the maturity date of the refunded bonds, the greater the interest savings generated for the issuer or borrower.

C. Escrow Investment Yield and Other Factors

1. Escrow investment yield is determined by the market.

2. Escrows are typically invested in (i) SLGS ordered from the Bureau of Public Debt or (ii) U.S. Treasury Obligations, but only if they are purchased at fair market value at or below the bond yield and have a better yield than SLGS.

3. Under federal arbitrage rules, an issuer may not invest the portion of the escrow funded with the refunding bond proceeds at a yield above the yield on the refunding issue. Thus, if the market rate for the escrow Treasuries is 7% and the yield on the refunding bond is 6%, the issuer is limited to a 6% rate of return on the refunding escrow. This is generally accomplished via the purchase of special low-coupon U.S. Treasury Obligations called


“SLGS”. If market rates are at 5%, the issuer will earn only 5%. The difference between the 5% market rate and the 6% maximum permitted rate is known as “negative arbitrage”.

4. Costs of issuance and the amount of call premium, if any, will affect the savings.

5. Federal tax laws (e.g., rebate) may impose economic costs on refundings.

6. Many issuers establish target savings levels that they use to determine whether to refund outstanding bonds, and different issuers may use different criteria to define target savings. These criteria may include the absolute dollar amount of interest rate savings; the percentage level of debt service savings (expressed as a percentage of refunded or refunding bonds), or both. Percentage savings tests vary widely. In addition, notwithstanding the level of potential savings that may be derived from refunding a particular bond, the absolute dollar level of savings may not make it worthwhile for an issuer to undertake the time, expense, and effort of issuing the refunding bonds, even if the percentage level of savings is high.

XII. CLOSING AND TAX CERTIFICATES AND AGREEMENTS:

A. Various parties.

B. Transcripts.

1. Recall the history of bond counsel opinions stating “based on the transcript we have reviewed …”

a. Thus, the transcript should contain material backing up the opinion.

b. Obviously some is left out - statutes and IRS regulations, for example - but a good transcript has everything in it that is necessary for a layman to review and understand the bond opinion with the exception of materials otherwise publicly available.

2. The transcript will also contain the basic documents that contain the terms of the transaction -- the primary agreements and instruments that set forth the bond transaction’s covenants and terms. It’s a pretty handy way of memorializing in an easy to use (relatively) fashion the documents that are needed during the life of the deal. The transcript will also contain those documents with the state law, tax and securities requirements pertaining to the issuance of the debt.


3. Also, in effect, with the proper covering materials, a transcript has everything in it that would enable a trial judge to rule on a summary judgment motion as to the validity of the bonds.

4. Typical groupings:

a. Basic Financing Documents

b. Documents and Proceedings of the Issuer

c. Documents and Proceedings of any Approving Agency

d. Documents and Proceedings of the Borrower

e. Closing Documents

f. Documents of the Trustee

g. Legal Opinions

h. Miscellaneous

C. Tax Regulatory/Compliance Agreement or Arbitrage Certificate - Contains certifications required to be made by the issuer and the borrower (in most cases) to satisfy the Tax Code provisions and regulations. It often contains elections required under the Code to be made at the time of bond issuance. Often, the certificate will describe the rules applicable to investment of the bond proceeds, as well as the issuer’s and borrower’s obligations as to rebate compliance and use of the funds.

D. Closing documents - Those certificates, receipts, directions, requests, and requisitions that are delivered at closing. These generally (i) document the factual representations required by the purchase contract and the accuracy and completeness of “expertized” portions of the disclosure (feasibility reports and appraisals), (ii) document compliance with legal requirements (statutory, local resolution and contractual) for the issuance of the bonds (including effectiveness of resolutions, due execution of documents); (iii) document the flow of funds at closing - the deposit and receipt of bond proceeds, investments of funds, payment of costs, defeasance of prior bonds (for refundings), and (iv) instruct parties to take certain actions upon closing - deposit funds into accounts, record documents, file reports, release security (for refundings) and the like. Often, these certificates provide the factual basis for bond counsel’s opinion. Important parts are especially those that specify amounts for receipt and deposit of funds, accuracy of representations, warranties, certifications, elections, and requisitions (to determine correctness of payments, deposits and transfers), as well as allocation of proceeds, useful life calculations and good cost/bad cost issues.


E. Deciding On Documents To Be Used

All of this is from the “ground up” and ignores the reality that every young attorney or legal assistant in this work is given a “go by” the first time. But the hope is that an understanding of the precepts here will allow a better analysis of what has to be changed in each transaction.

1. Figure out each substantive action, task or duty that has to be done in the transaction - e.g., paying the purchase price, holding the proceeds prior to use, investing the proceeds, paying out the proceeds, paying in the receipts, revenues or debt service payments, holding such payments, paying out such payments, holding a lien on real property as security, maintaining the project, etc. (the list could be quite long if detailed - possibly over one hundred tasks in a single transaction).

2. Figure out which party has to perform each task.

3. Figure out which party wants to be an assignee or beneficiary of the promise to do a task.

4. Group the tasks by who has to agree to perform - that is, if you imagine all the tasks are written on separate pieces of paper, put each slip in a pile for each party that has to agree to it. If multiple parties have to do a task, prepare multiple slips. Each party must be a signatory to all the documents which cover any task in its pile.

5. Then group the tasks by who has to be able to rely on those tasks being completed. The pile now in front of a party means it has to be a signatory to, an assignee of, or a third party beneficiary of each document which covers a task in its pile. If this is not true, that party will not be able to enforce all of the duties owed to it.

6. Next group the tasks required to be discussed in the same document because of federal or state law - for example, state property recordation laws will mandate some tasks be on the public record and they should be grouped that way.

7. Now go back and look at all the groupings to decide how many major documents you need. Usually this means one to deal with the money with the rights therein being for the benefit of the creditors - an indenture or trust agreement, etc.; at least one dealing with property security (whether there is more than one usually depends on the level and number of assignments and the state law); probably one dealing with the obligations of the borrower to maintain the facility financed or pledged as security; one to be used as an offering document if required; and one talking about the sale of the debt.


8. Once through this exercise you will probably end back up very close to a familiar structure but now you will understand why it is the way it is.

9. Just because it is done one way, that does not mean it cannot be done another -arbitrage expectations used to be in the indenture.

XIII. OTHER OBSERVATIONS ON DOCUMENTATION

A. Plain English and related matters: a “top ten” of good drafting techniques:

1. Use plain English, not jargon (SEC on plain English);

2. Use the active voice;

3. Avoid inconsistencies (if a phrase works, use it);

4. Avoid legal gobbledygook (“heretofore,” etc.);

5. Make efficient use of defined terms (neither over or under use);

6. Avoid weak verbs;

7. Avoid abstractions;

8. Use shorter sentences;

9. Avoid unnecessary details; and

10. Use modern tools - multiple fonts, different type styles, color, etc. If not taken to an extreme, these can be very effective.

B. Other good document practices

1. Keeping drafts through the closing.

2. Having a good document retention program in place for after the closing.

PART II: FINANCIAL ASPECTS OF MUNICIPAL BONDS

I. BASIC FINANCIAL CONCEPTS AND TERMS

A. Yield vs. Interest Rate.

Interest rate and yield are different concepts. Interest rate (sometimes called the “coupon rate”) is the amount of interest paid or accrued on bond principal. Yield is the “true” economic return of the bond that takes into account the amount paid for a bond, when paid, and the amounts received from the initial investment in the


bond, based on a designated compounding interval. For a typical fixed rate bond, the compounding interval is semiannual since the typical current interest fixed rate bond pays interest on a semiannual basis. Mathematically, yield is the rate of interest, or the “discount rate,” equal to that rate which, if used to present value all interest and principal payments on the bond, would equal the purchase price of the bond, using the designated compounding interval.

Alternatively, using a future value approach, yield is the rate which, if applied to the purchase price and compounded at the designated interval, would equal the aggregate payments of principal and interest with respect to the bond.

The above describes the actuarial approach to computing yield.

In pricing a bond, and in arbitrage and rebate tax calculations, the concept of yield is used, with a number of special tax adjustments (e.g., adjustments for credit enhancement). Another term for yield is “true interest cost” or “TIC,” which is not to be confused with “net interest cost” or “NIC” (which excludes adjustments).

The yield on a debt instrument will vary according to the perspective of the person doing the calculation. Thus, to the borrower (the issuer or conduit borrower) the true yield, or cost, will reflect costs of issuance, and costs paid to third parties (e.g., bond trustee, credit enhancer), as well as the interest rate on the bonds (also sometimes called the all-in true interest cost or effective interest cost).For the bond purchaser (the lender), however, the yield is a function only of what it receives relative to what it paid for the instrument. Thus, from the issuer’s perspective, the yield (cost) generally will be higher than the yield viewed from the perspective of the bond purchaser.

Yield is quoted as a percentage - say 5.00% - but because 1 percentage point of yield each year is a very big number (1% of $10 million is $100,000), yield movements are often referred to in “basis points,” there being 100 basis points for each percentage point of yield. “The market moved 10 basis points today” means the market moved one-tenth of one percent.

Distinguish “points” that generally refer to a percentage of principal amount of the bonds (as in the issuer paid 2 points (2% of bond principal) to the underwriters for underwriting the issue, or each lender in the pool will be charged “one point” to participate, or the points you may pay on your mortgage).

Distinguish payments in “dollars per bond,” which refer to payments per $1,000 of bond principal (as in, the underwriter may suggest underwriter’s compensation of $7 a bond, and the financial advisor/issuer may propose compensation of $5 a bond … this really means 0.70% and 0.50% of the principal amount, respectively).


B. Yield vs. Price.

REMEMBER THIS BASIC CONCEPT – When interest rates are fixed, bond yields and prices move in opposite directions. For any existing bond, if market interest rates rise, the price of the bond goes down. That’s because if a bond pays 6% and market rates rise to 7%, a buyer will pay less to buy that bond in order to achieve a 7% market return. One general rule of thumb for 30 year bonds is that for every increase or decrease of 0.125% or 12.5 basis points in market yield, the price will decrease or increase by 1% of principal. When you hear, “bonds are cheap,” that means (at least to the buyer) that yields are relatively high and prices are relatively low.

Bond prices are quoted in different ways. For example, United States Treasury Bonds are quoted in 32nds (hence, a quote of 98.25 is 98 25/32). Municipal and corporate bonds are traded in decimals so that a 98.25 quote is 98 25/100.

C. Spreads.

1. Municipal/Treasury Spread. Since municipal interest is generally tax-exempt, it would make sense that if U.S. Treasury Bond rates were at 6%, and the effective marginal tax rate of a taxpayer is 40%, that a municipal bond would trade at roughly 60% of 6% plus a bit more (say 0.75%, because U.S. Treasury Bonds are perceived as better credits), for a total yield of 4.35%. But, in general, municipal bonds trade at yields much higher than seems logical. Probably, this is due to the lack of liquidity in the municipal market (much lower volume compared to the Treasury or corporate bond markets) and investors’ fear of loss or diminution of tax exemption (e.g., flat tax leading to lower marginal rates).

2. Credit Spread. The credit characteristics (usually determined by ratings) will also affect the yield of a bond. In general, the lower a bond is rated the higher its yield. This is generally expressed in terms of credit spread (i.e., the additional yield over the yield applicable to a broad index of AAA rated tax-exempt bonds).

3. Bid/Ask Spread. As with any security, a dealer in that security is compensated by a bid/ask spread. In other words, the amount that the dealer will pay for a security (the bid) is something less than the price at which the dealer will sell that security (the ask). Credit quality and type of bond can affect the bid/ask spread.

D. Par, Discount and Premium Bonds.

1. “Par” Bonds. A bond has a stated par amount or principal amount and represents the issuer’s promise to repay such amount plus interest at a specified interest rate until maturity. Thus, if a $1,000 bond bears interest at 5% per year, the holder is entitled to receive $50 in interest per year until maturity. Interest is usually paid semiannually, but can also be paid


annually, quarterly, monthly, weekly or even daily. If a 5% bond were purchased at par (i.e., for $1000), its yield would be 5%.

2. “Discount” Bonds. If the same bond is purchased for less than its par amount, i.e., at a “discount” to par, its interest rate is still 5% but its yield exceeds 5% because the bond principal is repaid at the par amount--the return on the bond reflects not only the interest paid but also the “discount” amount. Thus, the discount, when repaid, is a “yield kicker” and will increase the yield on the bond to something in excess of 5%.

Bonds originally issued at a discount are said to be issued with “original issue discount” or “OID.” Bonds bought in the secondary market at a discount are said to have a “market discount.” These terms have specialized meanings under the federal tax code. OID is treated as tax-exempt interest; market discount is taxable income. Gain or loss on sale of tax-exempts is taxable income, usually capital gain or loss.

3. “Premium” Bonds. For the same 5% bond, if it is purchased at a price above par, i.e. a “premium,” the bond yield would be less than 5% because interest is paid only on the par amount. As discussed regarding discount, bonds can be issued with “original issue premium” (or “OIP”) or bought in the secondary market with a “market premium.” The premium is amortized over time as a deduction from the interest received. As with discount, there are special federal tax rules for the treatment of premium.

E. “Yield Curve” and Duration.

Yield is usually a function of the “term” or “duration” of the bond, that is, the time it takes to repay the principal of the bond.

Typically, long-term interest rates are higher than short-term interest rates. This is because lenders require a higher rate of return as an incentive to commit to a longer term investment and its attendant market and credit risks. When interest rates are charted on a graph as a function of term to maturity, the normal resulting curve (“yield curve”) generally moves upward with the term to maturity of the bonds. Generally, the curve begins to “flatten” at some point (e.g., around 10 years) and thereafter the yield pretty much stays the same. Thus, most structuring matters that involve the yield curve occur in the first 10 years. That is why serial bonds (usually with maturities of 1 to 10 years), which require lower interest rates than bonds with longer maturities, are used, as opposed to term bonds (with sinking funds or mandatory redemption of principal before their stated maturity) or bullet bonds (with no sinking funds).

To ensure that bondholders will get expected return, bondholders usually receive call protection (i.e., no redemption) for a number of years. Because yield curve starts to flatten out at ten years, most bonds are callable by that time.


On occasion, the yield curve flattens out; that is, short-term rates become as high as or higher than some longer term rates, usually due to excess supply of short-term obligations or uncertainty of investors during the short-term. If short-term rates actually exceed some longer term rates, there is said to be an “inverted” yield curve.

Duration refers to the time it takes to pay back principal. If a bond with a 10-year maturity pays all principal in 10 years then its duration is 10 years. But if principal is paid over time, then terms weighted average life and weighted average maturity are used. The terms refer to the average time it takes for a bond to repay its principal, taking into account (i.e., “weighting”) differing levels of principal paid in each year. For bonds secured by prepayable collateral (student loan and single family bonds), these concepts are particularly important because a wise buyer will price the bond based on its expected life derived from expected prepayments on the underlying collateral.

F. Yield to Maturity (YTM) vs. Yield to Call (YTC).

YTM is the yield of an issue calculated from the issue date or purchase date to the maturity date (taking into account mandatory redemptions and expected redemptions (e.g., from prepayable collateral)). YTC is the yield to a particular call date, usually the optional call date that produces the lowest yield. Typically, bonds are sold (or “priced”) at a price equal to the lower of the YTM or the YTC.


•2016 FUNDAMENTALS OF MUNICIPAL BOND LAW SEMINAR

General Session: Basic Structure & Documentation & Financial Aspects of Municipal Bonds


Why Are We Here?

To understand the basic elements, financial aspects and law relating to the issuance of

municipal bonds.


What is a Municipal Bond?

• Debt instrument

• A security

• An obligation



General Session: Basic Structure & Documentation & Financial Aspects of Municipal Bonds


Why Are We Here?

To understand the basic elements, financial aspects and law relating to the issuance of

municipal bonds.


What is a Municipal Bond?

• Debt instrument

• A security

• An obligation


Debt Instruments Typically Specify –• an obligation to pay

• a stated amount (the “principal”)

• at a given time (the “maturity”)

• with interest at a stated rate.


Four Important Areas of Law

• Securities Law 1933• Tax Law 1913• State Law 1783• Law of Contracts (yore)


Four Key Questions• What is the agreement?• Is it valid under state law?• Is it tax-exempt?• What are the securities law implications?

These questions are key considerations in rendering the bond opinion. Bond Counsel bases the bond opinion on an examination of material legal and factual sources regarding the subject addressed therein.



Lender (loans $)

Borrower (borrows $)

$ Loan Proceeds $ Loan Repayments

(usually evidenced by a note)

Basic Debt Transaction


$ Bond Repayments

(usually evidenced by a Bond)Bond Issuer (Governmental)

(borrows $)

$ Bond Proceeds

Basic Municipal Bond Transaction

Bondholders (“purchasers”)(loans $)


Basic Municipal Bond Transaction

$ Bond Debt Repayments

Bond Issuer (Governmental)(borrows $)

$ Bond Proceeds

Bondholders (“purchasers”)(loan $)

Paying Agent(acts in an agency

capacity for the Issuer)



Why An Issuer Uses Tax-Exempt Bonds

Taxable Rate 7.00%

Multiply by 1 minus marginaltax rate (assume 33%) x .67

Tax-exempt Rate 4.69%

Annual Interest Example

Taxable: $10,000,000 x 7.00% = $700,000Tax-Exempt: $10,000,000 x 4.69% = $469,000On $10,000,000, savings would be $231,000 in the first year alone.


Why An Investor Buys Tax-Exempt Bonds

Taxable Bond Rate 7.00%Tax-exempt Rate 4.69% Investor’s Assumed Tax Rate 33%

$10,000,000 Bond Example

Interest Income Tax Liability Net Interest Income

Taxable: $700,000 ($231,000) $469,000

Tax-Exempt: $469,000 N/A $469,000


A Brief Detour:Tax Credit and Direct Subsidy Bonds

• Low cost financing for targeted assets or programs

• Instead of tax-exempt interest, IRS permits:

• Federal income tax credit to bondholder

• Direct subsidy payment to issuer

• Most provisions have expired, but could be revived



Anatomy of a Transaction

1. Initial Communications and Analysis

2. Deal Team

3. Bond Documents

4. Bond Sale

5. Closing


Initial Communicationsand Analysis


Initial Communications & Analysis

• What is the deal being proposed?• What is the security/source of payment?• Initial Due Diligence – tax and disclosure• Timeline of required actions & hearings• Ethical obligations

• Who is your client?• Engagement letter



Anatomy of a Transaction

1. Initial Communications and Analysis

2. Deal Team

3. Bond Documents

4. Bond Sale

5. Closing


Initial Communicationsand Analysis


Initial Communications & Analysis

• What is the deal being proposed?• What is the security/source of payment?• Initial Due Diligence – tax and disclosure• Timeline of required actions & hearings• Ethical obligations

• Who is your client?• Engagement letter


The Project• State Law Concerns

• Is the Project within the issuer’s jurisdiction?• Are there limitations on the client’s ability to

purchase/finance the Project?• What approvals are required?


The Project (cont.)• Initial Tax Inquiry

• Who will own/use/manage the Project?• Does the Project require volume cap?• What is the anticipated timing of expenditures (use

of bond proceeds)?


The Project (cont.)

• What is the appropriate security for the Project?

• Will the Project produce revenue?• Will the Project produce net revenue?• Will the net revenue be sufficient?• Is another source of funding readily available?



Types of Security• General Obligation• Special Taxes or Assessments• Revenue Pledge

• Utilities• Airport• Hospitals

• Leases or Installment Payments• Payments from Conduit Borrowers• Additional Security

• Mortgage/Security interest in specific assets• Credit Enhancement


General Obligation Bonds• Know the requirements of your state / local laws

• Backed by the full faith and credit of the issuer

• Often supported by the ability of issuer to levy taxes(particularly ad valorem taxes)

• Often requires voter approval


Revenue Bonds

• Generally, not a tax pledge … but there are exceptions to the rule

• Supported by the revenues of the facility/enterprise/system being financed (can be rents, tuition, revenues, etc.)

• Collateral may include the project itself or various rights as to the project



Types of Security• General Obligation• Special Taxes or Assessments• Revenue Pledge

• Utilities• Airport• Hospitals

• Leases or Installment Payments• Payments from Conduit Borrowers• Additional Security

• Mortgage/Security interest in specific assets• Credit Enhancement


General Obligation Bonds• Know the requirements of your state / local laws

• Backed by the full faith and credit of the issuer

• Often supported by the ability of issuer to levy taxes(particularly ad valorem taxes)

• Often requires voter approval


Revenue Bonds

• Generally, not a tax pledge … but there are exceptions to the rule

• Supported by the revenues of the facility/enterprise/system being financed (can be rents, tuition, revenues, etc.)

• Collateral may include the project itself or various rights as to the project


$ Bond proceeds $ Debt service

Bondholders

Trustee

Issuer

Project

Revenues

• Project/System and Revenue Pledge

• Covenants

• Parties - Issuer and Trustee, on behalf of Bondholders

Revenue Bonds (cont.)

$ Debt service

$ Bond proceeds

$ Bond proceeds


Conduit Bonds• Governmental entity issues bonds to benefit

another entity (public or private)

• Conduit Borrower: the entity borrowing the bond proceeds and responsible for paying debt service

• Examples: small issue manufacturing facility (or “industrial development”) bonds, 501(c)(3) bonds, various “exempt facility” bonds


Debt Service

Debt Service

Conduit Issuer

Conduit Borrower

BondProceeds

ProjectBond Proceeds

Revenues

Bondholders

Trustee

Conduit Bonds (cont.)



Conduit Issuer

Conduit Borrower Project

Bondholders

Trustee

Conduit Bonds (cont.)

Various collateral /security possibilities


Refunding Bonds

Refundings:• Use new bond

proceeds to pay debt service on outstanding bonds

• Current – within 90 days

• Advance – more than 90 days

Defeasance:• Gross – fully funded at

amount needed to pay debt service

• Net – invested in obligations (like SLGs) sufficient to pay principal, interest and premium


Key Considerations of a Refunding

• Debt Service Savings• Usually, the higher the interest rate and the earlier the call date on the

refunded bonds, the greater the savings• Redemption Provisions

• Current versus Advance Refunding• Call provisions with respect to the bonds being refunded will govern

whether you have a current or advance refunding • Escrow Investment Yield and Other Factors



Debt Service Savings

• Usually, the higher the interest rate on the refunded bonds relative to today's market, the greater the savings

• The earlier the call date, the greater the savings


Deal Team


Possible Members of the Deal Team• Bond Counsel• Issuer Counsel• Tax Counsel• Disclosure Counsel• Financial Advisor• Engineer/Feasibility Consultant• Borrower• Borrower Counsel• Bond Purchaser• Purchaser’s Counsel• Trustee or Paying Agent• Trustee Counsel• Letter of Credit Bank/Bond Insurer/Credit Provider• Counsel to the Credit Provider



Bond Documents


The Basic Bond Document

• Contract between Issuer and Bondholders.

• Two basic types (lots of different names):• Indenture/Loan Agreement• Bond Ordinance or Resolution

• General or Master Document for Parity Bonds


Typical Document Provisions

• Security pledge

• Sale of bonds

• Terms

• Registration



Bond Documents


The Basic Bond Document

• Contract between Issuer and Bondholders.

• Two basic types (lots of different names):• Indenture/Loan Agreement• Bond Ordinance or Resolution

• General or Master Document for Parity Bonds


Typical Document Provisions

• Security pledge

• Sale of bonds

• Terms

• Registration


• Reimbursement

• Tax covenants & Designations

• Use of proceeds/construction of project

Typical Document Provisions (cont’d)


The Bonds maturing on or after April 1, 2025will be callable for redemption by the Issuer, inwhole or in part, on any date on or after April 1,2024, at a price of par plus accrued interest tothe date fixed for redemption.

Example Redemption Provision


The Bonds maturing on or after April 1, 2025, will be callablefor redemption by the Issuer, in whole or in part, on any dateon or after April 1, 2024, at the redemption prices,expressed as a percentage of the principal amount ofthe Bonds redeemed, as set forth below, together withaccrued interest to the date fixed for redemption:

Redemption Date Redemption PriceApril 1, 2024 to March 31, 2025 101.50%April 1, 2025 and thereafter 100.00%

Example Redemption Provision (cont.)



Typical G.O. Bond Covenants

• Pledge of full faith and credit

• Maintenance of revenue

• Priority/exclusivity of payment


Typical Revenue Bond Covenants

• Limitations on Additional Debt

• Rate Covenant

• Flow of Funds

• Maintenance Covenants

• Limitations on Asset Dispositions


Role of Purchasers in Structuring Transaction

• Who purchases municipal bonds?

• What is important to them?



Typical G.O. Bond Covenants

• Pledge of full faith and credit

• Maintenance of revenue

• Priority/exclusivity of payment


Typical Revenue Bond Covenants

• Limitations on Additional Debt

• Rate Covenant

• Flow of Funds

• Maintenance Covenants

• Limitations on Asset Dispositions


Role of Purchasers in Structuring Transaction

• Who purchases municipal bonds?



Official Statement

Securities Law Implications:

• Section 17(a) of Securities Exchange Act of 1933• Rule 10b-5 of Securities Exchange Act of 1934• Rule 15c2-12 of Securities Exchange Act of 1934

Preliminary versus Final Official Statement


Official Statement (cont.)

Contains material information on:

• Issuer and obligated persons

• Bonds being offered• Past compliance with continuing

disclosure undertakings


Role of Credit Enhancement in Structuring Transaction

• Who provides credit enhancement for municipal bonds?




Bond Sale


Methods of Sale

• Private Placement vs. Underwritten transaction

• Competitive vs. Negotiated

• Fixed Rate vs. Variable Rates


Underwritten Transaction



Trustee orPaying Agent

(acts in an agency capacity)

Underwriter

Bond Proceeds

Bond Proceeds

Debt Instrument

Debt Instrument

Debt Service



Bond Sale


Methods of Sale

• Private Placement vs. Underwritten transaction

• Competitive vs. Negotiated

• Fixed Rate vs. Variable Rates


Underwritten Transaction



Trustee orPaying Agent

(acts in an agency capacity)

Underwriter

Bond Proceeds

Bond Proceeds

Debt Instrument

Debt Instrument

Debt Service


Debt Service Structure• New Money Issues

• Often tied to assets being financed• Possible capitalization of interest during

construction• Refundings

• Up front vs. level savings• Wrap Around of Existing Debt• Principal payments are typically made annually;

interest payments are typically made semiannually (fixed rate) or monthly (variable rate).


Fixed Rate Bonds

• Interest rate is fixed for term of bonds, but typically have different interest rates for each maturity (especially in a public offering)

• Principal matures in stated amounts at stated intervals (generally annually)

• Issuer knows exact amount of principal and interest payments at closing


Variable Rate Demand Obligations (VRDBs)

• Interest rate adjusted periodically (typically weekly)• Typically offered in minimum denominations of $100,000 and sold mostly to

institutional investors• Typical put feature that provides option of bondholder to put bond back to

tender agent with seven days’ notice• Remarketing agent sets weekly rates (generally based on an index) and

remarkets bonds tendered by bondholders• Interest typically paid monthly with annual or semiannual principal or

mandatory sinking fund redemption payments• Bonds typically secured by letter of credit or liquidity facility arrangement

(credit rating requirements)• Typical structure for conduit borrowings but also used for governmental

bonds



Direct Bank Placement (DP)

• Interest rate may be fixed or adjusted periodically (typically monthly based on percentage of 1-month LIBOR index plus a fixed credit spread)

• Generally structured as a single bond with principal installments sold to one financial institution

• No optional put feature but generally subject to mandatory tender at end of negotiated holding period (3,5,7, etc. years)

• Interest typically paid monthly with annual or semiannual principal installment payments

• Bonds held directly by financial institution subject to limited transfer provisions• Subject to additional terms, provisions and covenants set forth in separate

credit agreement• No built-in remarketing features, but may have ability to convert to other

variable rate modes


“All-In” Variable Rate

• Base Rate: 0.30%• LOC Fee: 0.75%• Remarketing & Other Fees 0.15%Total “All-In” Variable Rate 1.20%

• 70% (+/-) of 1-mo. LIBOR: 0.20%• Credit Spread: 0.75%Total “All-In” Variable Rate 0.95%

VRDBs

DPs


Bondholder Risks

• Interest Rate Risk• Default Risk (Credit Risk)• Reinvestment Rate Risk• Inflation Risk• Call Risk• Maturity Risk• Liquidity Risk



Direct Bank Placement (DP)

• Interest rate may be fixed or adjusted periodically (typically monthly based on percentage of 1-month LIBOR index plus a fixed credit spread)

• Generally structured as a single bond with principal installments sold to one financial institution

• No optional put feature but generally subject to mandatory tender at end of negotiated holding period (3,5,7, etc. years)

• Interest typically paid monthly with annual or semiannual principal installment payments

• Bonds held directly by financial institution subject to limited transfer provisions• Subject to additional terms, provisions and covenants set forth in separate

credit agreement• No built-in remarketing features, but may have ability to convert to other

variable rate modes


“All-In” Variable Rate

• Base Rate: 0.30%• LOC Fee: 0.75%• Remarketing & Other Fees 0.15%Total “All-In” Variable Rate 1.20%

• 70% (+/-) of 1-mo. LIBOR: 0.20%• Credit Spread: 0.75%Total “All-In” Variable Rate 0.95%

VRDBs

DPs


Bondholder Risks

• Interest Rate Risk• Default Risk (Credit Risk)• Reinvestment Rate Risk• Inflation Risk• Call Risk• Maturity Risk• Liquidity Risk


Yield Curve

Graphical representation of yield and maturity (the term structure of interest rates)


Yield Curves


Current YieldYield calculated using coupon rate and current price

Yield to MaturityYield calculated to maturity date, equates present value of cash flows to current market price

Yield to CallYield calculated to a particular call date rather than maturity using the call price as opposed to the face value

Bond Yields



Yield vs. Interest Rate

Interest Payments: ($5,000 = 6% x 1/2 yr.) = $150 on every interestpayment date

• April 1, 2015 • Dated Date• $5,000 • Principal Amount• 6% • Coupon Rate• April 1 & October 1 • Compounding interval

(interest payment dates)• April 1, 2016 • Maturity Date

•

•


Yield vs. Price

Bond Yields & Bond PricesMove in Opposite Directions

Yield

Price


Par, Discount and Premium Bonds

• Par = Stated Principal Amount or Face Value

• Discount/Premium = Price not stated principal amount

• Importance of price in yield calculations

• Example Bond (6.00% coupon; 10-year maturity)Price 98% Yield of 6.27%Price 100% Yield of 6.00%Price 102% Yield of 5.73%



Yield vs. Interest Rate

Interest Payments: ($5,000 = 6% x 1/2 yr.) = $150 on every interestpayment date

• April 1, 2015 • Dated Date• $5,000 • Principal Amount• 6% • Coupon Rate• April 1 & October 1 • Compounding interval

(interest payment dates)• April 1, 2016 • Maturity Date

•

•


Yield vs. Price

Bond Yields & Bond PricesMove in Opposite Directions

Yield

Price


Par, Discount and Premium Bonds

• Par = Stated Principal Amount or Face Value

• Discount/Premium = Price not stated principal amount

• Importance of price in yield calculations

• Example Bond (6.00% coupon; 10-year maturity)Price 98% Yield of 6.27%Price 100% Yield of 6.00%Price 102% Yield of 5.73%


Example – Bond PricingYield to Call Call Premium

Maturity Date Price (-Discount) Takedown

Maturity

Bond Component Date Amount Rate Yield Price

Serial Bonds: 04/01/2016 1,325,000 4000% 0.300% 103.824 50,668.00 2.500 04/0112017 1,380,000 4000% 0.590% 106.891 95,095.80 2.50004/01/2018 1,070,000 5.000% 0.910% 112.219 130,74330 3.75004/01/2019 1,955,000 5.000% 1140% 115.183 296,827.65 3.75004/0112020 2,065,000 5.000% 1410% 117.392 359,144.80 3.750 04/01/2021 2,165,000 5.000% 1.640% 119.234 416,416.10 3.75004/0112022 2,305,000 5.000% 1.920% 120.180 465,149.00 3.750 04/0112023 2,460,000 5.000% 2.140% 121.011 516,870.60 3.75004/01/2024 2,615,000 5000% 2340% 121.550 563,532.50 3.75004/0112025 2,775,000 5.000% 2.500% 122.068 612,387.00 3.75004/01/2026 2,840,000 5.000% 2.670% 120.393 c 2.835% 04/0112025 100.000 579,161.20 3.75004/01/2027 3,015,000 5000% 2.780% 119324 c 3.068% 04/01/2025 100.000 582,618.60 3.75004/01/2028 1,600,000 3.000% 3.120% 98.721 -20,464.00 3.75004/0112029 1,580,000 3000% 3.180% 97.973 -32,026.60 3.750 04/01/2030 1,555,000 3.000% 3.230% 97.276 -42,358.20 3.750 04/01/2031 1,535,000 3000% 3310% 96.165 -58,867.25 3 750 04/01/2032 1,515,000 3.125% 3360% 96.969 -45,919.65 3.750

33,755,000 4,468,978.85

Serial Bonds 2: 04/0l/2028 1,380,000 5.000% 2.870% 118458 c 3.251% 04/01/2025 100.000 254,72040 3.750

35,135,000 4,723,699.25


Example – Sources & Uses Series 2014

Tax-Exempt Series 2014

Taxable Water

New Money Water and and SewerWater and Sewer Revenue Revenue

Sewer System Refunding RefundingSources: Revenue Bonds Bonds Bonds Total

Bond Proceeds: Par Amount 20,485,000.00 39,870,000.00 4,730,000.00 65,085,000.00Premium 2,669,612.35 4,772,278.55 7,441,890.90

23,154,612.35 44,642,278.55 4,730,000.00 72,526,890.90

Other Sources of Funds: Equity Contribution 2,439,600.00 2,439,600.00

23,154,612.35 44,642,278.55 7,169,600.00 74,966,490.90

Series 2014

Tax-Exempt

Series 2014

Taxable Water


Uses:

Sewer SystemRevenue Bonds

RefundingBonds

RefundingBonds

Total

Project Fund Deposits: Project Fund

23,000,000.00

23,000,000.00

Refunding Escrow Deposits:Cash Deposit

0.46

0.46

SLGS Purchases 44,342,610.00 7,132,693.00 51,475,303.00 44,342,610.46 7,132,693.00 51,475,303.46

Delivery Date Expenses: Cost oflssuance

78,685.57

153,145.89

18,168.54

250,000.00

Underwriter's Discount 74,709.60 147,013.15 17,440.99 239,163.74 153,395.17 300,159.04 35,609.53 489,163.74

Other Uses of Funds: Additional Proceeds

1,217.18

-490.95

1,297.47

2,023.70

23,154,612.35 44,642,278.55 7,169,600.00 74,966,490.90


$ Bond

$ Bond

$ DebtService

Proceeds

Proceeds

Bondholders

Underwriters

$ BondProceeds

Direct Pay Letter of Credit

Debt Service

$ Debt Service

Reimbursements

Trustee

Issuer

Credit Enhancement – Letter of Credit



$ Bond

$ Bond

$ BondProceeds

$ DebtService

$ DebtService

Proceeds

Proceeds

Bond Insurance

Policy

Premium

$ Debt Service (if necessary)

Bondholders

Underwriters

Trustee

Issuer

Credit Enhancement – Bond Insurance


“Vanilla” Interest Rate Swap

Issuer Counter-Party

Bondholders

floating swap rate*

fixed swap rate

floating interest rate

* A floating swap rate is intended to mirror or closely correlate with floating interest rate on the bonds, resulting in a synthetic fixed rate issue.


Closing



$ Bond

$ Bond

$ BondProceeds

$ DebtService

$ DebtService

Proceeds

Proceeds

Bond Insurance

Policy

Premium


Bondholders

Underwriters

Trustee

Issuer

Credit Enhancement – Bond Insurance


“Vanilla” Interest Rate Swap

Issuer Counter-Party

Bondholders

floating swap rate*

fixed swap rate

floating interest rate

* A floating swap rate is intended to mirror or closely correlate with floating interest rate on the bonds, resulting in a synthetic fixed rate issue.


Closing


The Closing Documents

• The certificates executed at closing support the opinions rendered by counsel:

• General/Incumbency Certificate• Tax Compliance/Non-Arbitrage Certificate• Registration Certificate• Parity Certificate• Official Statement/15c2-12 Certificates


The Closing Documents (cont.)

• Other documents delivered at closing memorialize promises made to Bondholders:

• Continuing Disclosure Agreement• Escrow Agreement• Ratings Reports• Deed of Trust/Mortgage• Feasibility Study/Engineer’s Report


Common Tax Documents

• Tax Certificate• Underwriter’s Certificate (a.k.a. Issue Price

Certificate)• IRS Forms 8038• Written Policies and Procedures



Opinions

• “Good Delivery” under MSRB Rules requires delivery of the bond opinion at closing.

• The Bond Opinion is addressed to the issuer.• Primary focus of the Bond Opinion is

validity/enforceability and tax exemption of the Bonds.

• Supplemental opinions address other topics (securities law, specific documents, reliance).


The Bond Opinion

• Bonds duly authorized and executed• Bonds valid and binding obligations (enforceability

opinion given for revenue bonds)• Lien on revenues• Federal tax opinion (includes AMT/ACE opinion)• State tax opinion


Other Opinions

• Underwriter’s Counsel Opinion• Effect of CDA• Exemption from securities laws• 10b-5 opinion vs. 10b-5 comfort letter

• Trustee’s Counsel Opinion• Valid, binding and enforceable• Due authorization and execution• No conflict

• Credit Provider’s Counsel Opinion



Opinions

• “Good Delivery” under MSRB Rules requires delivery of the bond opinion at closing.

• The Bond Opinion is addressed to the issuer.• Primary focus of the Bond Opinion is

validity/enforceability and tax exemption of the Bonds.

• Supplemental opinions address other topics (securities law, specific documents, reliance).


The Bond Opinion

• Bonds duly authorized and executed• Bonds valid and binding obligations (enforceability

opinion given for revenue bonds)• Lien on revenues• Federal tax opinion (includes AMT/ACE opinion)• State tax opinion


Other Opinions

• Underwriter’s Counsel Opinion• Effect of CDA• Exemption from securities laws• 10b-5 opinion vs. 10b-5 comfort letter

• Trustee’s Counsel Opinion• Valid, binding and enforceable• Due authorization and execution• No conflict

• Credit Provider’s Counsel Opinion


Common Limitations on Opinions

• Limited to federal law and law of 1 state• Speaks only as of its date• No obligation to update• Not a guaranty or warranty• May only be relied upon by addressee


The Money• Who sends money?

• Purchaser wires bond proceeds less underwriter’s discount.• Issuer wires equity contribution (excess reserve fund

moneys, sinking fund deposits, other funds on hand)• Who receives money?

• New money: Issuer or trustee • Refunding: Escrow agent or refunded bonds paying

agent/trustee• Credit Provider

• What is the Rounding Amount?


The Money (cont.) Series 2014

Tax-Exempt Series 2014

Taxable Water


Sewer System Refunding RefundingSources: Revenue Bonds Bonds Bonds Total

Bond Proceeds: Par Amount 20,485,000.00 39,870,000.00 4,730,000.00 65,085,000.00Premium 2,669,612.35 4,772,278.55 7,441,890.90

23,154,612.35 44,642,278.55 4,730,000.00 72,526,890.90

Other Sources of Funds: Equity Contribution 2,439,600.00 2,439,600.00

23,154,612.35 44,642,278.55 7,169,600.00 74,966,490.90

Series 2014

Tax-Exempt

Series 2014

Taxable Water


Uses:

Sewer SystemRevenue Bonds

RefundingBonds

RefundingBonds

Total

Project Fund Deposits: Project Fund

23,000,000.00

23,000,000.00

Refunding Escrow Deposits:Cash Deposit

0.46

0.46

SLGS Purchases 44,342,610.00 7,132,693.00 51,475,303.00 44,342,610.46 7,132,693.00 51,475,303.46

Delivery Date Expenses: Cost oflssuance

78,685.57

153,145.89

18,168.54

250,000.00

Underwriter's Discount 74,709.60 147,013.15 17,440.99 239,163.74 153,395.17 300,159.04 35,609.53 489,163.74

Other Uses of Funds: Additional Proceeds

1,217.18

-490.95

1,297.47

2,023.70

23,154,612.35 44,642,278.55 7,169,600.00 74,966,490.90



The Money (cont.)

• Purchaser retains $239,163.74• Purchaser wires:

• $23,000,000.00 to Issuer for project costs• $49,035,703.46 to Escrow Agent for refunding• $252,023.70 for costs of issuance/rounding

• Issuer wires:• $2,439,600.00 to Escrow Agent for refunding


$ DebtService

$ DebtService

Bondholders

Trustee

Issuer

DTC Participants

Indirect

Brokers/Banks

The Depository Trust Company / DTC

Participants

DTC (“Cede & Co.”) is typically the only registered Bondholder to the Trustee.

DTC Participants are registered and typically are known underwriting and investment firms.




Basic Training General Session: General Securities Law

Faculty:Kenneth R. Artin Bryant Miller Olive P.A. – Orlando, FL Kathleen Miles PNC Financial Services Group, Inc. – Washington, D.C. Kris A. Moussette Hinckley, Allen & Snyder LLP – Boston, MA Bradley D. Patterson Ballard Spahr LLP - Salt Lake City, UT

I. Introduction

II. Federal Securities Law – 1933 Act Registration Requirements

III Federal Securities Law – Trust Indenture Act of 1939

IV. Federal Securities Law – The Anti-Fraud Provisions and Civil Remedies

V. Federal Securities Law – Common Law Causes of Action

VI. Federal Securities Law – Rule 15c2-12

VII. Federal Securities Law – SEC Enforcement

VIII. Municipal Securities Rulemaking Board and its Rules

IX. State Blue Sky Laws


GENERAL SECURITIES LAW/CONTINUING DISCLOSURE

I. INTRODUCTION

Even though municipal bonds are exempt from certain securities law requirements, many securities laws apply to municipal bond transactions. In addition, a transaction may have more than one security. Failure to comply with all securities laws applicable to a transaction can result in liability for all of the parties to the transaction, including the lawyers.

II. FEDERAL SECURITIES LAWS -- 1933 ACT REGISTRATION REQUIREMENT

A. Section 5 of the Securities Act of 1933 (the “1933 Act”) is the primary enforcement tool: It generally provides that it is unlawful for any person to use the mail or other forms of interstate commerce to sell or deliver any security unless a proper “registration statement” has been filed with the SEC and is in effect.

B. What is a “security”?

The term “security” under the 1933 Act is very broad and includes bonds, notes, certificates of participation (COPs), other evidences of indebtedness and investment contracts, together with guarantees of the foregoing. (1933 Act, § 2(a)(1), 15 USC § 77b(a)(1)). This definition encompasses not only the primary instruments in most municipal financings (i.e. bonds, notes and COPs), but also such collateral documents as guaranteed investment contracts (GICs), letters of credit, bond insurance policies and debt service reserve surety bonds. The term also may include certain leases, loan agreements and other payment arrangements with third parties which may be deemed separate securities, as described below.

C. Exempt Securities, 15 USC § 77c.

There are two ways to gain an exemption from the registration requirements of the 1933 Act: (1) exempt the security, or (2) exempt the transaction. Section 3(a)(2) exempts most municipal securities from the registration requirement, but not from the anti-fraud provisions.

1. Most municipal securities do not need to be registered because Section 3(a) of the 1933 Act provides that, for most purposes, certain classes of securities are not subject to the 1933 Act. These include:

a) Any security issued or guaranteed by the United States or any Territory thereof. (1933 Act, § 3(a)(2)).

b) Any security issued or guaranteed by any State of the United States, or by any political subdivision of a State or Territory, or by any public instrumentality of one or more States or Territories. (1933 Act, § 3(a)(2)). Includes most municipal securities, but does not include securities issued by Indian tribes. No-action letters have extended this exemption to 63-20 corporations.


c) Any security issued or guaranteed by a national bank or a banking institution organized under the laws of any State, Territory or the District of Columbia, the business of which is substantially confined to banking and is supervised by the state or territorial banking commission or similar official. (1933 Act, §3(a)(2)).

(i) Includes most, but not all, letter of credit banks; may cover COPs issued by banks.

(ii) Letters of credit issued by domestic branches of foreign banks may qualify for a Section 3(a)(2) exemption on the basis of Interpretive Release No. 33-6661.

d) Any security which is an “industrial development bond” (within the meaning of Section 103(c)(2) of the 1954 Tax Code, as in effect in 1970) the interest on which is excludable from gross income under Section 103(a)(1) of the 1954 Tax Code (other than multi-family housing bonds and bonds issued to finance industrial parks). (1933Act, §3(a)(2)).

(i) This exemption was added in 1970 to mitigate the impact of SEC Rule 131 (17 CFR § 230.131) , which was adopted by the SEC in 1968 (and amended in 1970) to combat potential abuses by industrial development bond issues. Rule 131 provides that the obligations of the ultimate obligor in a conduit bond issue are deemed to be separate securities (and thus would be subject to the 1933 Act registration requirements). The SEC has acknowledged that the exemption was intended to apply to both the industrial development bond itself and the underlying conduit loan.

(ii) This exemption does not include taxable IDBs, so Rule 131 analysis of the underlying conduit loan and related guarantees is still necessary.

(iii) This exemption includes most “exempt facility bonds” issued under Section 142 of the 1986 Tax Code and “qualified small issue bonds” issued under Section 144(a) of the 1986 Tax Code.

(iv) This exemption does not include multi-family housing bonds, which were specifically excluded from this exemption. While the bonds themselves will usually qualify under the Section 3(a)(2) exemption, the underlying conduit loan and related guarantees must be analyzed as potential separate securities. See below.


e) Any security issued by an entity organized and operated exclusively for religious, educational, benevolent, fraternal, charitable or reformatory purposes and not for pecuniary profit, and no part of the net earnings of which inures to the benefit of any person, private stockholder or individual (which should include most 501(c)(3) corporations and some 63-20 corporations). (1933 Act, §3(a)(4)).

f) Any insurance policy issued by a corporation subject to the supervision of the insurance commissioner, bank commissioner or other similar officer of a State or Territory or the District of Columbia. (1933 Act, §3(a)(8)). This exemption covers bond insurance policies of major bond insurers.

g) Securities offered and sold only to persons resident within a single State or Territory by an issuer that is resident (or incorporated by) and doing business with such State or Territory. (1933 Act, §3(a)(11)).This exemption can be lost if resale out of state.

2. Separate Securities Analysis for Conduit Issues.

a) Under Rule 131(a), any part of a bond or other obligation (including those bonds or obligations otherwise exempt under Section 3(a)(2)) payable from payments to be made in respect of property or money which is or will be used under a lease, sale or loan arrangement, by or for an industrial or commercial enterprise, is considered a “separate security” issued by the lessee or obligor under such lease, sale or loan arrangement. Thus, the obligations of the ultimate obligor in a conduit bond issue are deemed to be separate securities and are subject to the 1933 Act registration requirements unless an exemption is available.

b) As noted above, the exemption under Section 3(a)(2) for tax-exempt “industrial development bonds” mitigates the impact of Rule 131(a), but does not apply to separate securities related to taxable IDBs or multi-family housing conduit bonds.

c) Under Rule 131(b), the obligation(s) underlying a conduit issue will not be deemed to be a separate security if: (i) the obligation is payable from the general revenues of a governmental unit specified in Section 3(a)(2); or (ii) the obligation relates to a public project owned and operated by or on behalf of and under the control of a governmental unit; or (iii) the obligation relates to a facility that is leased to and under the control of an industrial or commercial enterprise but is part of a public project that is owned by a governmental unit.

d) In the case of multi-family housing issues, SEC no-action letters indicate that housing projects owned and operated by private developers may satisfy the requirements of Rule 131(b) if adequate governmental “control” is demonstrated. Factors showing


governmental control include: (i) the right to access the project; (ii) the right to inspect books and records; (iii) the right to receive periodic reports relating to project operations; (iv) the right to obtain possession of the project in the event of a material default under the mortgage; (v) approval of the timing of construction; and (vi) approval of plans and specifications.

D. Exempt Transactions, 15 USC § 77d.

1. Section 4 “Issuer” Exemptions. If the securities being issued do not qualify as exempt securities under Section 3(a) of the 1933 Act, the issuer must register the securities or qualify the offering and sale of the securities as an exempt transaction under Section 4 of the 1933 Act. Note that separate exemptions under Section 4 apply for issuers and purchasers.

a) Section 4(6) exemption: Transactions involving offers or sales by an issuer solely to “accredited investors” if (i) the aggregate offering price is $5 million or less, (ii) there is no advertising or public solicitation in connection with the transaction, and (iii) the issuer files a Form D with the SEC.

b) Section 4(2) (15 USC § 77d(2)) exemption: Transactions by an issuer not involving any “public offering.” The issuer must comply with SEC Rules 501 through 508 (“Regulation D”)(17 CFR §§ 230.501-230.508).

(i) Exemption for offerings of $1 million or less (a “Rule 504 offering”). $1 million threshold applies to all securities sold within 12 months.

(ii) Exemption for offerings of $5 million or less sold to not more than 35 purchasers, excluding accredited investors (a “Rule 505 offering”). Also measured over 12 months. Securities may not be sold pursuant to general solicitation, and issuer must exercise “reasonable care” to assure purchasers are not “underwriters.”

(iii) Exemption for offerings sold to not more than 35 purchasers, regardless of dollar amount (a “Rule 506 offering”). Among the requirements for meeting this exemption is that each purchaser (other than accredited investors) must have “such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment.” Accredited investors do not count toward the 35 purchaser limit.


2. Section 4 “Purchaser” Exemptions. If the securities being issued do not qualify as exempt securities under Section 3(a) of the 1933 Act and have not been registered, the purchaser can qualify the initial purchase and subsequent resale of the securities as exempt transactions under Section 4 of the 1933 Act.

a) Section 4(1) (15 USC § 77d(1) exemption: “Transactions by any person other than an issuer, underwriter, or dealer.”

(i) The term “underwriter” is broadly defined to include any person who (X) has purchased securities from an issuer with a view to distribute such securities, or (Y) offers and sells securities for an issuer in connection with the distribution thereof. (Rules 144 (17 CFR § 230.144) and 144A (17 CFR § 230.144A) provide safe harbors in this regard). (1933 Act, §2(a)(11)).

(ii) “Dealer” means a person who works as an agent, broker or principal in the business of offering, buying, selling or otherwise dealing and trading in securities issued by another person. (1933 Act, §2(a)(12)).

(iii) The Section 4(1) exemption should allow “accreditedinvestors” other than dealers (e.g., high net worth individuals) to acquire securities directly from an issuer that has qualified such sale under the 4(2) or 4(6) exemption.

b) Section 4(3) exemption: “Transactions by a dealer (but not in the capacity of an underwriter), so long as the transactions”

(i) do not take place within 40 days after the initial public offering of the security by the issuer or an underwriter, or

(ii) do not take place within 40 days after the effective date of a registration statement, or

(iii) do not involve an unsold subscription or allotment to such dealer in connection with the distribution of the securities by the issuer or an underwriter. To qualify for this exemption, investment bankers must avoid activities that will cause them to be “underwriters” within the meaning of Section 2(a)(11) of the 1933 Act. (SEC Rules 144 and 144A provide safe harbors in this regard.)

c) Rule 144: If the requirements of Rule 144 are satisfied, the seller of the securities (not including the issuer) will not be deemed to be engaged in the “distribution” of the securities, and thus is not deemed to be an “underwriter.” Rule 144(b). Rule 144 requires that the issuer


make certain information publicly available (Rule 144 (c)(2)) and that investors generally hold the securities for at least one year (Rule 144(b)(1)), among other requirements.

d) Rule 144A: The result is the same under Rule 144A—i.e. the resale of securities by an investment banker (or other person) will not cause the investment banker to be an “underwriter.” However, the requirements of Rule 144A are more lenient than those of Rule 144.

(i) Rule 144A involves the sale of securities only to qualified institutional buyers (“QIBs”) by persons other than the issuer. (Rule 144A(d)(1)).

(ii) Most QIBs will qualify as “accredited investors” under Section 2(a)(15) of the 1933 Act and Rule 215 (17 CFR § 230.215), but not all accredited investors will qualify as QIBs.

(iii) The seller of the securities is allowed to rely on a certificate from the purchaser, among other things, to determine whether the purchaser is a QIB. (Rule 144A(d)(1)(iv)).

(iv) The seller must notify the purchaser that the seller is relying on Rule 144A for an exemption from Section 5 of the 1933 Act. (Rule 144A(d)(2)).

(v) Continuing disclosure requirement: the holder and the prospective purchaser of the securities must have the right to obtain from the issuer by the time of any sale or resale: (W) a brief statement of the nature of the issuer’s business and the products and services it offers, which statement shall be as of a date within 12 months prior to the date of resale; (X) the issuer’s most recent balance sheet, which must be dated not more than 6 months before the date of resale (if such balance sheet is not as of a date less than 6 months before the date of resale, it must be accompanied by additional statements of profit and loss and retained earnings from the date of such balance sheet to a date not less than 6 months before the date of resale); (Y) the issuer’s most recent profit and loss and retained earnings statement, which must be for the 12 months preceding the date of such balance sheet; and (Z) similar financial statements for such part of the two preceding fiscal years as the issuer has been in operation. (Rule 144A(d)(4)).

3. Certain Real Estate Secured Debt. Section 4(5) exempts first mortgage notes for residential or commercial development originated by financial institutions. A $250,000 minimum applies and purchaser must buy for its own account.


III. FEDERAL SECURITIES LAWS -- TRUST INDENTURE ACT OF 1939, 15 USC § 77aaa et seq.

A. The Trust Indenture Act applies specifically to notes, bonds, other evidences of indebtedness, certificates of participation in such instruments, and guarantees of debt instruments (Trust Indenture Act, §304(a)(1)), and generally requires that any “indenture” under which securities are issued be qualified by the SEC. (TrustIndenture Act, §§305 & 306). The term “indenture” is broadly defined to include indentures, mortgages, deeds of trust and similar instruments under which debt instruments are issued. Accordingly, bond ordinances and bond resolutions are potentially subject to the indenture qualification requirements.

B. As is the case with the registration requirements of the 1933 Act, certain securities and transactions are exempt from the indenture qualification requirements of the Trust Indenture Act. These include:

1. Any security exempted from the provisions of the 1933 Act by means of Sections 3(a)(2) through (8), 3(a)(11) or 3(a)(13) of the 1933 Act. These securities are exempted from the Trust Indenture Act in its entirety.

2. Securities issued under an indenture that limits the aggregate principal amount of such securities to $10 million. These securities are exempted from the Trust Indenture Act in its entirety.

3. Securities issued in a transaction that is exempted from the requirements of Section 5 of the 1933 Act by Section 4 of the 1933 Act. These securities are exempted only from the indenture qualification requirements of the Trust Indenture Act.

IV. FEDERAL SECURITIES LAWS -- THE ANTI-FRAUD PROVISIONS AND CIVIL REMEDIES.

A. Overview of Statutory and Regulatory Bases for Liability.

1. Two basic objectives of the 1933 Act and the Securities Exchange Act of 1934 (the “1934 Act”):

a) Require disclosure of material information about securities to allow investors to make informed decisions.

b) Prohibit misrepresentation or other fraudulent conduct in connection with the purchase and sale of securities.

2. Municipal securities are exempt from the registration requirements of the 1933 Act and the reporting requirements of the 1934 Act but are not exempt from the antifraud provisions of 17(a) of the 1933 Act, Section 10(b) of the 1934 Act and Rule 10b-5 promulgated under the 1934 Act.


B. Section 17 (a) of the 1933 Act, 15 USC § 77q.

1. It shall be unlawful for any person in the offer or sale of any securities by the use of any means or instruments of transportation or communication in interstate commerce or by the use of the mails, directly or indirectly -

a) to employ any device, scheme or artifice to defraud, or

b) to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading, or

c) to engage in any transaction, practice or course of business which operates or would operate as a fraud or deceit upon the purchaser.

C. Section 10(b) of the 1934 Act, 15 USC § 78j and Rule 10b-5, 17 CFR § 240.10b-5

1. Section 10(b) of the 1934 Act prohibits the use, in connection with the purchase or sale of a security (whether or not required to be registered) of “any manipulative or deceptive device,”

2. Rule 10b-5 prohibits the use of any instrumentality of interstate commerce, mails, or facilities of national securities exchange, in connection with the purchase or sale of any security, to:

a) Employ any device, scheme or artifice to defraud;

b) Make any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading; or;

c) Engage in an act, practice or course of business which operates or would operate as a fraud or deceit upon any person.

3. Courts recognize private cause of action. Both buyers and sellers are protected by Section 10(b) and Rule 10b-5. Liability can apply to various parties in transaction, including bond counsel or underwriters’ counsel, but not based on causes of action for aiding and abetting.

4. Elements - similar to traditional elements of common law fraud (elements listed in (a) - (f) below are discussed in detail in subparagraphs (7) - (12) below):

a) Misstatement or omission.

b) Material fact (cf. opinion, projections).

c) Scienter (intent to deceive, manipulate or defraud plaintiff).


d) Reliance.

e) Proximate cause of damages.

f) Damages.

5. “Buyer or seller” rule establishes certain jurisdictional requirements for a cause of action (standing; plaintiff must be actual buyer or seller at time fraud occurred).

6. “In connection with” rule (misrepresentation or omission must occur in connection with the purchase or sale of security).

7. Element 1 - Misstatement or omission.

a) With respect to omissions, see Backman v. Polaroid, 910 F. 2d 10 (1st Cir. 1990) - Rule 10b-5 does not mean that “by revealing one fact about a product, one must reveal all others that, too, would be interesting market wise, but means only such others, if any, that are needed so that what was revealed would not be ‘so incomplete as to mislead’.” Concept of duty to disclose (this duty concept is relevant to secondary market disclosure discussion).

8. Element 2 - Materiality (“facts and circumstances”).

a) TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438 (1976), “An omitted fact is material if there is a substantial likelihood that a reasonable shareholder would [not might] consider it important in deciding how to vote.” (426 U.S. at 449).

(i) “There must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.”

(ii) Basic, Inc. v. Levinson, 485 U.S. 224 (1988) (adopted TSC) materiality depends upon balancing of both indicated probability that event will occur and anticipated magnitude of event in light of totality of company facts; materiality depends on significance a reasonable investor would place on withheld or misrepresented information.

b) Applies to certain opinions or projections, as well as facts.

c) Useful considerations:

(i) Fact specific inquiry.


(ii) How would the omission of the fact sound in a Plaintiff’s complaint?

(iii) What items do the company or underwriters least wish to disclose?

9. Element 3 - Scienter - Supreme Court requires actual mental state embracing intent to deceive, manipulate or defraud rather than simple negligence (Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1975)).

a) Recklessness may substitute for actual intent - issue left open in Hochfelder but applied by circuit courts considering the issue.

(i) Reckless conduct involves more than simple or inexcusable negligence - requires extreme departure from standards of ordinary care.

(ii) Standard of proof is clear and convincing evidence rather than preponderance of the evidence.

10. Element 4 - Reliance (used as means of establishing causal connection between defendant’s misrepresentation or omission and plaintiff’s injury).

a) In cases of misstatements, plaintiff must have (i) actual knowledge of misstatement and (ii) belief in truth of the misstatement; misstatement must have been a cause of plaintiff’s entering the transaction. But see “Fraud on the Market” and “Fraud Created the Market” theories below which avoid showing of reliance.

b) In cases of omission, reliance is presumed from showing of materiality (Affiliated Ute Citizens v. United States, 406 U.S. 128 (1972) presumption).

c) “Fraud on Market” Theory - no need for proof of actual reliance; with proper disclosure, security could not have been sold at any price; theory extends presumption of reliance to cases of affirmative misrepresentation by allowing presumption of reliance on market price and the market itself to substitute for proof of reliance; case law has developed from cases involving open, developed markets to new issuances in undeveloped markets (see Fraud Created the Market, below); now some retrenchment in theory. (Blackie v. Barrack, 524 F.2d 891 (9th Cir. 1975), cert denied, 429 U.S. 816 (1976); Basic v. Levinson; Stinson v. Van Valley Dev. Corp., 714 F. Supp. 132 (E.D. Pa. 1989, and 719 F. Supp. 362 (E.D. Pa. 1989); Freeman v. Laventhol & Horwath., 915 F.2d 193 (2d. Cir. 1990)).

d) “Fraud Created the Market” Theory – no need for proof of actual reliance; extension of “fraud on the market” theory to situations of


newly issued securities on underdeveloped markets (where plaintiff has not read disclosure document) (Shores v. Sklar, 647 F. 2d 462 (5th Cir. 1981); Ross v. BankSouth, N.A., 885 F. 2d 723 (11th Cir. 1989) (economic unmarketability) and Abell v. Potomac Insurance Company, 858 F. 2d 1104 (5th Cir. 1988) (factual unmarketability)). Theory limited to two lines of cases: (1) situations where security is economically unmarketable because it’s valueless, or (2) situations where security, whether or not it has economic value, was subject to a scheme so fraudulent and pervasive as to render it unmarketable.

11. Element 5 – Causation.

a) Plaintiff must show that the misstatement or omission was in some reasonably direct or proximate way responsible for loss.

b) Without causation, Rule l0b-5 serves as an insurance policy.

c) Courts do not always apply element.

12. Element 6 – Damages.

a) At common law, seller’s remedy is a recission - may be problem if property has depreciated in value.

b) At common law, buyer’s remedy is damages.

c) Theories of damages.

(i) Benefit of the bargain (value of what would have been received if misrepresentation were true vs. actual value of what plaintiff received).

(ii) Out-of-pocket loss (traditional for Rule l0b-5: fair market value given less fair market value of what was received).

(iii) Problem of dates on which to measure damages.

d) Section 12(2) (generally inapplicable to municipal securities) permits recission.

13. Statute of Limitations.

a) Federal court applies either state, common law fraud or Blue Sky law limitations.

b) Lampf - established uniform statute of limitations for federal securities fraud actions (one year from discovery of violation or three years after sale); decision applied retroactively.


D. Secondary Liability Under Antifraud Provisions.

1. Aiding and abetting - makes participants in securities transactions liable under antifraud provisions although not expressly covered by such provisions.

2. Elements derived from criminal law.

a) A primary violation has occurred.

b) Knowledge of or a duty of inquiry with regard to the primary violation by the person charged.

c) Necessary contribution to the underlying scheme (substantial assistance to primary violator).

3. No clear standard as to knowledge.

a) Actual knowledge.

b) General awareness.

c) Role in transaction.

4. Central Bank: no private cause of action for aiding and abetting.

V. FEDERAL SECURITIES LAWS -- COMMON LAW CAUSES OF ACTION

A. Fraud and deceit - action for money damages.

1. Elements:

a) False representation.

b) Materiality.

c) Statement of fact.

d) Scienter (knowledge of falsity).

e) Reliance.

f) Damages as a consequence of deceit.

B. Rescission (for use by buyer (restitution) or seller (breach of contract)).

1. Elements:

a) Misrepresentation.


b) Materiality.

c) Facts.

d) No scienter or intent required.

e) Reliance.

f) Does not require causation - need not show causal nexus between misrepresentation and damages; do not have to demonstrate damages.

2. Equitable Defenses.

VI. FEDERAL SECURITIES LAWS -- RULE 15c2-12, 17 CFR § 240.15c2-12.

Rule 15c2-12 (the “Rule”) was promulgated in 1989 and originally covered only matters related to primary offerings of municipal securities. The Rule is not an antifraud rule; rather, it is a procedural rule intended to reduce the opportunity for fraud. The Rule was amended in 1994 to add the continuing disclosure provisions discussed below. The Rule was further amended in 2008 and 2010 to modify certain of the continuing disclosure provisions of the Rule.

A. Applicability. Brokers, dealers and municipal securities dealers (“Participating Underwriters”) involved in a primary offering of municipal securities in a principal amount greater than $1 million (“Offering”) must comply with the requirements of Rule 15c2-12 or must be exempt from the requirements of Rule 15c2-12 before acting as an underwriter in such an Offering. Initial step is to determine whether the Rule applies to a particular offering. (Rule 15c2-12(a)).

1. Primary offering is defined by the Rule (at 15c2-12(f)(7)) to be an offering of municipal securities directly or indirectly by or on behalf of an issuer of such securities. Primary offering specifically includes a remarketing of municipal securities if such remarketing involves (a) a change in authorized denomination from $100,000 or more to less than $100,000 or (b) a change in the period of tender for redemption or purchase from a period of nine months or less to a period of more than nine months. Other remarketings would also be included unless specifically exempt under the Rule.

2. Exemptions from the Rule.

a) Limited placement exemption. The Rule does not apply to municipal securities in authorized denominations of $100,000 or more which are sold to no more than 35 knowledgeable and experienced investors who are not purchasing with a view to distributing the securities. (Rule 15c2-12(d)(1)(i)).


b) Short-term debt exemption. Prior to the 2010 amendments to the Rule, the Rule did not apply to the primary offering of municipal securities in authorized denominations of $100,000 or more and (i) that which had a maturity of nine months or less or (ii) that could be tendered at option of the holder for redemption or purchase at least every nine months. Effective December 1, 2010, although securities that can be tendered at option of the holder for redemption or purchase at least every nine months remain exempt from the primary offering provisions of the Rule, these securities are subject to the continuing disclosure provisions of the Rule. (Rule 15c2-12(d)(1) and (5)).

c) Limited exemption from continuing disclosure requirements. Prior to the 2008 amendments to the Rule, the Rule did not apply to any Obligated Person (defined at 15c2-12(f)(10)) who, at the time of the issue, would be an Obligated Person with respect to less than $10 million of outstanding municipal securities.

(i) Includes current offering.

(ii) Excludes offerings exempt under existing provisions of Rule relating to limited offerings and short term securities.

(iii) Includes offerings under $1 million unless otherwise exempt from Rule.

(iv) Amendment to the Rule. Effective July 1, 2009, an Obligated Person that has $10 million or less in outstanding securities is subject to the events notice requirements and is required to provide financial information and operating data that is “customarily prepared by such obligated person and is publicly available.” Financial information and operating data are required to be submitted on at least an annual basis.

d) Limited exemption from annual reporting requirements. None of the Rule requirements except event disclosure undertakings apply to offerings of municipal securities having a stated maturity of 18 months or less. (Rule 15c2-12(d)(3)).

B. Obtain and review “deemed final” official statement (“DFOS”). The Participating Underwriter must obtain and review an official statement “deemed final” by an issuer of municipal securities (with certain permitted omissions) prior to bidding for, purchasing, offering or selling such municipal securities. (Rule 15c2-12(b)(1)).

1. Issuer of municipal securities is defined by the Rule (at 15c2-12(f)(4))to be the governmental issuer and the issuer of any separate security, such as a conduit borrower.


2. Official statement must be “deemed final” prior to offering the securities, i.e., before a purchase contract would ordinarily be executed. However, the Rule does not require that the official statement be “deemed final” by such an Issuer in writing. Often the BPA or authorizing document contains a representation deeming the POS final.

3. The following are permitted omissions: the offering price(s), interest rate(s), selling compensation, aggregate principal amount, principal amount per maturity, delivery dates, any other terms or provisions required to be specified in a competitive bid, ratings, other terms of the securities depending on such matters, and the identity of the underwriter(s). This is information determined at pricing and therefore is not known at the time the POS or other document(s) are deemed final.

a) Redemption terms are not specified but may be considered terms dependent on offering price and therefore a permitted omission.

b) Similarly, the use of proceeds information may be dependent on the aggregate principal amount of the offering and omitted.

c) Credit enhancement information.

4. A combination of documents may qualify as a “deemed final” official statement. If material changes are made in a financing after the POS is printed, the POS will not be an adequate document to serve as the deemed final official statement and will need to be supplemented.

5. Participating Underwriter must not only obtain a DFOS but must also review it in a professional manner in both a negotiated offering and competitive bid situation. By participating in an underwriting, an underwriter makes an implied recommendation about the securities sold in the offering, and implies that the underwriter has a reasonable basis for believing in the accuracy and completeness of key representations made in the disclosure documents. (SeeSEC Rel. No. 34-26100 (September 22, 1988), SEC Rel. No. 34-26985 (June 28, 1989) and SEC Rel. No. 34-33741 (March 9, 1994) (the “Interpretive Release”).

C. Dissemination to potential customers. Except in competitively bid offerings, from the time the issuer selects the Participating Underwriter until a final official statement is available, the Participating Underwriter is required to send, no later than the next business day, a copy of the most recent preliminary official statement, if any, to any potential customer on request. From the time the final official statement becomes available until the earlier of (1) 90 days from the end of the underwriting period, or (2) the time when the final official statement is available from the Municipal Securities Rulemaking Board, but in no case less than 25 days following the end of the underwriting period, the Participating Underwriter is required to provide the final official statement to any potential customer on request. (Rule 15c2-12(b)(2) and (b)(4)).


D. Contract to receive final official statement. The Participating Underwriter is required to contract with an issuer of municipal securities (or an agent thereof such as a financial printer) to receive within 7 business days after a final agreement to purchase, offer or sell municipal securities (ordinarily, a bond purchase agreement in a negotiated offering and an “award” pursuant to a notice of sale for a competitive offering) and within sufficient time to accompany confirmations to customers, copies of a final official statement in sufficient quantities to meet requests and MSRB rule requirements (such as MSRB Rules G-15 and G-32, requiring delivery of information). This is an important rule for underwriter’s counsel in coordinating printing and delivery of the final official statement. Delivery may need to be sooner than seven business days if the closing is earlier than seven business days from pricing. (Rule 15c2-12(b)(3)).

E. What is a final official statement?

1. Final official statement is defined by the Rule (at 15c2-12(f)(3)) as “a document or set of documents prepared by an issuer of municipal securities or its representatives that is complete... and that sets forth... information, including financial information or operating data, concerning such issuers of municipal securities and those other entities, enterprises, funds, accounts and other persons material to an evaluation of the Offering...”

a) The parties determine whose financial information is material to the offering and the form and content of such information to be included. (SEC Rel. No. 34-34961, November 10, 1994, the “Adopting Release,” at fn. 32).

b) The definition of final official statement allows information to be included by specific reference to documents previously made “publicly available.” Documents are considered publicly available only if submitted to the MSRB (see VI., F., 5, below) or, if concerning a reporting company, filed with the SEC, and if a final official statement, must be available from the MSRB. (AdoptingRelease at fn. 47).

c) Final official statement includes all information and documents that have been cross referenced. (Adopting Release at fn. 45).

d) Commission encourages use of voluntary guidelines and Interpretive Release in preparing disclosure documents. (Adopting Release at fn. 35).

F. Determine that satisfactory continuing disclosure commitment has been made.Participating Underwriters must have reasonably determined that an issuer of municipal securities and/or an Obligated Person for whom financial or operating data is presented in the final official statement has undertaken in writing for the benefit of the bondholders to provide certain required information. Undertaking is often in the


form of a Continuing Disclosure Agreement from all Obligated Persons and may be an agreement with a dissemination agent. (Rule 15c2-l2(b)(5)).

1. Undertaking must encompass ongoing information about issuers and/or other “Obligated Persons” for whom financial information is provided in the final official statement.

2. Obligated Person is defined by the Rule to be any person, including an issuer of municipal securities, who is either generally or through an enterprise fund or account of such person committed by contract or other arrangement to support payment of all or part of the obligations on the municipal securities in the Offering (other than bond insurers, letters of credit or liquidity providers).

a) Nexus to the financing is through a contractual commitment or other arrangement that is structured to support payment of all or part of the obligations on the municipal securities, whether or not enforceable by bondholders. (Adopting Release at fn. 69).

b) Persons that are the source of cashflow, but have no relationship to the financing, are not included. (Adopting Release at fn. 70).

c) The phrase “obligations on municipal securities” in the definition is intended to encompass debt obligations, lease payments and any other repayment obligation on or resulting from the municipal securities. (Adopting Release at fn. 72).

d) The definition includes but is broader than the concept of issuers of separate securities under Rule 131 pursuant to the Securities Act of 1933. (Adopting Release at fn. 73).

e) The definition does not include a specified percentage of payment. The issuer and other participants are to determine, at the time of preparing the final official statement, which Obligated Persons (by name or objective criteria) are material to an Offering. (AdoptingRelease No. at fn. 78). (See American Bar Association, March 15, 1996 [referred to as the “ABA Letter”] for a discussion of pooled financings).

f) Bond insurers, letter of credit providers and other liquidity facility providers are excluded from the definition of Obligated Person to avoid the burden on issuers to obtain information about such providers and on the basis of representations that such providers will deposit publicly available reports which may be easily obtained. (Adopting Release at fn 82). (See National Association of Bond Lawyers, June 23, 1995 [referred to as “NABL I”], Question 22 andNational Association of Bond Lawyers, September 19, 1995 [referred to as “NABL II”], Question 9).


3. Scope of Required Information. The information required to be disclosed to the market through the undertaking includes certain annual financial information, audited financial statements and material events notices. (Rule 15c2-12)(b)(5)(i)).

a) Annual financial information.

(i) Annual financial information must be provided (X) for each Obligated Person for whom financial information is presented in the final official statement or (Y) for each Obligated Person meeting the objective criteria specified in the undertaking. Undertaking must identify these people. (Rule 15c2-12(b)(5)(i)(A)).

(ii) Annual financial information is defined by the Rule (at 15c2-12(f)(9)) to mean financial information or operating data, provided annually, of the type included in the final official statement with respect to the affected Obligated Person. Undertaking must specify in reasonable detail this information and specify the date by which and to whom the information will be delivered. Rule 15c2-12(b)(5)(ii)).

(iii) The Rule does not specify the reporting format or content of such annual report. Content is determined at time of preparing the final official statement and annual information must be of the same type. The final official statement serves as a baseline for continuing information. Nevertheless, the Adopting Release cautions that “[t]he fact that the amendments rely on the final official statement to set the standard for ongoing disclosure should not serve as an incentive for issuers to reduce existing disclosure practices in the preparation of the final official statement.” (Adopting Release at fn. 34).

(iv) Reference may be made to other information already submitted to the MSRB or the Commission, including other final official statements. (Adopting Release at fn. 44). (See NABL 1, Question 7; NABL II, Question 8).

(v) The Adopting Release emphasizes the intended quantitative nature of the information. (Adopting Release at fn. 111).

(vi) Reference should be made to applicable industry guidelines for determining operating data to be provided initially and on an ongoing basis. (Adopting Release at fn. 111).

(vii) Changing conditions. Issuers and Obligated Persons cannot unilaterally determine that certain types of information are no longer necessary or meaningful to investors. (AdoptingRelease at fn. 111). However, persons about which


information is provided may be adjusted to the extent they are identified by objective criteria and information need not be provided about persons that are no longer Obligated Persons with respect to the securities. (See NABL 1, Questions 15 and 16).

b) Audited financial statements.

(i) If not otherwise submitted as part of the annual financial information, audited financial statements for each Obligated Person are required to be disseminated only when and if otherwise available. (Rule 15c2-12(b)(5)(i)(B) (But see NABL II, Question 11).

(ii) The Release states that “it is anticipated that full financial statements will be provided for entities with ongoing revenues and operating expenses.” (Adopting Release at fn. 104) (See NABL I, Question 6).

(iii) The Rule does not mandate any specific use of either GAAP or GAAS. Undertaking must identify in reasonable detail to accounting principles to be used. (Adopting Release at fn. 105).

c) Events notices.

(i) Prior to December 1, 2010, the Rule at (b)(5)(i)(C) required an undertaking to require an issuer or obligated person to provide “timely” notice of the following eleven events, if “material:”

(a) Principal and interest payment delinquencies;

(b) Non-payment related defaults;

(c) Unscheduled draws on debt service reserves reflecting financial difficulties;

(d) Unscheduled draws on credit enhancements reflecting financial difficulties;

(e) Substitution of credit or liquidity providers, or their failure to perform (see NABL II, Question 3);

(f) Adverse tax opinions or events affecting the tax-exempt status of the security;

(g) Modifications to rights of security holder;


(h) Bond calls (see NABL I, Question 8 and NABL II, Question 10);

(i) Defeasances;

(j) Release, substitution or sale of property securing repayment of the securities; and

(k) Rating changes (see NABL I, Question 9).

(ii) Effective December 1, 2010 (see SEC Rel. No. 34–62184A,May 26, 2010, “Adopting Release II”), the Rule at (b)(5)(i)(C)now requires an undertaking to require an issuer or obligated person to provide notice of the following fourteen events within 10 business days of the occurrence of the event:

(a) Principal and interest payment delinquencies;

(b) Non-payment related defaults, if material;

(c) Unscheduled draws on debt service reserves reflecting financial difficulties;

(d) Unscheduled draws on credit enhancements reflecting financial difficulties;

(e) Substitution of credit or liquidity providers, or their failure to perform (see NABL II, Question 3);

(f) Adverse tax opinions, the issuance by the Internal Revenue Service of proposed or final determinations of tax-ability, 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;

(g) Modifications to rights of security holders, if material;

(h) Bond calls, if material, and tender offers (see NABL I, Question 8 and NABL II, Question 10);

(i) Defeasances;

(j) Release, substitution, or sale of property securing repayment of the securities, if material;

(k) Rating changes (see NABL I, Question 9);


(l) Bankruptcy, insolvency, receivership or similar event of the obligated person;

(m) The consummation of a merger, consolidation, or acquisition involving an obligated person or the sale of all or substantially all of the assets of the obligated person, 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; and

(n) Appointment of a successor or additional trustee or the change of name of a trustee, if material.

(iii) The Release states that “[t]he determination of whether other events also should be the subject of notification pursuant to the information undertaking is left to the parties.” (AdoptingRelease at fn. 118). Issuers may disclose other material developments to ensure equal access to information by the market.

(iv) The Rule also requires notice of a failure of any person to provide annual financial information as required by the undertaking. (Rule 15c2-12(b)(5)(i)(D)).

(v) Undertakings must include reference to all fourteen events. (See NABL II, Question 2).

(vi) Obligations to give a notice may not be conditioned on knowledge of the event. (See ABA Letter, Question 3).

d) Additional information. Information in addition to that specified in the undertaking may need to be disclosed to the secondary market to make the disclosure complete and satisfy antifraud provisions of the federal securities laws. (Adopting Release at fn. 112).

e) A final official statement must also disclose the specifics of the undertakings required by the Rule. At a minimum, the description of the undertaking must inform market participants of the identity of entities about which information will be provided and the type of information to be provided. (Rule 15c2-12(f)(3)).

f) The final official statement must disclose any instances in the previous five years in which an Obligated Person covered by the continuing disclosure undertaking has failed to comply, in all material respects, with any previous written undertakings to provide continuing disclosure. (Rule 15c2-12(f)(3)). As underwriter’s counsel


it is a good idea to check the information repositories (see VI., F., 5, below) to see if any required filings have been made on a timely basis.

(i) A Participating Underwriter is not prohibited from underwriting an offering in which issuer or Obligated Person has failed to comply with previous undertakings. (AdoptingRelease at fn. 53).

(ii) If failure to comply has not been remedied, however, or if history of “persistent and material breaches,” Participating Underwriter probably cannot form a reasonable basis for relying on the accuracy of the ongoing disclosure representations of such issuer or Obligated Person. (AdoptingRelease at fn. 53 and Adopting Release II at fn. 350).

4. Reasonable Determination.

a) A “reasonable determination” that a qualified continuing disclosure undertaking has been made must be made by the Participating Underwriter prior to purchasing or selling municipal securities in connection with an Offering. (Rule 15c2-12 (b)(5)(i)).

(i) A Participating Underwriter needs to receive assurances from the Issuer or Obligated Persons in a purchase agreement, notice of sale or otherwise that the undertakings to be made in the indenture, bond resolution or elsewhere would be made before agreeing to act as an underwriter. (Adopting Release at fn. 22).

(ii) Participating Underwriters will review the DFOS with a view to ascertaining that it contains, among other things, certain specifics of the continuing disclosure undertakings as required by the definition of final official statement. (Adopting Release at fn. 27).

5. Deposit and Dissemination of Information.

a) Past Practices: Repositories.

(i) NRMSIRs. The Rule previously required that Participating Underwriters reasonably determine that annual financial disclosure and material events notices (except to the extent filed with the MSRB) will be submitted to each Nationally Recognized Municipal Securities Information Repository (“NRMSIR”). NRMSIRs had to meet certain qualifications outlined in the Adopting Release and could not charge to accept information. NRMSIRs had to reapply for status so


that Commission could determine whether dissemination standards were met. The NRMSIRs changed on a regular basis, eventually winding up at 4.

(ii) SIDs. The Rule also required that Participating Underwriters reasonably determine that annual financial disclosure and material events notices will be submitted to each state information depository (“SID”) if an “appropriate” SID has been established in the applicable state. “An appropriate SID would be a depository operated or designated by the state that receives information from all Issuers within the state and makes this information available promptly to the public on a contemporaneous basis.”

b) Past Practices: The Central Post Office - DisclosureUSA.org.

(i) The SEC approved the use of the “Central Post Office” (created by the Municipal Advisory Council of Texas) by Issuers and Obligated Persons for purposes of complying with the Rule. (See Texas MAC September 7, 2004). The Central Post Office (“CPO”) was an electronic filing system whereby Issuers and Obligated Persons could make filings electronically at www.DisclosureUSA.org, free of charge. Once a transmission was made to the CPO, the CPO transmitted the information to the NRMSIRs and applicable SIDs.

c) Current Practice: Electronic Municipal Market Access (“EMMA”)

(i) In 2008 the SEC amended the Rule to require Issuers and Obligated Persons to submit annual financial information and any material event notices in an electronic format to the MRSB through its web-based system known as Electronic Municipal Market Access, or “EMMA.” The amendment affects all filings made after July 1, 2009, including filings made pursuant to undertakings entered into before July 1, 2009. (See www.emma.msrb.org)

(ii) Effective July 1, 2009, in a separate action in conjunction with its amendment of the Rule, the SEC:

(a) designated the MSRB as the sole NRMSIR for bonds issued prior to July 1, 2009, and

(b) revoked its “no action” letters that designated the four then current NRMSIRs and approved DisclosureUSA as a means for filing with those NRMSIRs.


(iii) Submissions to EMMA had to be filed in portable document format or “PDF.” Beginning January 1, 2010, documents were required to be filed in word-searchable PDF.

d) Dissemination agents. Dissemination responsibilities may be delegated to designated agents (Adopting Release at fn. 87). See also SEC No-Action Letter, dated September 21, 2011 re: Digital Assurance Certification, LLC (“DAC”).

e) Selective Disclosure. Liability concerns with selective disclosure. Selective disclosure regulations of the SEC, known as “Regulation FD” or “Regulation Fair Disclosure,” do not apply to municipal issuers directly. Regulation FD requires “that when an issuer, or person acting on its behalf, discloses material nonpublic information to certain enumerated persons (in general, securities market professionals and holders of the issuer’s securities who may well trade on the basis of the information), it must make public disclosure of that information.” (see SEC, Rule FD, Selective Disclosure and Insider Trading, Release Nos. 33-7881, 34-43154, IC-24599, File No. S7-31-99, 17 CFR Parts 240, 243, and 249)). Although Regulation FD does not apply directly, use of EMMA is encouraged to ensure that any disclosure made to a bondholder is available to the market. (See September 2000 NABL position statement).

VII. FEDERAL SECURITIES LAWS - - SEC ENFORCEMENT.

A. The Process

1. Investigations

a) Enforcement actions are generally preceded by an investigation; may be formal or informal.

b) Formal investigation requires entry of an order by the SEC directing staff to conduct inquiry (authorizes the staff to issue subpoenas and administer oaths).

c) Informal investigation can be initiated by the SEC staff without specific authorization.

2. Enforcement Actions - At the end of the investigation, staff may recommend an enforcement action (no requirement that staff inform a person that investigation is over and no enforcement action will be brought).

a) Administrative Proceedings - SEC has power to initiate an administrative proceeding before an administrative law judge. A


party can consent to the entering of a proceeding without admitting or denying the charges contained therein.

(i) If target is a person that is subject to registration or regulation by SEC (e.g. broker-dealer), SEC may impose monetary penalties, remedial sanctions, a temporary cease-and-desist order or a permanent cease-and-desist order.

(ii) For any other person, SEC may impose a permanent cease-and-desist order.

(iii) SEC can also order an accounting and disgorgement of profits obtained illegally in either case.

b) Civil proceeding in federal district court.

c) Criminal referral to the Dept. of Justice.

d) Referral to other federal, state or self-regulatory authorities.

e) Deliver a “21(a) Report” - Issuance of a report on an investigation based on the statutory authority under Section 21(a) of the 1934 Act to issue such a report. Allows the SEC to make statements without bringing an action. As a practical matter, always done with the consent of the parties involved.

B. SEC Enforcement Activity.

1. Increasing Emphasis on Municipal Securities Offerings.

a) Enforcement activity generally based on broad antifraud provisions of securities laws; therefore, cases are driven by facts and circumstances. Chapter 3 of Disclosure Roles of Counsel (3rd ed. 2009) summarizes many of these enforcement actions.

b) SEC authority over broker-dealers (investment bankers) is broad, but is limited as to other parties. As to lawyers, issuers and independent financial advisors, SEC’s enforcement powers are limited to the antifraud provisions of the securities laws (primarily Section 10(b) of the 1934 Act and 17(a) of the 1933 Act). Some believe that the SEC tries to fit a wide range of actions under these provisions, as it is the only authority for action.

c) New York City: SEC Staff Reports. (1977; 1979). The SEC broadly addressed the municipal securities market in connection with the financial crisis in New York City in the mid 1970s. This was the first significant promulgation from the SEC in recent history with respect to a specific municipal situation. The SEC staff issued a Report in


1977 concerning transactions in securities issued by New York City and then issued its final report in 1979.

(i) The two stated objectives of the Staff Report, which lay the groundwork work for much of the enforcement activity that the SEC has undertaken in the past 15 years, were:

(a) To determine the nature and extent of the knowledge of City officials, underwriters, and bond counsel with respect to the steadily worsening financial condition of the City.

(b) To compare the knowledge of these parties to the disclosures made to the public.

(ii) The Staff Report states that “Although municipalities have certain unique attributes by virtue of their political nature, insofar as they are issuers of securities, they are subject to the proscription against false and misleading statements.”

(iii) The Staff Report concluded that the City had employed budgetary, accounting and financing practices which distorted its true financial condition and that investors in its securities did not receive the protections of the federal securities laws. The Staff Report also concluded that, in varying degrees, the participants in the underwriting process, including the principal underwriters, bond counsel and the rating agencies, failed to meet their responsibilities to the investing public.

(iv) The Staff Report found that there appears to be no clear understanding that the underwriter should make a reasonable investigation to assure the accuracy of the information disclosed. There also is no clear separation or statement of the functions of issuers’ and underwriters’ counsel.

(v) The SEC determined not to take any enforcement action against New York or the professionals.

d) Washington Public Power Supply System: SEC Staff Report (1988). Eleven years after the New York City Report, the SEC staff issued a report regarding its investigation of WPPSS.

(i) The Staff Report focused on three issues:

(a) Developments during the sale of bonds relating to costs, financing, power demand and participant support.


(b) Marketing of the bonds during the same period, including the roles of the underwriters, the rating agencies and unit investment trusts.

(c) The extent to which WPPSS counsel recognized and disclosed legal problems relating to the validity of those agreements.

(ii) The SEC closed its investigation without initiating enforcement action in part, because the matter “reflects systematic characteristics of the regulatory framework for municipal securities that might be addressed more appropriately by regulatory or legislative initiatives.”

(iii) On the same day, the SEC published a release on the regulation of the municipal securities market and proposed Rule 15c2-12.

2. Key Factors Examined by SEC in Recent Enforcement Cases.

a) Responsibilities under federal securities laws by issuer officials that authorize disclosure documents.

b) Degree and manner in which issuer officials may rely on staff, third-party experts and attorneys in the drafting and review of disclosure documents.

c) Applicability and interpretation of materiality standard.

d) Responsibilities of underwriters.

e) Responsibilities of non-regulated third-parties.

3. Responsibility of Local Government Officials

a) Orange County

(i) The SEC investigated Orange County, California in connection with various municipal securities offerings and certain investment strategies undertaken in connection therewith. These matters ultimately led to the County filing bankruptcy and the default by the County on over $900 million of municipal securities.

(ii) The 11 financings aggregated over $2 billion of offerings by the County and other entities within the County. The repayment of the financings was dependent upon pooled investment funds managed by the County. The basic strategy employed by two County employees was to borrow funds by


issuing short term securities and investing the borrowed funds in securities with longer maturities. The investment strategy was dependent upon interest rates of the short term securities being lower than the longer maturity securities. Also a significant amount of leverage was integral to the investment strategy which used derivative instruments. The strategy collapsed when short term interest rates rose.

(iii) SEC alleged that the disclosure documents used by the County failed to disclose information material to investors. SEC alleged that the issuers did not describe either the investment strategy of the County investment pools or the dependence on the success of the strategy to pay the bonds.

(iv) SEC obtained permanent injunctions against the two County employees and cease and desist orders against the County and the Board of Supervisors.

(v) In its Report, the SEC set forth its views regarding the responsibilities under the federal securities laws of local government officials who authorized the issuance of municipal securities and related disclosure documents. The Report states: “In authorizing the issuance of securities and related disclosure documents, a public official may not authorize the disclosure that the official knows to be false; nor may a public official authorize disclosure while recklessly disregarding facts that indicate that there is a risk that the disclosure may be misleading. When, for example, a public official has knowledge of facts bringing into question the issuer’s ability to repay the securities, it is reckless for that official to approve disclosure to investors without taking steps appropriate under the circumstances to prevent the dissemination of materially false or misleading information regarding those facts.” The test of “steps appropriate under the circumstances” becomes important guidance. The Report says that steps could have included becoming familiar with the disclosure documents and questioning the issuer’s officials, employees or other agents about the disclosure of those facts.

(vi) The Report demonstrates that the SEC puts an affirmative responsibility on issuers’ officials with respect to the disclosure. Issuers should be told this and understand the important role that they play in their disclosure documents.

(vii) The SEC concluded in the Report that the reliance upon hired professionals did not relieve the Board of the responsibility to question the professionals involved to determine if they have knowledge of material facts.


b) City of Victorville, CA

(i) In April 2013, the SEC filed a complaint against an underwriter, two investment bankers, a developer, a city, the director of economic development for the city, and an Airport Authority (the Authority), alleging fraud in connection with tax increment bonds issued by the Authority in 2006, 2007, and 2008. Proceeds from the bonds were used to fund redevelopment projects on a former Air Force base located in San Bernardino County, California.

(ii) According to the SEC’s complaint, the redevelopment projects undertaken by the Authority included four new airplane hangars. The SEC alleges that, in constructing the hangars, the underwriter, one of the investment bankers, and the developer misappropriated $2.75 million in bond proceeds. According to the SEC, these proceeds were used to pay excessive construction and property management fees, which were concealed from the Authority. Due to the non-disclosure of the unauthorized and excessive fees, the SEC contends that the 2007 and 2008 Official Statements contained material misstatements and omissions.

(iii) The SEC further alleges in its complaint that the Authority’s 2008 Official Statement was false and misleading because, according to the SEC, it misstated the tax increment available to repay bondholders and the debt service ratio for the bonds. The SEC alleges that the calculations of the tax increment and debt service ratio were based on an improperly inflated $65 million valuation by the developer of the new airplane hangars.

(iv) Finally, the SEC alleges that the underwriter and investment bankers falsely represented to investors that they had reviewed the Authority’s Official Statements as part of their due diligence efforts and that the information contained therein was complete and accurate.

(v) The SEC’s complaint is based on nine claims of securities law violations. The claims include securities fraud and aiding and abetting securities fraud against all of the defendants, as well as alleged violations and aiding and abetting violations of MSRB Rules G-17, G-27, and G-32 against the underwriter and investment bankers. The SEC is seeking civil penalties, disgorgement, and permanent injunctions against the defendants. The case is currently pending in the U.S. District Court for the Central District of California.


c) City of Miami, FL

(i) In July 2013, the SEC filed an enforcement action in federal court against a City and its former budget director alleging securities fraud in connection with the City’s 2007 and 2008 annual financials and subsequent 2009 bond offerings. This lawsuit, which is the first suit the SEC has brought against a municipality for a violation of a cease-and-desist order, highlights the SEC’s continued increased scrutiny of the substance of primary and secondary municipal market disclosures as well as the related conduct of municipal officials.

(ii) The SEC’s complaint against the City focused on alleged improper conduct—and the consequent annual financials and bond offering disclosures—involving interfund transfers by the City. The SEC alleged that, from 2007 to 2009, the City made transfers from capital project funds (which comprised monies restricted to specific purposes) to a general use fund to mask deficits in the general fund. The interfund transfers totaled $37.5 million, according to the SEC. The SEC asserted that these improper transfers falsely inflated the general fund balance to meet a reserve level requirement for that fund. Bolstering the City’s general fund in this manner led ultimately to more favorable ratings by credit rating agencies on the City's 2009 bonds, according to the SEC.

(iii) The SEC claimed that the City made numerous material misrepresentations and omissions about the interfund transfers in its bond offering documents and its 2007 and 2008 annual financials. This included the failure to disclose the full amount or effect of the transfers to the general fund’s budget and balance; the misstatement that transferred project funds were “unexpended” or “unused” when in fact the funds were allocated to and needed for specific projects; the failure to disclose that a portion of the transferred funds were restricted from interfund transfer; and the failure to disclose that the City had not adjusted its capital projects funds budget to reflect the transfers to the general fund.

(iv) The SEC charged that the City’s former budget director arranged the improper transfers, misrepresented the true nature of transfers to City officials and others (including the rating agencies), and falsified justification for transfers in the City's internal records. The SEC asserted that the improper transfers came to light when the City’s Office of Independent Auditor General issued a report in 2009 after conducting an annual compliance review.


(v) In its complaint, the SEC pleaded claims against both the City and former budget director for violations of Section 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 (and Rule 10b-5 thereunder); a claim against the former budget director for aiding and abetting the City's violation of Section 10(b)/Rule 10b-5; and a claim against the City for violations of a 2003 cease-and-desist order due to prior violations of the anti-fraud provisions. The case is pending in the U.S. District Court for the Southern District of Florida. On December 27, 2013, the court denied the City’s motion to dismiss the SEC’s claims against it.

4. Stale Financial Information (Maricopa County, Arizona (1996))

a) The SEC instituted and settled cease and desist proceedings against Maricopa County, Arizona, the population center of Arizona and the sixth largest county in the country. The SEC charged that the Official Statements used in connection with the July 1993 offer and sale of two series of general obligation bonds failed to disclose that the County’s financial condition had seriously worsened between the close of the fiscal year covered by the audited financial statements in the official statements and the time of issuance of the 1993 bonds.

(i) The SEC’s order alleged that the Official Statements failed to disclose that the County had developed a deficit in its general fund and had nearly doubled the deficit in its medical center enterprise fund.

(ii) The Official Statement for one of the offerings represented that bond proceeds would be used to finance specific County projects, although the Order alleged that the County in fact planned to use the bond proceeds to finance its deficit on a temporary basis.

(iii) The Order found that the omitted facts were material and would have been important for an investor to consider in deciding whether or not to purchase the County’s bonds.

b) The Maricopa County proceedings illustrate the SEC’s view that facts may be material even if they do not adversely affect the ability to pay principal and interest in a timely fashion. The County’s short-term deficit had no impact on its ability to levy unlimited ad valorem property taxes to pay its general obligation debt, and the County was current in the payment of all general obligation debt service, including the 1993 Bonds. The enforcement proceedings therefore suggest that omissions concerning an issuer’s financial condition, at least in the SEC’s view, may be material, regardless of the possibility of default.


5. Reliance on Experts (City of Miami (2001 SEC LEXIS 1250 (2001))

a) SEC brought action against the City, city manager and finance director in connection with omissions and misstatements in three Official Statements and a Comprehensive Annual Financial Statement (CAFR) claiming that the City had falsely misrepresented the lack of an adverse change in financial condition.

(i) Recent downgrade by Standard & Poor’s had not been disclosed

(ii) Bond funds were actually used for operating expenses

(iii) Reasons given for programs disguised the poor financial health of the City.

b) Significant differences from historical cases

(i) Bonds were insured by municipal bond insurance

(ii) Never any default

(iii) Liability found for use of CAFR unconnected to actual sale of bonds

c) City contended it relied on its accountants in the financial disclosure, but administrative judge denied defense.

d) In order to successfully claim reliance on experts, must show

(i) Complete disclosure

(ii) Sought advice as to challenged conduct

(iii) Received advice that action was appropriate

(iv) Relied in good faith on advice

e) City failed to satisfy any elements

6. Postemployment Benefits/Disclosure Procedures Part #1 (City of San Diego (2006))

a) The City of San Diego, California is subject to a cease and desist order entered on November 14, 2006 to resolve an administrative proceeding brought by the SEC. The order found that the City violated the antifraud provisions of the federal securities laws, including in connection with the offer and sale of five separate municipal bond offerings. In particular, it found that the “City failed


to disclose material information regarding substantial and growing liabilities for its pension plan and retiree health care and its ability to pay those obligations in the future in the disclosure documents for its 2002 and 2003 offerings, in its continuing disclosures filed in 2003, and in its presentations to the rating agencies.”

b) The San Diego proceeding highlights why issuers should carefully consider whether to implement appropriate disclosure controls and procedures, both to ensure the accuracy and completeness of those disclosures that are subject to federal securities law liability and to establish compliance by municipal officials with their legal responsibilities. San Diego’s procedures, adopted after the commencement of an SEC investigation into the City’s disclosure practices, go considerably beyond those utilized by most municipal issuers, even large issuers that are regularly in the market. The City’s procedures, however, provide a menu of alternatives that regular issuers may wish to consider in determining what controls and procedures may be appropriate for their particular circumstances. Basic elements of any such controls and procedures would likely include:

(i) Disclosure training for officials responsible for producing, reviewing and approving disclosures;

(ii) Establishing a procedure with accountability for review of relevant disclosure; and

(iii) Ensuring that any procedures established are in fact followed.

7. Postemployment Benefits/Disclosure Procedures Part #2 (State of New Jersey (2010))

a) The SEC charged the State of New Jersey with violating securities fraud laws for its failure to disclose to bond investors that it was underfunding the State’s two largest pension plans in connection with over $26 billion in bonds issued by the State from August 2001 through August 2007.

b) The SEC found that New Jersey made material misrepresentations and omissions about the solvency of certain of its pension funds in various bond disclosure documents including preliminary official statements, official statements and continuing disclosures by specifically failing to disclose the fact that New Jersey was unable to continue making contributions to the pension funds without raising taxes, cutting services or otherwise altering its budget.


c) The SEC also found that New Jersey failed to provide certain financial information regarding its pension funding in bond disclosure documents.

d) In agreeing to settle the matter, the SEC considered New Jersey’s cooperation with the investigation and certain remedial measures taken by the State, which included:

(i) Hiring disclosure counsel to advise the State on an on-going basis regarding its disclosure obligations under the federal securities laws.

(ii) In 2007 and 2008, with the assistance of disclosure counsel, reviewing the State’s bond offering documents and enhancing its disclosures.

(iii) With the assistance of disclosure counsel, reviewing, evaluating, and enhancing the State’s disclosure practices by instituting formal, written policies and procedures relating to its bond offerings.

(iv) Establishing a committee of senior officials to oversee the entire disclosure process and to review and make recommendations regarding the State’s disclosures and disclosure practices.

(v) Implementing an annual mandatory training program for State employees involved in the disclosure process to ensure compliance with the State’s disclosure obligations under the federal securities laws.

8. Postemployment Benefits/Disclosure Procedures Part #3 (State of Illinois (2013))

a) In March 2013, the SEC charged the state with securities fraud for allegedly misleading investors by failing to disclose the systematic underfunding of its pension plans. The SEC alleged that the information was omitted from bond offering documents between 2005 and 2009.

b) The state consented to the cease-and-desist order without admitting or denying the SEC’s allegations. Importantly, the order provided that the state’s conduct was actionable as negligence; the SEC did not claim that the state’s conduct constituted intentional securities fraud. The SEC noted that the state had taken remedial actions, such as retaining disclosure counsel and effecting written disclosure controls, policies, and procedures.


c) Most states’ employee pension plan funding obligations are legislatively imposed, and Illinois is no exception. Beginning in 1995, the state Pension Funding Act sought to address pension funding issues and achieve 90 percent funding through a 50-year contribution schedule. According to the SEC’s order, those contribution calculations resulted in underfunded pension obligations, increased unfunded pension liability, and deferral of public pension contributions, which posed significant future risks to the state’s financial health. The SEC’s order noted that between 1996 and 2010, unfunded pension liability increased by $57 billion.

d) In the offering documents, the state disclosed that its pension obligations are funded under a statutory plan and provided details of the plan. According to the SEC, however, the state failed to disclose that the plan could threaten its budget and financial condition, which in turn could have jeopardized the security of bondholders’ investments.

e) The SEC’s order also alleged that the state failed to provide investors with material information about amendments to the statutory plan. In particular, the SEC found that the state did not inform investors of the impact of legislatively enacted pension holidays that lowered contribution requirements in 2006 and 2007. Consequently, these holidays increased the state’s unfunded pension liability and further pushed payment of the deferred portion of the contribution into the future.

f) Here, as in the previous case against a state, the SEC did not seek monetary fines or penalties on the state or any individuals.

9. Continuing Disclosure Obligations

a) City of Harrisburg, PA

(i) In May 2013, the SEC charged a municipality with misleading investors about its financial health in the annual State of the City address, as well as in its financial and budget reports. This is the first SEC action against a state or local government based on statements made publicly, as opposed to in the required municipal bond disclosure documents. The action is also the first to cite the failure of a municipal securities issuer to post continuing disclosure information on the Electronic Municipal Market Access (EMMA) website as contributing to the SEC’s finding of fraud.

(ii) The SEC’s allegations relate both to general obligation bonds issued by the city and to debt for which the city acted as primary guarantor. The SEC order charged that the city’s 2007


annual financial report failed to include that the city had made $4 million in guarantee payments on debt for a resource recovery facility (RRF).

(iii) Although the city had been repaid in 2007 from proceeds of a subsequent borrowing, the SEC alleged that the prior guaranty payments were an indicator of possible future debt guarantee payments required for the RRF. The SEC’s order also charged that the city’s 2008 financial report did not accurately reflect the likelihood of continued guarantee payments by the city or their effect on the city’s financial condition.

(iv) According to the SEC, the 2009 budget posted on the city’s website did not include the RRF debt guarantee payments the city knew would likely be required and misstated the city’s credit rating. The SEC further alleged that the city’s 2009 midyear fiscal report, intended to reflect the city’s budget-to-actual numbers, improperly omitted $2.3 million in RRF guarantee payments made by the city. The final public misstatement alleged by the SEC occurred in the State of the City address given by the Mayor in 2009 (an election year). According to the SEC, the Mayor improperly described the RRF financial difficulties as an “additional challenge” and an “issue that can be resolved” after it had become clear the city may be forced to make significant RRF debt guarantee payments.

(v) The SEC claimed that the city failed to timely post its 2008, 2009, 2010, and 2011 annual financial reports and certain event notices on EMMA as required by its continuing disclosure obligations as an issuer and a guarantor. As a result, according to the SEC, investors looked elsewhere for information about the city’s financial health, and what they found included material misrepresentations and omissions by the city.

(vi) Quoting 1994 Interpretive Guidance issued by the SEC, the order states that “[s]ince access by market participants to current and reliable information is uneven and inefficient, municipal issuers presently face a risk of misleading investors through public statements that may not be intended to be the basis of investment decisions, but nevertheless may be reasonably expected to reach the securities markets.” The SEC found the public statements by the city material, given the “total mix” of limited public information.

(vii) The SEC’s order considered remedial actions taken by the city, including developing written disclosure policies and


procedures, designating a city administrator to file annual financial information and event notices with EMMA, and implementing an annual training program for city employees involved in the disclosure process. The city also agreed to post its disclosure policy on EMMA as well as on its website. The city consented to the SEC’s order without admitting or denying the allegations, and no monetary fines were imposed.

(viii) The SEC issued a Section 21(a) Report. These are rarely issued. The SEC uses 21(a) reports as a vehicle to signal how it views a particular problematic area or set of practices – so they are essentially policy statements. Perhaps more importantly, they put people on notice that going forward, the SEC and its Enforcement Division would consider similar conduct to be fair game for more conventional enforcement actions.

(ix) Why: Based upon information obtained during the investigation, the Commission deemed it appropriate that it issue a Report to address the obligations of public officials relating to their secondary market disclosures for municipal securities. Public officials should be mindful that their public statements, whether written or oral, may affect the total mix of information available to investors, and should understand that these public statements, if they are materially misleading or omit material information, can lead to potential liability under the antifraud provisions of the federal securities laws.

(x) Lesson: Issuers and other municipal market participants should follow and further develop voluntary industry initiatives to enhance disclosure policies and procedures for both primary offering and ongoing disclosures. Such initiatives may include the adoption of issuer disclosure committees and training programs.

b) West Clark Community Schools

(i) In July 2013, for the first time, the SEC issued a cease-and-desist order charging a school district with falsely stating in 2007 municipal bond offering documents that it was compliant with its continuing disclosure obligations. In a related action, the SEC charged the school district’s underwriter and its vice president with inadequate due diligence and supervision in failing to discover the school district’s lack of compliance.

(ii) In 2005, using the services of the underwriter, the school district issued $52 million in municipal bonds. In connection with the 2005 transaction, as required by SEC Rule 15c2-12,


the school district contractually agreed to provide annual financials as well as material event notices. In 2007 offering documents, the school district represented that it was compliant with its continuing disclosure undertakings. The school district, however, had not submitted any of the required annual financials or event notices. The SEC charged that the school district violated Section 17(a)(2) of the Securities Act, Section 10(b) of the Exchange Act, and SEC Rule 10b-5. As part of its settlement with the SEC, the school district agreed to remedial actions, including adopting written disclosure policies and implementing annual training for personnel involved in the bond offering and disclosure process.

c) The Municipalities Continuing Disclosure Cooperation Initiative (“MCDC”)

(i) Overview

(a) Rule 15c2-12 of the Securities Exchange Act of 1934 (the “Exchange Act”) requires that all underwriters buying or selling municipal securities ensure that the issuer has committed to providing continuing disclosures regarding the security and the issuer. Specifically, Rule 15c2-12 mandates disclosures regarding instances in the previous 5 years in which the issuer failed to comply in all material respects with any previous continuing disclosure requirement.

(b) While the SEC may file enforcement actions under Section 17(a) of the Securities Act of 1933 (the “Securities Act”), and/or Section 10(b) of the Exchange Act against issuers who falsely state that they have complied with all continuing disclosure requirements, underwriters for the offending offerings may also be the target of enforcement if they failed to exercise adequate due diligence to form a reasonable basis for believing the truthfulness of a key representation in the issuer’s official statement.

(c) MCDC was initiated to incentivize issuers and underwriters who self-report potential violations of the continuing disclosure requirements by providing them with favorable settlement terms.

1. For offerings of $30 million or less, the underwriter will be required to pay a civil penalty of $20,000 per offering containing a materially false statement;

2. For offerings of more than $30 million, the underwriter will be required to pay a civil penalty of $60,000 per offering containing a materially false statement;


3. However, there is a cap on the total amount that an underwriter can be liable for. Such cap is dependent on the underwriter’s total revenue as reported on its Annual Audited Report.

(d) The MCDC does not provide any guarantees for individuals associated with the non-complying offers (i.e. municipal officials or employees of the underwriting firm).

(e) This is not a continual opportunity; the SEC allotted two 6 and 9 month periods for underwriters and issuers, respectively, to report the violations and take advantage of the settlement terms.

(ii) Related Cases

(a) In June, 2015, the SEC announced that it had made enforcement determinations on 36 municipal underwriting firms, in September 2015, it announced enforcement determinations against another 22, and, in February 2016, it announced enforcement determinations against another 14.

(b) Each of these firms allegedly sold municipal bonds with offering documents that contained “materially false statements or omissions about the bond issuers’ compliance with the continuing disclosure obligations.” Additionally, the SEC charged that the firms had neglected to conduct sufficient due diligence and therefore failed to identify the omissions or misstatements before offering and selling the bonds.

(c) All 72 cases were under the Municipalities Continuing Disclosure Cooperation (MCDC), and the firms all self-reported the violations.

(d) A representative case was In the Matter of Edward D. Jones & Co., L.P. In that case, Edward Jones acted as senior or sole underwriter for a number of securities offerings in which the official statements failed to disclose non-compliance with previous continuing disclosure undertakings, making certain statements materially false and/or misleading. Specifically, in at least three offerings, the issuer had failed to disclose that it had filed annual or audited financial reports late, and failed to file required notice of late filings for these.

(1) As underwriter, Edward Jones had “failed to form a reasonable basis through adequate due diligence for believing the truthfulness of the assertions by these issuers… regarding their compliance with previous continuing disclosure undertakings pursuant to Rule 15c2-12.”


(2) In addition to a $100,000 civil money penalty, pursuant to the MCDC, Edward Jones was required to hire an Independent Consultant to review its policies and procedures for municipal securities underwriting due diligence and make recommendations for improvements.

(iii) In a related cease-and-desist order, the SEC charged that the underwriter and its vice president violated Section 17(a) of the Securities Act, Sections 10(b) and 15B(c)(1) of the Exchange Act, SEC Rules 10b-5 and 15c2-12, and MSRB Rule G-17 by failing to discover that the school district was delinquent in its continuing disclosure obligations. The SEC also charged the underwriter with violating MSRB Rule G-20 by providing improper gifts and gratuities to issuer personnel, including lunches, golf trips, and tickets to Chicago Cubs games as well as Notre Dame football games. The SEC further alleged that the underwriter charged such expenses back to the school district as official statement printing and distribution costs. Without admitting or denying the SEC’s allegations, the underwriter agreed to pay approximately $580,000 to settle the charges and to enhance its disclosure and expense reimbursement policies. The underwriter’s vice president, also without admitting or denying the SEC’s allegations, agreed to pay approximately $48,000 to settle the charges as well as to a one-year collateral bar and permanent supervisory bar.

10. Issuer Financial Penalties - Greater Wenatchee Regional Events Center Public Facilities District

a) In November 2013, the SEC announced that it has, for the first time, assessed a financial penalty against a municipal securities issuer. The penalty arose from a settled administrative proceeding charging the issuer with negligently misleading investors in a bond offering that financed the construction of a regional events center and ice hockey arena. The SEC routinely has declined to impose penalties on municipal issuers on the ground that it does not want to impose penalties that must be paid by taxpayers, but in this case the SEC appears confident that the issuer can pay the penalty without taxpayer assistance. The settlement also is notable for the wide scope of transaction participants sanctioned.

b) The SEC’s charges arose from a $41.77 million offering of Bond Anticipation Notes (BANs) by the Greater Wenatchee Regional Events Center Public Facilities District (District) in 2008. The BANs were to mature in 2011, with the principal to be repaid solely through the issuance of long-term bonds. By 2011, however, the District was unable to issue long-term refunding bonds, and consequently defaulted on the BANs. This occurred for two reasons: the events


center’s revenue was insufficient to support a long-term take-out financing, and the District’s ability to issue long-term debt was constrained by the City of Wenatchee’s legal debt capacity of $19.3 million.

c) Before the 2008 offering, the District hired an outside developer to develop and operate the events center. Over the course of the development and construction of the events center, the developer prepared a series of financial projections to be used both for budgeting purposes and for inclusion in the District’s Official Statement accompanying the BANs. An independent consultant reviewing the developer’s first two sets of projections, however, identified errors with the projections and raised concerns about the events center’s economic viability.

d) The developer subsequently produced a new set of projections, which were not reviewed by the independent consultant, according to the SEC’s Order. After reviewing the new projections, the former Mayor of the City of Wenatchee and a senior staff member urged the developer to include more optimistic numbers in its projections, arguing that they were confident that the local citizens would support the events center. The developer then provided a set of revised projections, which were included in the Official Statement for the BANs.

e) According to the SEC, the Official Statement was materially false and misleading on several fronts:

(i) It failed to warn investors that the District’s obligation to pay off the BANs could be constrained by the City’s debt limit.

(ii) It wrongly stated there had been no independent reviews of the financial projections for the events center, when, in fact, an independent consultant had examined the projections twice and questioned the project’s economic viability.

(iii) It failed to inform investors that the Mayor and the senior staffer had influenced the financial projections, rendering them unduly optimistic.

f) The District agreed to pay a $20,000 penalty and undertake remedial actions to settle the SEC’s charges. The SEC stated that it believes the penalty will be paid from the events center’s operating fund without directly affecting District taxpayers. In addition to the District, the SEC’s settled proceedings also name the developer and its then-CEO, the underwriter and its lead investment banker, and the District’s senior staff member who certified the accuracy of the Official Statement.


11. Tax Law Violations as Securities Law Violations – City of South Miami, FL

a) In May 2013, the SEC charged a municipality with fraud for allegedly failing to disclose improper arrangements with the developer of a city parking and retail project that put at risk the tax-exempt status of bonds held by investors. The SEC announced a settlement with the city through a cease-and-desist order.

b) According to the SEC’s order, the city entered into a lease agreement (the Lease) in 2002 with a for-profit developer to develop a mixed-use retail and public parking project. Under the Lease, the city incurred the costs of the parking structure portion of the project and maintained control over its operation, maintenance, and revenue. The limited role of the developer was key to the project’s eligibility for tax-exempt financing, according to the SEC. The city received a $6.5 million loan to finance the project from proceeds of tax-exempt bonds issued by the Florida Municipal Loan Council (FMLC) in 2002. In connection with the loan, the SEC alleged the city represented in a tax certificate that bond proceeds would not be used for the retail portion of the project and that the project would be operated in accordance with IRS regulations. According to the SEC’s order, however, the city subsequently loaned $2.5 million of the bond proceeds to the developer (the Developer Loan) without the knowledge of the FMLC or bond counsel.

c) Later in 2002, the City Commission voted not to move forward with the project and the developer sued the city, according to the SEC’s order. The SEC alleges that the Lease was revised as part of negotiations to settle the lawsuit to provide, among other revisions, that the city would lease both the retail and the parking portion of the project to the developer as well as share parking profits with the developer (the Lease Revisions).

d) According to the SEC’s order, in 2006 the City failed to disclose information to the FMLC about the Developer Loan and the Lease Revisions in connection with the FMLC’s issuance of an additional series of tax-exempt bonds, resulting in an inaccurate 2006 tax certification. The SEC alleged that bond proceeds were used to loan an additional $5.5 million to the city. Furthermore, the SEC alleged the city failed to disclose to the FMLC the Developer Loan and the Lease Revisions in annual certifications, which included a certification by the city that the tax-exempt status of the bonds had not been affected by any events.

e) The SEC’s order found that the city’s failure to disclose the Developer Loan and Lease Revisions was material because, if such actions by the city caused the interest on the 2002 and 2006 bonds to become taxable, investors could be subject to tax penalties.


Furthermore, investors trading the bonds relied on their tax-exempt status for pricing purposes and investment decisions, according to the SEC.

f) As part of its settlement with the SEC, the city agreed to undertake remedial efforts, including hiring an independent consultant to review the city’s disclosure policies and procedures and help implement disclosure compliance training programs. The SEC did not impose any monetary fines on the city. In a related settlement, the city settled possible tax-exempt issues with the Internal Revenue Service pursuant to its Voluntary Compliance Agreement Program.

12. Other Theories of Liability in SEC Enforcement Cases. (Caveat: These theories are heavily dependent on facts and circumstances.)

a) Failure to disclose credit risks.

b) Illegal payments/material interests on transaction.

c) Garden variety fraud.

d) Failure to disclose possible loss of tax exemption.

e) Failure to disclose source of escrow securities and excessive markups.

f) Bond counsel negligence.

g) Inappropriate reliance on experts.

C. Recent Focus on Enforcement.

1. SEC Reorganization. The SEC recently reorganized itself into five specialized enforcement units, including the Municipal and Public Pension Fund Unit. These units are focusing on five areas of misconduct: offering and disclosure fraud; tax or arbitrage-driven fraud; pay-to-play and public corruption violations; public pension accounting and disclosure violations; and valuation and pricing fraud.


2. Memorandum of Understanding. The SEC and the IRS have recently agreed to coordinate on municipal enforcement matters and other areas relevant to municipal securities. Pursuant to a Memorandum of Understanding dated March 2, 2010, the SEC and the IRS have agreed “to work cooperatively to identify issues and industry trends within the tax exempt bonds/municipal securities industry and to develop strategies to enhance performance of their respective responsibilities. To support this effort, the parties will share information, primarily through the creation of a committee … in connection with the respective responsibilities of the parties regarding tax exempt bonds/municipal securities, in a manner consistent with, and as permitted by, the laws and other requirements that govern the parties.”

3. “Report on the Municipal Securities Market” (July 31, 2012). In its report the SEC identified a “wish list” of legislative actions to expand its authority over municipal disclosure practices as well as potential regulatory actions the SEC could undertake pursuant to its existing authority.

a) Legislative grant of authority to require issuers to prepare and disseminate disclosure documents for their securities.

b) Legislative elimination of the 3(a)(2) exemption from the registration requirement for conduit borrowers.

c) Legislative grant of authority to establish requirements for the financial statements of issuers.

d) Legislative grant of authority to enforce compliance with continuing disclosure obligations.

e) Issuing updated interpretive guidance regarding disclosure obligations.

f) Amending Rule 15c2-12 to expand the types of required continuing disclosures and provide methods to address noncompliance.

4. Municipalities Continuing Disclosure Cooperation Initiative (See above discussion).

5. Recent Cases Brought by the SEC based on Fraud Claims

a) The SEC alleges that the failure to disclose transactions that presented a conflict of interest in the Official Statement was a material omission in the Official Statement—SEC v. United Neighborhood Organization of Chicago and UNO Charter School Network, Inc. (June 2, 2014)

b) The SEC alleges that the failure to disclose in a current Official Statement that the proceeds of bonds previously issued by the governmental entity were not used in a manner consistent with the description in the Official Statement for the prior bond issue was a material omission in the current


Official Statement—SEC v. City of Harvey, Illinois and Joseph T. Letke (June 24, 2014).

c) The SEC brings action against a former mayor and former city administrator under Section 20(a) of the Exchange Act, each as a control person—In the Matter of Allen Park, Michigan (November 6, 2014).

d) The SEC alleges that failure to disclose in the Official Statement that a governmental entity’s pension liability was significantly underfunded was a material omission in the Official Statement—SEC v. State of Kansas (August 11, 2014).

VIII. MUNICIPAL SECURITIES RULEMAKING BOARD AND ITS RULES.

A. The MSRB is a self-regulatory organization for the municipal securities industry created by Congress in 1975. The MSRB is authorized by federal law to make rules with respect to municipal securities activities for brokers and dealers and municipal advisory activities or municipal advisors but not issuers, investors, rating agencies or other market participants. (www.msrb.org)

B. Rules have force of law; enforcement and inspection authority for rules delegated to FINRA for securities firms; FDIC, Federal Reserve Board and Comptroller for the Currency for Banks and the SEC for certain municipal advisors.

C. Rules must be approved by the SEC.

D. The mission of the MSRB is to protect investors, municipal entities, including issuers of municipal securities, obligated persons and the public interest and to promote a fair and efficient municipal market. The MSRB supports this mission by rulemaking, collection and dissemination of market information and educational activities.

E. Some key rules:

1. Rule G-11: Governs conduct of members in syndicate during underwriting period including disclosure of types of order.

2. Rule G-14: Reports of Sales or Purchases (transaction data)

3. Rule G-17: Conduct of Municipal Securities and Municipal Advisory activities, general “fair dealing” rule.

4. Rule G-19: Suitability; Discretionary Accounts.

5. Rule G-20: Gifts, Gratuities and Non-Cash Compensation.

6. Rule G-23: Activities of Financial Advisors

7. Rule G-27: Supervision.


8. Rule G-30: Prices and Commissions.

9. Rule G-32: Delivery of final official statement in connection with new issues and information regarding underwriting spread and initial offering price, including NRO.

10. Rule G-34: CUSIP numbers, New Issue and Market Information Requirements (including certain information related to auction rate securities and VRDO’s)

11. Rule G-37: Political Contributions and Prohibitions on Municipal Securities Business.

12. Rule G-38: Disclosure of Consultants

13. Rule G-43: Broker’s Brokers.

14. Rule G-48: Transactions with Sophisticated Municipal Market Professionals (becomes effective March 21, 2016)

F. The Dodd-Frank Wall Street Reform and Consumer Protection Act was enacted July 21, 2010. Among other things, the Act modified the composition of the MSRB’s board of directors and expanded the MSRB’s authority to regulate municipal advisors.

G. In September 2013, the SEC issued its final definition of “municipal advisor” for purposes of registration, giving the MSRB the green light to proceed with its municipal advisor rulemaking activities.

I. MSRB Rules Recently Approved by the SEC:

1. Rule G-18: Best Execution (becomes effective March 21, 2016).

2. Rule G-44: Supervisory and Compliance Obligations of Municipal Advisors (became effective April 23, 2015)(in furtherance of Dodd-Frank).

3. Rule G-42: Duties of Non-Solicitor Municipal Advisors (becomes effective June 23, 2016)

4. Amendments to Rule G-20: Gifts, Gratuities and Non-Cash Compensation—extend to municipal advisors (becomes effective May 6, 2016).

J. Rules/Rule Amendments Approved by the MSRB to be Proposed to the SEC (in furtherance of Dodd-Frank):

1. Proposed Amendments to Rule G-37: Political Contributions and Prohibitions on Municipal Securities Business—extend to municipal advisors.

IX. STATE BLUE SKY LAWS.

A. In addition to the federal securities laws, the sale of bonds likely is subject to state securities laws. The laws are commonly known as the “blue sky laws.” Historically,


states required the registration or qualification of securities before such securities could be sold within such states.

1. No obvious pattern of regulation.

2. Uniform act serves as starting point for many states.

3. Many exceptions and distinctions.

B. Blue Sky Memoranda are surveys of state securities law registration requirements.

1. Preliminary Blue Sky Memorandum is delivered to the underwriters at the time the Preliminary Official Statement is distributed to the public.

2. Exempt Securities Section includes a list of states where the security is exempt and a list of states where further action is necessary for the security to be offered without registration.

3. Exempt Transactions Section includes, for each state surveyed, the transactions that are exempt from registration. Generally, these transactions are between sophisticated parties.

4. Final Blue Sky Memorandum is delivered at pricing to confirm what actions have been taken to gain exemption in states where further action was necessary.

5. Bring down is delivered at closing to confirm whether there have been any changes.

6. CCH Blue Sky Reporter or NABL Blue Sky Materials are very helpful.

C. In 1996, Congress enacted the National Securities Markets Improvements Act (“NSMIA”), which added Section 18 to the 1933 Act (15 U.S.C. § 77r), which curtailed the states’ authority to require the registration or qualification of “coveredsecurities,” to impose conditions on the use of offering documents, and prohibit the offer or sale of securities within its jurisdiction based on the merits of the securities or the issuer. “Covered securities” generally include:

1. Securities that are exempt from registration pursuant Section 3(a) of the 1933 Act, except that municipal securities that are exempt under Section 3(a)(2) are not “covered securities” with respect to offers and sales in the state in which the issuer is located.

2. Securities that are exempt from registration pursuant to the SEC’s rules and regulations issued under Section 4(2) of the 1933 Act. 1933 Act, §18(b)(4)(D).

D. Under Section 18 of the 1933 Act, a state securities commission can require that the issuer of “covered securities”: (i) file with the state any document required to be filed


with the SEC pursuant to the 1933 Act (e.g., a Form D); (ii) file annual or periodic reports of the value of the securities sold or offered to persons located in the state; and (iii) consent to service of process. These filings are for notice purposes only. The state securities commission also can assess a fee for the filings. State requirements may vary depending upon the federal securities exemption relied upon. A state securities commission can suspend the offering or sale of securities within the state if the issuer fails to submit any filing or fee that is required by state law and is otherwise permitted by Section 18(c) of the 1933 Act.

E. As a practical matter, the issuer should file (or cause to be filed) the proper forms with each state in which the securities are expected to be offered before the offering. Once the securities are sold, revised forms (reflecting the final issue size, etc.) must be filed in the states in which the purchaser(s) resides. If the purchaser is represented by counsel and is involved with structuring the financing, it may be possible to delegate the “blue sky” filings to such counsel.


2016 FUNDAMENTALS OF MUNICIPAL BOND LAW SEMINAR

General Securities Law


What We Will Cover• 1933 Act – Registration Requirements• Trust Indenture Act of 1939• Anti-Fraud Provisions• Common Law Causes of Action• SEC Rule 15c2-12• SEC Enforcement• MSRB • MSRB Rules• State Blue Sky Laws


Introduction

• Many securities laws apply to municipalsecurities

• Bond transactions contain multiple securities• Violation results in liability



1933 Act Registration Requirement• Section 5 requires a registration statement be filed with

the SEC before selling securities• “Security” is broadly defined

• Includes bonds, notes, other evidences of indebtedness and investment contracts, guarantees

• Encompasses bonds, notes, certificates of participation, guaranteed investment contracts, letters of credit, surety bonds, leases, loan agreements, etc.


A Municipal Offering May Have Multiple Securities

Bondholders

Bond Issuer

Conduit Borrower

Bond Insurer

Bond(Security #1)

Guaranty of Debt Service(Security #3)

Loan/Lease(Security #2)


Exempt Securities

• Section 3(a)(2) • Issued or guaranteed by U.S. or any territory thereof• Issued or guaranteed by any state, political subdivision or public

instrumentality thereof• Issued by a national bank or state bank• Certain IDBs (as defined in the 1954 Code)

• Section 3(a)(4) – 501(c)(3) securities• Section 3(a)(8) – Insurance policies• Section 3(a)(11) – Intrastate offerings• Rule 131 – Separate security doctrine



A Municipal Offering May Have Multiple Securities –But Also Multiple Exemptions From Registration

Bondholders

Bond Issuer

Conduit Borrower

Bond Insurer

Bond(Security #1) –

Exempt under Section 3(a)(2)?

Guaranty of Debt Service(Security #3) –


Loan/Lease(Security #2) –

Exempt under Section 3(a)(2) or Section 3(a)(4)?

Rule 131?


Exempt Transactions

• Section 4 of the 1933 Act• Issuer exemptions

• Section 4(6) – “accredited investors” only and less than $5 million• Section 4(2) – not a “public offering” (Regulation D as safe harbor)

• Purchaser exemptions• Section 4(1) – transactions by persons other than an issuer,

underwriter or dealer• Section 4(3) – transactions by a dealer (not as an underwriter) • Rule 144 and 144A (“qualified institutional buyers” only) safe

harbors


Trust Indenture Act of 1939

• Indentures under which securities are issued must be qualified by the SEC, unless an exemption is available

• Indenture is broadly defined• Exempt securities exempt from all Indenture

Act requirements• Exempt transactions exempt from

qualification requirement



A Municipal Offering May Have Multiple Securities –But Also Multiple Exemptions From Registration

Bondholders

Bond Issuer

Conduit Borrower

Bond Insurer

Bond(Security #1) –


Guaranty of Debt Service(Security #3) –


Loan/Lease(Security #2) –

Exempt under Section 3(a)(2) or Section 3(a)(4)?

Rule 131?


Exempt Transactions

• Section 4 of the 1933 Act• Issuer exemptions

• Section 4(6) – “accredited investors” only and less than $5 million• Section 4(2) – not a “public offering” (Regulation D as safe harbor)

• Purchaser exemptions• Section 4(1) – transactions by persons other than an issuer,

underwriter or dealer• Section 4(3) – transactions by a dealer (not as an underwriter) • Rule 144 and 144A (“qualified institutional buyers” only) safe

harbors


Trust Indenture Act of 1939


• Indenture is broadly defined• Exempt securities exempt from all Indenture

Act requirements• Exempt transactions exempt from

qualification requirement


Antifraud Provisions and Civil Remedies – Overview

• Objectives of 1933 Act and 1934 Act• Disclosure of material information about securities to

allow investors to make informed decisions• Prohibit misrepresentation or other fraudulent conduct

in connection with the purchase or sale of securities• Municipal securities exempt from registration are

not exempt from the antifraud provisions• Section 17(a) of 1933 Act• Section 10(b) of 1934 Act/Rule 10b-5


Section 17(a) of the 1933 Act

• In “offer or sale” of securities, unlawful to use interstate commerce or the mails -

• To employ any device, scheme or artifice to defraud;• To obtain money or property by means of any material

misstatement or omission; or• To engage in any transaction, practice or course of

business operating as a fraud or deceit upon the purchaser


Section 10(b) of 1934 Act/Rule 10b-5

• Section 10(b) prohibits the use, in connection with purchase or sale of a security, of “any manipulative or deceptive device”

• Rule 10b-5 – prohibits use of interstate commerce, mails or national securities exchange -

• To employ any device, scheme or artifice to defraud; • To make any material misstatement or omission; or• To engage in any fraud or deceit

• Courts recognize private causes of action



Antifraud Provisions and Civil Remedies

• Elements of Section 10(b) & Rule 10b-5• Misstatement or omission• Material fact• Scienter (intent to deceive, manipulate or defraud)• Reliance (or Fraud on Market/Fraud Created Market)• Proximate cause of damages• Damages

• Statutes of limitations


Secondary Liability under Antifraud Provisions

• Extension of 17(a) and 10(b) liability to parties not directly involved in securities offering

• Aiding and abetting elements• Existence of primary violation• Defendant’s knowledge or duty of inquiry as to primary violation • Substantial assistance to primary violation

• 1994 Central Bank decision – no private cause of action for aiding and abetting

• 1995 amendments – SEC and federal prosecutors may bring such actions under 10(b)

• Dodd – Frank Act – Loosen scienter standard to include reckless conduct (not just knowing conduct) for aiding and abetting


Common Law Causes of Action• Fraud and deceit – action for money damages

• False representation• Materiality• Misstatement of fact• Scienter (knowledge of falsity)• Reliance• Damages

• Rescission• Misrepresentation• Materiality• Facts• Reliance• Not required to show scienter, causation or damages



Rule 15c2-12• Promulgated in 1989, following WPPSS default,

amended in 1994 to add continuing disclosure, and amended in 2008 and 2010 to modify certain continuing disclosure provisions of the rule

• The Rule is not an antifraud rule; rather, it is a procedural rule intended to reduce the opportunities for fraud.

• Directly governs underwriters; indirectly governs issuers/obligors on bonds

• Applies to primary offering of municipal securities with a principal amount of $1 million or more, and certain remarketings involving changes in authorized denomination or tender period


Exemptions from Rule 15c2-12• Limited placement exemption

• $100,000 denominations• 35 or fewer knowledgeable/experienced investors

• Short-term debt exemption • $100,000 denominations• Maturity 9 months or less (VRDOs now subject to continuing

disclosure requirements but not primary offering requirements)• Limited exemption for continuing disclosure

• Obligated person of no more than $10 million• Effective July 1, 2009, this limitation changed• Under $10 million issuers are now subject to the material events

notice requirements and are required to provide financial information and operating data that is “customarily prepared by the municipality and is publicly available”

• Limited exemption from annual reporting for municipal securities having maturity 18 months or less


Primary Disclosure Requirements of Rule 15c2-12

• Review of Deemed Final OS• Participating underwriter must obtain and review prior to bidding

for, purchasing, offering or selling municipal securities• Issuer (including any conduit borrower) must deem final• Pricing information and other permitted omissions• May be combination of documents

• Dissemination to potential customers• POS• OS – “end of underwriting period” and implied duty to update

• Contract to receive final OS• What is a final OS?



Continuing Disclosure Requirements of Rule 15c2-12

• Participating underwriter must reasonably determine that issuer and/or obligated persons have undertaken in writing to provide continuing disclosure

• Obligated persons• Any person committed by contract or other arrangement to support

payment of all or part of security • Excludes bond insurers and letter of credit or liquidity providers


Continuing Disclosure Requirements of Rule 15c2-12 (cont.)

• Scope of Continuing Disclosure• Annual financial information• Audited financial statements• Material event notices• Disclosure in OS of scope of undertaking and

prior failures, within the past five years, to comply, in all material respects, with prior continuing disclosure undertakings.


Other Rule 15c2-12 Considerations

• Reasonable determination that undertaking made

• Effect of failure to comply with prior undertakings• Appropriate level of due diligence

• Dissemination of Information – Prior Process• NRMSIRs• SIDs• Central Post Office - DisclosureUSA.org


Electronic Municipal Market Access (“EMMA”)

• Became effective July 1, 2009.• Annual financial information and any material event

notices must be submitted in an electronic format to the MSRB through its web-based system known as EMMA.

• MSRB has been designated as the sole NRMSIR for bonds issued prior to July 1, 2009.

• “No action” letters that designated the four current NRMSIRs and approved DisclosureUSA as a means for filing with those NRMSIRs were revoked.

• Does not automatically include filings made prior to July 1, 2009 with then-existing NRMSIRs.


SEC Enforcement• SEC investigations – formal or informal• May be followed by Enforcement Action

• Administrative proceedings• monetary penalties• remedial sanctions• cease and desist orders

• Civil proceedings in federal district court• Criminal actions referred to DOJ• Referrals to other federal, state or self-regulatory

authorities• Delivery of 21(a) reports


SEC Enforcement (cont.)• Municipal Securities Enforcement Actions

Illustrate:• Disclosure responsibilities of issuer and authorizing

officials• Limited ability of issuers to rely on staff and third-

parties (consultants, attorneys) in drafting and reviewing of disclosure

• Responsibilities of underwriters• Responsibilities of third parties• Applicability and interpretation of “materiality”

standard



Electronic Municipal Market Access (“EMMA”)

• Became effective July 1, 2009.• Annual financial information and any material event

notices must be submitted in an electronic format to the MSRB through its web-based system known as EMMA.

• MSRB has been designated as the sole NRMSIR for bonds issued prior to July 1, 2009.

• “No action” letters that designated the four current NRMSIRs and approved DisclosureUSA as a means for filing with those NRMSIRs were revoked.

• Does not automatically include filings made prior to July 1, 2009 with then-existing NRMSIRs.


SEC Enforcement• SEC investigations – formal or informal• May be followed by Enforcement Action

• Administrative proceedings• monetary penalties• remedial sanctions• cease and desist orders

• Civil proceedings in federal district court• Criminal actions referred to DOJ• Referrals to other federal, state or self-regulatory

authorities• Delivery of 21(a) reports


SEC Enforcement (cont.)• Municipal Securities Enforcement Actions

Illustrate:• Disclosure responsibilities of issuer and authorizing

officials• Limited ability of issuers to rely on staff and third-

parties (consultants, attorneys) in drafting and reviewing of disclosure

• Responsibilities of underwriters• Responsibilities of third parties• Applicability and interpretation of “materiality”

standard



SEC Enforcement (cont.)• Recent trends show increased focus on tax

exempt/municipal securities• Orange County, CA (1996)• Maricopa County, AZ (1996)• City of Syracuse, NY (1997)• City of Miami, FL (2001 and 2013)• City of San Diego, CA (2006)• State of New Jersey (2010)• City of Victorville, CA (2013)• State of Illinois (2013)• Greater Wenatchee, WA (2013)• UNO Charter School Network, Inc. (2014)• City of Harvey, IL and Joseph T. Letke (2014)• Allen Park, MI (2014)• State of Kansas (2014)


SEC Enforcement (cont.)• Continuing Disclosure Enforcement Actions

• City of Harrisburg, PA (2013)• West Clark Community Schools, IN (2013)

• SEC’s Municipalities Continuing Disclosure Cooperation Initiative


MSRB• Self-regulatory organization

• Relationship with the SEC

• Relationship with FINRA

• Relationship with Financial Entities and Municipal Advisors



SEC Enforcement (cont.)• Recent trends show increased focus on tax

exempt/municipal securities• Orange County, CA (1996)• Maricopa County, AZ (1996)• City of Syracuse, NY (1997)• City of Miami, FL (2001 and 2013)• City of San Diego, CA (2006)• State of New Jersey (2010)• City of Victorville, CA (2013)• State of Illinois (2013)• Greater Wenatchee, WA (2013)• UNO Charter School Network, Inc. (2014)• City of Harvey, IL and Joseph T. Letke (2014)• Allen Park, MI (2014)• State of Kansas (2014)


SEC Enforcement (cont.)• Continuing Disclosure Enforcement Actions

• City of Harrisburg, PA (2013)• West Clark Community Schools, IN (2013)

• SEC’s Municipalities Continuing Disclosure Cooperation Initiative


MSRB• Self-regulatory organization

• Relationship with the SEC

• Relationship with FINRA

• Relationship with Financial Entities and Municipal Advisors


MSRB (cont.)• Some Key Rules

• Rule G-11 - Primary Offering Practices• Rule G-17 - Fair Dealing Rule• Rule G-19 - Suitability; Discretionary Accounts• Rule G-20 - Gifts, Gratuities and Non-Cash Compensation• Rule G-23 - Activities of Financial Advisors• Rule G-27 - Supervision• Rule G-30 - Prices and Commissions• Rule G-32 - Delivery of Final OS• Rule G-34 - CUSIP numbers, New Issue and Market Information

Requirements (including certain information related to auction rate securities and VRDO’s)

• Rule G-37 - Political Contributions• Rule G-38 - Disclosure of Consultants• Rule G-43 - Broker’s Brokers• Rule G-48 – Transactions with sophisticated professionals


MSRB (cont.)• Dodd-Frank Wall Street Reform and Consumer

Protection Act altered MSRB governance structure and expanded MSRB powers

• New MSRB Rules Approved by the SEC:• Rule G-18 – Best Execution• Rule G-44: Supervisory and Compliance Obligations of

Municipal Advisors• Rule G-42: Duties of Non-Solicitor Municipal Advisors• Amendment to Rule G-20: Gifts, Gratuities and Non-Cash

Compensation Extended to Municipal Advisors

• Proposed MSRB Rules/Rule Amendments:• Proposed Amendment to Rule G-37: Political Contributions

Extended to Municipal Advisors


State Blue Sky Laws• State Securities Laws

• Uniform act is basis for many states’ laws• However, many exceptions and distinctions

• Blue Sky Memoranda – distributed to underwriters with Preliminary Official Statement

• Survey of states’ securities laws• Exempt securities section – list of states where exempt or where

further action is necessary• Exempt transaction section – types of sales that are exempt –

generally sophisticated institutional purchasers

• 1996 NSMIA• Limits states’ authority with respect to “covered securities”• Securities laws of the state of issuance still apply• State laws requiring notice filings and fees permitted





Basic Training General Session: General Tax Law

Faculty:Perry E. Israel Law Office of Perry Israel – Sacramento, CA Linda B. Schakel Ballard Spahr LLP – Washington, DC Carla A. Young Nixon Peabody LLP – Washington, DC

I. Introductions and Overview

A. The General Tax Law session of the Fundamentals of Municipal Bond Law Seminar represents a general overview of the federal tax law aspects of public finance transactions. Municipal indebtedness enjoys a special advantageous status in the investment securities community (i.e., lower interest rate than conventional debt securities) solely by virtue of the fact that the interest paid on most municipal debt is not subject to federal income taxation of the registered owners of the debt securities. Thus, the tax analysis is absolutely integral to what we do; otherwise we do not have tax-exempt debt. The following information sets forth the basic requirements for tax-exemption through practical examples. Readers of this outline may want to also refer to the more complete summary of general tax laws contained in the “Federal Tax Aspects of Municipal Bonds” chapter of NABL’s companion book entitled “Fundamentals of Municipal Bonds.”

B. General Tax-Exemption Rule: Section 103(a) of the Internal Revenue Code of 1986 (the “Code”) provides that the interest on debt of a state or political subdivision is excluded from federal gross income, except in the following cases:

1. A private activity bond is not tax-exempt unless it is a “qualified bond”.

2. An arbitrage bond is not tax-exempt.

There are many technical requirements that have evolved either through statutory amendments or IRS regulations and rulings.

C. Role of Tax Certificate: Most bond issues include as a closing document a tax certificate prepared by bond counsel, in which the municipal issuer covenants to comply with the various tax requirements that are set forth in the tax certificate.


II. Very Basic General Rules

Section 103(a) of the Code states that “gross income does not include interest on any State or local bond.”

EXAMPLE 1:

A City determines that it must build roads and other infrastructure to serve a rapid expansion of both commercial and residential development. The City Charter and State Constitution require that any debt incurred by the City be subject to voter approval and specified limitations on the amount of debt that may be outstanding. The fact that residents have already begun to complain about the high property taxes makes it unlikely that the City will obtain voter approval of the proposed bond issue. In addition, there are concerns about how quickly the City will be able to complete roads given the cumbersome bidding and condemnation processes. The financial advisor to the City suggests that perhaps the City can use the local industrial development agency (an “IDA”), a local improvement district or a “63-20 corporation” to avoid the bidding requirements and avoid a pledge of general taxes. Can the City use any of these proposed entities to issue tax-exempt bonds for this situation?

A. Section 1.103-1 of the Treasury Regulations (the “Regulations”) says that a state or local government includes States, territories, District of Columbia or any possession of the United States and any political subdivision thereof.

1. The issuing entity must be a political subdivision for federal tax purposes. The mere labeling that is given an entity in state or local statutes is not sufficient. A political subdivision for federal tax purposes is a state or local governmental unit with one or more of the three substantial sovereign powers (i.e., taxation, eminent domain and police). There are certain entities other than states, cities and counties that qualify as political subdivisions (e.g., a school district that has taxing power, or a local improvement district that has power of eminent domain). We expect new guidance soon relating to what constitutes a “political subdivision” for purposes of Section 103.

2. Bonds issued by or on behalf of a state or local governmental unit may also be eligible for tax exempt treatment. This includes bonds issued by constituted authorities and 63-20 corporations.

a. “Constituted authorities” are entities specifically authorized by state law to issue bonds on behalf of political subdivisions of a state, among other specific powers granted to such entities in order to further public purposes. Rev. Rul. 57-187 sets forth the general criteria for determining whether an organization qualifies as a


“constituted authority.” Such criteria are: (i) the issuance of bonds must be authorized by a specific state statute; (ii) the bond issuance must have a public purpose; (iii) the governing body of the authority must be controlled by the political subdivision; (iv) the authority must have the power to acquire, lease and sell property and issue bonds in furtherance of its purposes; (v) earnings cannot inure to the benefit of private persons; and (vi) upon dissolution, title to all bond-financed property must revert to the political subdivision.

In example 1, the industrial development agency is created by State statute and its purposes include issuance of debt to finance infrastructure to facilitate economic development. The IDA does not have the power of eminent domain or the power to tax. However, the directors of the IDA are appointed by the Mayor of the City. The IDA is not subject to public bidding rules, and its bonds are not subject to statutory debt limitations or referendum requirement.

The local improvement district is created by State statute when property owners petition a local jurisdiction to form the district. The improvement district has a limited power of eminent domain (the City must make final determination upon recommendation of district) and can levy property taxes on property in the district (a tax in addition to the property tax imposed by the City on all City property owners). The improvement district is not subject to public bidding rules, and the bonds are not subject to statutory debt limitations or referendum requirement.

b. “63-20 corporations” are corporations formed under general state nonprofit corporation law, the obligations of which are treated as issued on behalf of a political subdivision for purposes of Section 1.103-1(b) of the Regulations. The name comes from Rev. Rul. 63-20, which, together with Rev. Proc. 82-26, sets forth the criteria of such on behalf of entities. Such criteria are substantially the same as the criteria for constituted authorities described in Rev. Rul. 57-187. The most significant difference is the type of authorizing statute under which each is organized. The formation of the entity (including articles of incorporation) and the actual issuance of the bonds must be approved by action of the governmental unit on whose behalf the bonds are being issued. The property financed by the bonds issued by a 63-20 corporation must vest in the governmental unit no later than the end of the term of the bonds.

The 63-20 corporation does not have the power of eminent domain or the power to levy taxes. Unlike an IDA or local improvement district, a 63-20 corporation does not require special state legislation authorizing or enabling


the creation of the entity. It is not subject to the public bidding rules, and its bonds are not subject to statutory debt limitations or referendum requirement.

3. Other Issuers.

a. Volunteer Fire Departments.

b. Qualified Scholarship Funding Corporations.

c. Indian Tribal Governments.

d. Non-Code Issuers (i.e., tax-exemption permitted under federal law other than the Internal Revenue Code) (pre-1986 bonds only).

B. Bond or obligation required.

1. Legally valid exercise of the borrowing power.

2. Nonrecourse, conduit or revenue financings are allowed.

3. Debt must be incurred.

a. Installment sale or finance lease is allowed. Note that the sale agreement or lease must have a separately stated interest component for each payment to be made thereunder. See, e.g.,Rev. Rul. 72-399.

b. A certificate of participation is not itself a debt. The “debt” which is the basis of a tax-exempt financing with certificates of participation is typically the underlying lease or loan agreement.

c. Equity e.g., (ownership of property) is not debt and, therefore, cannot give rise to tax-exempt interest.

d. There must be a reasonable expectation that the debt obligation will be repaid.

C. Interest includes accrued original issue discount.

III. Private Activity Bond Status

EXAMPLE 2:

A County proposes to acquire an existing office building, including limited parking spaces underground, near a new rapid transit stop. The County has


decided that putting employees in space away from the County administration building will allow the County and its employees to provide services more efficiently to outlying areas, will stimulate overall economic development of the area and will alleviate traffic problems. The building has some existing retail space tenants, including a branch of the United States Department of Housing and Urban Development (HUD), which provides needed services to surrounding businesses. The leases will not expire for 3 years, unless the County is willing to buy out the leases. The County will not need all of the office space initially, but expects to use all the space within 5 years. The County is considering putting a medical clinic run by a local nonprofit hospital in the excess space, which will generate some revenues during the five years. The employees that will be moved to the building have requested that the new building include a cafeteria and a health club. The County does not intend to run these services themselves, but will contract them out. The bonds will be paid with general County sales tax revenues.

Can all of the building be financed with tax-exempt bonds?

If not, how much can be and how is this determined?

One County Commissioner has also suggested that a portion of the bond issue be used to provide low interest loans to those County employees who want to purchase a home near the satellite office building.

A. Section 103(b) of the Code: Interest on a private activity bond that is not a qualified private activity bond is included in gross income.

1. The focus is on determining whether we have a private activity bond and, if we do, whether it is a qualified private activity bond.

2. Generally, bonds are private activity bonds if either (i) both the 10% private business use test and the 10% private payment or security test of Section 141(b) of the Code are met or (ii) the private loan test of Section 141(c) of the Code is satisfied.

B. Private business use: The only use that is not private business use is use by (i) a state or local government, (ii) an individual not in a trade or business or (iii) the general public. Note that use of financed facilities is treated as the use of bond proceeds.

1. Organizations described in Section 501(c)(3) of the Code and the federal government are considered private business users (nongovernmental persons) for this purpose.

2. A “special legal entitlement” in favor of a nongovernmental person is considered private business use.


a. Ownership by a nongovernmental person is private business use.

b. Leases to nongovernmental persons represent private business use.

c. Measurement of 10% use over term of bonds.

In example 2, there are existing retail and HUD leases and the proposed lease to the medical clinic.

d. Management and service contracts must be carefully drafted to comply with safe harbors published by the IRS (Revenue Procedure 97-13).

Example 2 includes a health club and restaurant, and perhaps parking.

e. Output contracts (special rules quantify use).

f. Research agreements.

g. Other uses that create special economic benefit if there is no general public use.

h. Naming rights.

Would the housing developers near the office building have a special economic benefit if property values are expected to increase?

3. Exceptions.

a. General public use.

The parking spaces in the County building are open to the general public on a first come/first serve basis at generally applicable rates, with no reserved parking for retail business patrons.

b. Short-term use (200-day, 100-day and 50-day use contracts).

One-year agreement for rental of conference room in office building by Chamber of Commerce for monthly meetings.

c. Incidental use.

Pay telephones and vending machines in lobby of County office building that are owned and serviced by private vendors.


d. Temporary use by developer where infrastructure is turned over to governmental unit within reasonable time of completion.

4. Measurement.

a. Private business use is measured over the entire “measurement period,” commencing on the later of the date the bonds are issued or the financed facilities are placed in service and ending on the earlier of the end of the useful life of the facilities or the date the last bond is retired.

b. The average amount of private business use in each year is determined and averaged over the entire measurement period.

c. In general you must find a proxy for bond proceeds—e.g., where space costs approximately the same in the building, the amount of private use of the building might be determined by measuring the space that is privately used. However, watch out for situations where proceeds aren’t used equally for all assets for spaces.

d. Also, there are new allocation and accounting rules that allows private business use to first be allocated to “qualified equity.” See Treas. Reg. § 1.141-6.

C. Private payment or security test.

1. Includes all private payments benefiting issuer, regardless of whether the payments are used to pay debt service on the bonds. (Note also that the payment can be a private payment even if it is not a payment made by the private business user!)

For example, private payments would include rent from retail space, HUD office, and nonprofit clinic. Would not include revenues from public parking if determined it met rules of being general public use.

2. Limited to an amount corresponding to the amount of private business use.

3. Generally applicable taxes are not private payments.

4. Sports stadium example.

D. Unrelated or Disproportionate Use: The 10% limit changes to a 5% limit.

Is the clinic or restaurant unrelated to the County building so that its use changes the private business use limit from 10% to 5%?


E. Private Loan Financing Test: Separate and distinct test from private business test that can cause private activity bond status.

1. Lesser of 5% or $5,000,000 limitation on nongovernmental-person loans (including individuals not acting in trade or business).

For example, the County Commissioner’s home loan proposal would involve loans to natural persons and the 5%/$5 million test must be met for the bonds to be tax-exempt.

2. Assessment exception.

a. Governmental tax or assessment of general application is not a private payment.

b. Essential governmental function.

IV. Qualified Private Activity Bonds

If determine that both the private use and private payment tests are met or the private loan test is exceeded, bonds will be tax-exempt only if the financing is for a permitted purpose (meeting many specified rules) and other additional general private activity limitations and rules are met.

EXAMPLE 3:

County plans to acquire land and build a disposal facility that will process municipal solid waste and turn the waste into electricity. The technology is fairly sophisticated, so the County has entered into negotiations with Company to privatize the service. The Company suggests that it may be able to cut costs by acquiring reconditioned equipment. The Company will have a sizable investment in the privatization and determines that the safe harbor management contract provisions are inadequate. The County and Company agree to enter into a lease of the facility. Even though the lease will cause the bonds to be private activity bonds, the Code permits issuance of private activity bonds for solid waste disposal facilities (“qualified bonds” under Section 142(a)(6) of the Code). An affiliate of the Company may purchase bonds to generate tax-exempt income. How will issuance procedures and tax analysis differ from doing this as a governmental bond deal?

A. 95% Test: A private activity bond is not a “qualified bond” unless at least 95% of the bond proceeds (net of reasonably required reserve funds) is used to provide the specific exempt facility. (See also section K below.)

1. Working capital is not a qualified cost.


2. Interest during construction until the facility is placed in service is a qualified cost.

3. Costs of issuing the bonds are not qualified costs.

B. TEFRA Hearing and Approval (Section 147(f)): A private activity bond is not a “qualified bond” unless it is the subject of public notice, a public hearing, and public approval. (Note that regulations have been proposed that, if finalized, would relax the TEFRA hearing and approval requirements.)

1. 14-day notice requirement.

2. Required content of notice and approval (insubstantial deviations allowed).

3. Current refunding exception.

C. 2% Limit on Bond-Financed Issuance Costs (Section 147(g)): A private activity bond is not a “qualified bond” if more than 2% of the bond proceeds is used to pay the costs of issuing the bonds. (Note that costs for qualified guarantees do not need to be treated as subject to the 2% limit.)

D. Substantial user limitation on tax-exempt interest (Section 147(a)).

Company or an affiliate of Company that buys any bonds will receive interest that is taxable.

1. Usually a caveat in opinion.

2. Not applicable to 501(c)(3) bonds or single-family bonds.

E. Limitation on Land Acquisition (Section (147(c)).

1. No more than 25% of net proceeds of a private activity bond may be used to acquire land.

Would need to make this determination because acquiring land – would not apply if governmental bond.


3. First-time farmer and environmental airport exceptions.

F. Limitation on Acquisition of Used Property (Section 147(d)).


1. Rehabilitation expenditures must be incurred on a used building acquired with bond proceeds. The amount of rehab expenditures must be at least 15% of the dollar amount of acquisition cost financed with bond proceeds.

2. The rehabilitation requirement increases to 100% with regard to used equipment that is not part of the building acquired.

Our example includes “reconditioned equipment” which is used equipment?


G. Volume Cap (Section 146).

1. A private activity bond is not a “qualified bond” unless it has an allocation of state private activity bond cap.

2. No state cap is required for 501(c)(3) bonds and current refundings.

3. There are also exceptions for certain governmentally owned solid waste disposal facilities, airports, docks and wharves if lease or management agreement is subject to certain limitations.

This bond issue could avoid having to get a volume cap allocation, but would have to structure lease with Company correctly.

H. Useful Life/Maturity Limitation (Section 147(b)).

1. The average maturity of the bonds must not exceed 120% of the weighted average reasonably expected useful life of the facilities financed by the bonds.

If solid waste equipment had an IRS class life of 10 years, but an independent engineer certifies it will have a 25-year life, most bond counsel would rely on the engineer’s certificate and the average bond maturity could not exceed 30 years.

2. Not applicable to single family and student loan bonds.

I. Prohibited Facilities (Section 147(e)): None of the proceeds of a “qualified bond” may be used to finance skyboxes, airplanes, gambling facilities, package stores, health club facilities (except for 501(c)(3) bonds).

J. Prohibition against advance refunding of a private activity bond (Section 149(d)).

1. 90-day current refunding definition.


2. Exception for one advance refunding of 501(c)(3) bonds.

K. Qualified Private Activity Bond Categories: Generally, 95% of proceeds must be used for qualifying purposes; qualifying purposes vary depending upon type of financing.

1. Qualified 501(c)(3) bonds.

2. Exempt facility bonds: airports, docks and wharves, mass commuting facilities, water furnishing facilities, sewage facilities, solid waste disposal facilities, low- and moderate-income rental housing, “two-county” electric and gas facilities, local district heating and cooling facilities, hazardous waste facilities, high-speed intercity rail facilities, and certain environmental enhancements of hydroelectric facilities.

3. Single-family mortgage revenue bonds (financing mortgage loans for purchasers of principal residence).

4. Small issues (up to $10M) for manufacturing facilities and first-time farmers.

5. Student loan bond issues.

6. Qualified redevelopment bonds.

7. Enterprise zone facility bonds.

L. Interest on tax-exempt private activity bonds is an item of tax preference for purposes of the alternative minimum tax imposed on individuals and corporations.

1. AMT bonds bear an interest rate that is between 10 and 20 basis points higher than comparable non-AMT bonds.

2. Qualified 501(c)(3) bonds are not subject to alternative minimum tax.

3. Refundings of private activity bonds that were originally issued before 8/8/86 are not subject to alternative minimum tax.

V. Miscellaneous Rules Applicable to All Bonds (Section 149).

A. Reimbursement (a/k/a “pyramid bonds”).

1. Cannot finance facility costs incurred before municipal issuer adopts a resolution of intent to finance with bonds.


2. Special rules for qualified 501(c)(3) bonds.

B. Registration Requirement (Section 149(a)).

C. Federal Guarantee Restriction (Section 149(b)).

D. Information Reporting (Section 149(e)).

1. Form 8038, Form 8038-G or Form 8038-GC.

2. Information compiled from underwriter, issuer and borrower.

3. Filing deadline, late filing procedures.

E. Treatment of Pooled Financing Bonds (Section 149(f)).

1. Defined generally as reasonable expectation that more than $5,000,000 of issue is to be used directly or indirectly to make or finance loans to 2 or more ultimate borrowers.

2. Permitted under the Code, but limits on when loans must be made and when costs of issuance must be paid and special rules for temporary periods and rebate exceptions.

F. Hedge Bonds (Section 149(g)).

G. One time advance refunding limitation (Section 149(d)).

VI. ARBITRAGE AND REBATE

EXAMPLE 4:

Issuer issues $100 million twenty-year fixed rate tax-exempt bonds. Issuer applies $20 million to build a stadium and invests $80 million balance in twenty-year Treasury securities that, since they bear higher taxable rates, generate enough cash to pay off all $100 million of bonds.

A. Basic concept of arbitrage.

1. For our purposes, arbitrage is borrowing in one market (tax-exempt) and investing in a different market (taxable) at a higher rate. This is generally easy because of the difference between taxable and tax-exempt rates.

2. The test is based on “reasonable expectations.”

a. Confirmed by tax or arbitrage certificate.


b. But – subsequent deliberate acts are relevant.

3. Basic questions for Arbitrage and Rebate

a. Arbitrage – Can you earn it?

b. Rebate – Can you keep it?

c. For each dollar of proceeds, for as long as it is “unspent” on the purposes of the issue, the Issuer must find that either:

(1) It will only be invested at a materially higher yield during a temporary period;

(2) It is part of a minor portion – lesser of $100,000 or 5% of issue (of minor importance only);

(3) It is part of a reasonably required reserve fund (see (C)(3) below);

or

(3) It is not invested at a materially higher yield.

Note – it must be “invested” at a “market” yield (otherwise there is a diversion of arbitrage profit).

Note – notwithstanding the ability to invest at a materially higher yield, the allowable arbitrage profit must be rebated to the U.S. Government (see section G below).


EXAMPLE 5:

A 501(c)(3) independent secondary school will be issuing bonds to finance the construction of a gymnasium. The construction project is expected to take approximately two years to construct. The school has an endowment, but would like to maintain it rather than use it to build the project. The school has begun a general capital campaign for the project, scholarships and faculty salary increases. The school expects to receive some money before the bonds are issued, but a majority of the funds will come in over a specific period of time. The bonds will be sized to cover all of the costs of the project except to the extent of amounts received before the bonds are issued. The proceeds from the sale of the bonds will be invested, and the school plans to use investment earnings to pay a portion of interest during construction. A bank has agreed to purchase the bonds, but has asked that the school maintain liquid assets equal to 100% of the loan amount. What will the school need to know about investing these funds under the arbitrage rules?

B. Gross Proceeds: Arbitrage restriction on earnings above the bond yield applies to “gross proceeds.” Gross proceeds include sale proceeds, investment proceeds, replacement proceeds and transferred proceeds.

1. Sale Proceeds: Amounts actually or constructively received from the sale of the issue (including underwriter’s discount). In general, accrued interest may be excluded.

2. Investment Proceeds: Amounts actually or constructively received from investing proceeds.

3. Replacement Proceeds: Amounts with certain nexus to issue.

a. Sinking Fund: Amounts expected to be used directly or indirectly to pay debt service on an issue (regardless of whether pledged to pay the bonds).

If the debt service payments are made from investment income from investment of the endowment, the endowment will be a sinking fund.

b. Pledged Fund: Amounts directly or indirectly pledged to an issue and reasonably expected to be available to pay debt service if needed.

c. “Negative Pledges”: Might be treated as replacement proceeds (an agreement to maintain a minimum amount of assets, even though not pledged to pay debt service.

The liquid asset requirement of the Bank may be a negative pledge.


d. “Other Replacement Proceeds.”

The capital campaign creates replacement proceeds by generating funds for the same purpose as the bonds.

4. Transferred Proceeds: Reallocation of unspent proceeds of refunded issue to refunding issue as refunding pays principal on refunded bonds.

C. Temporary Periods: Permitted period for investing above the yield of the bonds.

1. Construction or other capital projects – emphasis on three-part test.

a. At least 85% of net sale proceeds are reasonably expected to be allocated to expenditures (“spent”) within 3 years.

b. Within 6 months, issuer incurs substantial binding obligation to spend at least 5% of net sale proceeds.

c. Construction or acquisition of the project must proceed with due diligence.

School can invest the bond proceeds to build the project if it has these expectations.

2. Debt service fund (“bona fide debt service fund”): 13-month temporary period for revenues set aside to pay debt service.

3. Replacement proceeds (30 days).

4. Refunding escrow – yield restricted if advance refunding.

5. Miscellaneous – interest (one year), working capital (generally 13 months).

D. “Reasonably required reserve or replacement fund” or 4R fund.

1. Sizing limits:

a. 10% proceeds – funding limit with bond proceeds.

b. The amount that may be invested above the bond yield cannot exceed the least of (i) 10% of the principal amount of the bonds, (ii) maximum annual bond debt service, and (iii) 125% of average annual bond debt service.


2. The reserve fund must be reasonably required (generally, a reserve fund is not required for a general obligation bond).

E. Yield

1. Calculation methodology – general.

a. Yield is the discount rate that, when computing the present value as of the issue date of all payments of principal and interest on the obligation, produces an amount equal to the issue price of the obligation.

b. Typically rely on underwriter as financial advisor to calculate.

c. Determined at closing if fixed rate issue (if any variable rate bonds, yield is calculated over 1 to 5-year periods for rebate purposes).

2. Issue price of bonds is the initial offering price to the public.

3. Qualified guarantee fees are treated as additional interest on the bonds (e.g., bond insurance premium or letter of credit fees).

4. Single issue rules – separate bonds will be considered a single issue with a single composite yield if:

a. Sold at substantially the same time (within 15 days);

b. Sold pursuant to the same plan of financing; and

c. Reasonably expected to be paid from the same source of funds.

F. Definition of materially higher yield for yield restricted investments.

1. Generally 1/8 of 1% (0.125%).

2. 1/1000 of 1% (0.001%) for replacement funds and advance refunding escrow.

3. 1-1/2% for “acquired program obligations.”

4. Special rules applicable to loans than finance owner-occupied residences and student loans.


G Rebate – Can you keep it? If permitted to earn arbitrage, must be rebated to the Federal government.

For example, if school invested funds in construction fund above the bond yield and used all the investment earnings to pay debt service during construction, the School may have to come up with funds later to pay rebate if there is no rebate exception.

1. Exceptions to rebate requirement

a. Spending exceptions – spend bond proceeds at least as fast as spending schedule set forth in the Code and Regulations (separate rules relating to expenditures within 6 months, 18 months or 24 months).

b. Small issuer exception – expect to issue no more than $5,000,000 of governmental bonds for the year.

c. Earnings on a bona fide debt service fund.

d. Earnings from investing in non-AMT municipal bonds.

2. Required to rebate 90% of amount every 5 years, 100% when bonds are fully retired or redeemed.

VII. Post Closing Events

EXAMPLE 6:

A State issued bonds several years ago to finance the construction of a State office building. The State government has downsized and finds it no longer needs 20% of the space in the building. The State has explored several possible tenants and narrowed it down to two: a 501(c)(3) organization that will use the space for a child development center or a for-profit computer services company that will use the space as a business incubator and computer services headquarters. Must the State do anything with its bonds? Does it matter which tenant they select?

A. Change in use of facilities – discuss with issuers the ongoing compliance requirements.

1. Change in use from governmental to non-governmental could cause loss of tax-exemption retroactively to the date of issuance of the bonds.

2. Remedial action under Section 1.141-12 of the Regulations and Rev. Proc. 97-15.


If State leases space and lease payments are paid over time and not as an upfront payment, the State must find money to redeem bonds if lease to computer services business. If lease to 501(c)(3) entity, may be able to treat as reissued as 501(c)(3) bond and keep the bonds outstanding.

B. Change in law – Generally, changes in statutes or regulations have not been retroactive, which means that a bond issue typically is subject to the law as it existed on the issuance date.

1. Effect on ability to refund and transition rules – new law applies to new bonds.

2. Reissuance – new law applies to “reissued” (old) bonds.

a. What is a reissuance, what to watch out for – Section 1.1001-3 of the Regulations and Notice 88-130.

b. Procedural concerns – new filing of IRS Form 8038 required, arbitrage certifications.

c. Reissuance triggers arbitrage rebate date.



General Tax Law


General Rule

Interest on debt obligations of a state or political subdivision is excluded from gross income undersection 103 unless the obligations are an issuethat consists of private activity bonds (other than qualified private activity bonds) or arbitrage bonds,provided that you meet the miscellaneous rules.

Tax credit bonds


Section 103

The focus of the opinion is whether interest is excluded from gross income under Section 103.

There are other rules that may require that the interest on an otherwise tax-exempt bond be included or taken into account when computing tax liability. For example, the interest on some bonds is treated as a preference item for purposes of the alternative minimum tax or the interest might be taken into account in determining Social Security benefits.

back



Interest

• Interest includes stated interest• Interest generally includes original issue discount• In certain types of debt instruments (e.g., leases), interest must

be stated• Special limitations on “contingent interest,” so watch out for

anything other than fixed rate bonds or normal variable rate bonds

• back


Debt Obligations

• Must be an exercise of the borrowing power• Case law says that notes issued as part of eminent domain proceeding or

other situations where the state can compel acceptance of the note do not get the benefit of the subsidy

• May include not only instruments denominated as “debt” under state law, but also installment sales contracts and financing leases

• back


State or Political Subdivision

• “State” includes the District of Columbia and any possession of the United States (e.g., Puerto Rico, Guam, Virgin Islands)

• In some cases, Indian tribal governments are treated as “states”• Political subdivision is a division of state or local government

that is a municipal corporation or has been delegated the right to exercise a “not insubstantial” amount of one of the three sovereign powers—taxation, eminent domain, or police power

• May additionally be some “control” issue• Also, there are entities that can issue “on behalf of” the State or

local government



Interest

• Interest includes stated interest• Interest generally includes original issue discount• In certain types of debt instruments (e.g., leases), interest must

be stated• Special limitations on “contingent interest,” so watch out for

anything other than fixed rate bonds or normal variable rate bonds

• back


Debt Obligations

• Must be an exercise of the borrowing power• Case law says that notes issued as part of eminent domain proceeding or

other situations where the state can compel acceptance of the note do not get the benefit of the subsidy

• May include not only instruments denominated as “debt” under state law, but also installment sales contracts and financing leases

• back


State or Political Subdivision

• “State” includes the District of Columbia and any possession of the United States (e.g., Puerto Rico, Guam, Virgin Islands)

• In some cases, Indian tribal governments are treated as “states”• Political subdivision is a division of state or local government

that is a municipal corporation or has been delegated the right to exercise a “not insubstantial” amount of one of the three sovereign powers—taxation, eminent domain, or police power

• May additionally be some “control” issue• Also, there are entities that can issue “on behalf of” the State or

local government


“On Behalf Of” Issuers

• Revenue Ruling 63-20 or Rev. Proc. 82-26 issuers (nonprofit corporation)

• Constituted authorities (entity formed under state statute)• Rev. Rul. 57-187 and Rev. Rul. 60-248

• Other

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Issue of Bonds

Tax law generally is based upon analyzing the “issue” of bonds: two or more debt obligations (e.g., different maturities) that are

• Sold within 15 days of each other (“sold at substantially the same time”• Sold pursuant to a “common plan of financing”—unclear what this means• Payable from the same source of funds

Intentionally taxable bonds are not part of the same “issue” as tax-exempt bondsIt is possible to make a “multipurpose election” to focus the tax analysis on two or more “sub-issues” for some tax purposes

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Private Activity Bonds

Bonds are private activity bonds if either• more than 5% of the proceeds (or $5 million, if lesser) is loaned to

nongovernmental persons (“private loan test”) or• both

• (a) more than 10% of the proceeds or the bond-financed property are used in private trade or businesses and

• (b) more than 10% of the debt service on the bonds is secured by privately used property or comes directly or indirectly from payments from private users of the bond-financed property(together, “private business tests”)

(A word about qualified 501(c)(3) bonds.)back



Private Loans

• Generally, any arrangement treated as a loan for federal tax purposes

• Note that benefits assessments are generally treated as loans. So, there’s a special exception for assessment bonds

• Mandatory tax or assessment of general application• Must finance an essential governmental function, typically owned by a

governmental entity• Both assessed businesses and nonbusinesses must have an equal

opportunity to make the deferred payments• Guarantees by person treated as a borrower are not permitted if it is

expected that the guarantee will be usedback


Private Business Use

• Ownership• Lease• Management contract• Sponsored research• Output contract• Special legal entitlement• Special economic benefit• Exceptions


Qualified Management Contracts (97-13)

• Rev. Proc. 97-13, as modified by Notice 2014-67, provides guidelines for when a management contract will not be consider private use.

• In general, all compensation must be reasonable and not based in whole or in part on net profits.

• Longer-term contracts must generally be 90% or 95% fixed compensation.

• Contracts up to maximum of 5 years may have compensation based on any combination of stated fee, periodic fixed fee, capitation fee, per-unit fee, or percentage of either gross revenues or expenses

• Rules limiting overlapping directors, etc.back



Private Loans

• Generally, any arrangement treated as a loan for federal tax purposes

• Note that benefits assessments are generally treated as loans. So, there’s a special exception for assessment bonds

• Mandatory tax or assessment of general application• Must finance an essential governmental function, typically owned by a

governmental entity• Both assessed businesses and nonbusinesses must have an equal

opportunity to make the deferred payments• Guarantees by person treated as a borrower are not permitted if it is

expected that the guarantee will be usedback



• Ownership• Lease• Management contract• Sponsored research• Output contract• Special legal entitlement• Special economic benefit• Exceptions


Qualified Management Contracts (97-13)

• Rev. Proc. 97-13, as modified by Notice 2014-67, provides guidelines for when a management contract will not be consider private use.

• In general, all compensation must be reasonable and not based in whole or in part on net profits.

• Longer-term contracts must generally be 90% or 95% fixed compensation.

• Contracts up to maximum of 5 years may have compensation based on any combination of stated fee, periodic fixed fee, capitation fee, per-unit fee, or percentage of either gross revenues or expenses

• Rules limiting overlapping directors, etc.back


Exceptions to Private Business Use

• General public use• 200-day contracts• 100-day contracts (rate scale)• 50-day contracts (negotiated FMV)• Agents• Use pursuant to financing arrangements• Temporary use by developers• Incidental use (no more than 2.5%)• Qualified improvements• New rules related to partnershipsnext


Measuring Private Business Use

• Average private business use cannot exceed 10% or 5% if unrelated or disproportionate

• Measure use by reference to square feet (leases, etc.)• Measure use by comparison of revenues (naming rights, etc.)

• Measure over time; special rules for allocating “qualified equity”• Compliance must be reasonably expected• Noncompliance can be remedied through bond redemption

(Remedial action)• Alternate remedy by applying sale proceeds to qualified purpose

(Remedial action)back


Private Payment or Security

• Payments may be made directly or indirectly (need not go into debt service)—look for payments from private users or payments by general public pursuant to private use (e.g., hospital with management contract problem)

• Measurement• Exception for generally applicable taxes, but watch for

guarantees or special charges

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Qualified Private Activity Bonds

• There are various types of “qualified private activity bonds”• Exempt Facility bonds (e.g., airports, residential rental property, sewage)• Qualified mortgage bonds and qualified veterans’ mortgage bonds• Qualified small issue bonds (manufacturing facilities)• Qualified student loan bonds• Qualified redevelopment bonds• Qualified 501(c)(3) bonds

• Special rules relate to each; in general 95% of the proceeds must be used for “good costs”

• May have volume cap requirement and other limitationsLink


Debt Obligation of a State or Local Government


Arbitrage Bonds

Bonds are arbitrage bonds if gross proceeds of the issue are invested in investments witha composite yield that is materially higherthan the yield on the issue unless (unless an exception applies) or if an issuer fails to pay rebate on permitted arbitrage (unless an exception applies).back



Qualified Private Activity Bonds

• There are various types of “qualified private activity bonds”• Exempt Facility bonds (e.g., airports, residential rental property, sewage)• Qualified mortgage bonds and qualified veterans’ mortgage bonds• Qualified small issue bonds (manufacturing facilities)• Qualified student loan bonds• Qualified redevelopment bonds• Qualified 501(c)(3) bonds

• Special rules relate to each; in general 95% of the proceeds must be used for “good costs”

• May have volume cap requirement and other limitationsLink


Debt Obligation of a State or Local Government


Arbitrage Bonds

Bonds are arbitrage bonds if gross proceeds of the issue are invested in investments witha composite yield that is materially higherthan the yield on the issue unless (unless an exception applies) or if an issuer fails to pay rebate on permitted arbitrage (unless an exception applies).back


Gross Proceeds

• Gross Proceeds are• Proceeds• Replacement proceeds

• Pledged amounts (amounts that are reasonably expected to be available to pay debt service in the event of financial difficulties of the issuer)

• Invested sinking funds (amounts expected to be used to pay debt service)

• “Other replacement proceeds”—effectively hidden working capital borrowing

back


Invested (v. Spent)• Gross proceeds are treated as invested unless they are

spent• Proceeds can generally be allocated to expenditures on any

reasonable basis, including direct tracing or accounting entries

• Exceptions for refundings and working capital financings• Reimbursement of pre-issuance expenditures

• Reimbursement intent, 60-day look back, capital expenditures, some exceptions

back


Investment Property

• Securities, obligations, annuity contracts, “investment-type property”, residential rental property located outside the jurisdiction of the issuer (except for PABs)

• Investment-type property—any property of the type typically held for passive investment of income

• Includes “noncustomary prepayments”

• Excludes tax-exempt obligations, except for non-AMT/AMT arbitrage

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Composite Yield

• Yield is generally determined on a composite basis using an actuarial or internal rate of return calculation

• For bond yield—special rules relating to callable premium bonds

• For investments—separate yield calculation for different “classes” of investments

• Purpose investments• Nonpurpose investments• Single investment rule for refundings• Noncomposite calculation if an overburdening or overissuance

back


Materially Higher

• Generally, 1/8th of a percentage point• Special rules for refundings, program investments, student

loans

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Exceptions Allowing Unrestricted Investment

• Temporary periods• 3-year temporary period—expenditure test, time test, due diligence test• 5 years in some cases• 13 months for restricted working capital expenditures• 13 months for bona fide debt service funds• 90 days for current refundings

• Reserve or replacement funds• Least of 10% of par, MADs, and 125% of AADs

• Minor portion (lesser or 5% or $100,000)• So—watch out for advance refundings and large pledge funds

back



Composite Yield

• Yield is generally determined on a composite basis using an actuarial or internal rate of return calculation

• For bond yield—special rules relating to callable premium bonds

• For investments—separate yield calculation for different “classes” of investments

• Purpose investments• Nonpurpose investments• Single investment rule for refundings• Noncomposite calculation if an overburdening or overissuance

back


Materially Higher

• Generally, 1/8th of a percentage point• Special rules for refundings, program investments, student

loans

back


Exceptions Allowing Unrestricted Investment

• Temporary periods• 3-year temporary period—expenditure test, time test, due diligence test• 5 years in some cases• 13 months for restricted working capital expenditures• 13 months for bona fide debt service funds• 90 days for current refundings

• Reserve or replacement funds• Least of 10% of par, MADs, and 125% of AADs

• Minor portion (lesser or 5% or $100,000)• So—watch out for advance refundings and large pledge funds

back


Arbitrage Rebate

• Even if you are permitted to invest at a higher yield, in general you are required to “rebate” or remit to the federal government all earnings received by investing nonpurpose investments at above the yield on the bonds Actuarial calculation

• Payments due every 5 years and within 60 days after paying off bonds

back


Rebate Exceptions

• Small issuer exception—no more than $5 million of bonds in the year ($10 million for public school capital expenditures)

• 6-month expenditure exception• 18-month expenditure exception (15% in 6 months, 60% in 12

months)• 2-year construction exception (10%, 45%, 75%)• Reasonable retainage• Penalty electionback


Miscellaneous Rules

• Registration requirement• Federal guarantee limitation—restricts investments and certain types

of “double dipping”• Tax-exemption derived from tax law only• Advance refunding limitations—only governmental and 501(c)(3)

bonds; only one advance refunding; other• Information reporting (8038s)• Pooled financing bonds• Hedge bonds—plan on spending money quicklyback



Tax Credit and Direct-Pay Bonds

• Subsidy payment to issuers• May pay 0% interest or allow holder a federal income tax credit

equal to market taxable rate • Qualified zone academy bonds (QZABs) issued by state or local

government for public school facilities • Qualified School Construction Bonds (QSCBs)• New clean renewable energy bonds (New CREBs)• Qualified energy conservation bonds (QECBs)• Recovery zone facility bonds (RZFBs)• Build America Bonds legacy



Tax Credit and Direct-Pay Bonds

• Subsidy payment to issuers• May pay 0% interest or allow holder a federal income tax credit

equal to market taxable rate • Qualified zone academy bonds (QZABs) issued by state or local

government for public school facilities • Qualified School Construction Bonds (QSCBs)• New clean renewable energy bonds (New CREBs)• Qualified energy conservation bonds (QECBs)• Recovery zone facility bonds (RZFBs)• Build America Bonds legacy Tax Law Training Session

Materials




May 4 – May 6, 2016 – Chicago, IL

01. Arbitrage & Rebate Faculty:Linda B. Schakel Ballard Spahr LLP – Washington, DC Stephen E. Weyl Hinckley Allen – Boston, MA

I. GENERAL CONCEPTS OF ARBITRAGE.

A. Tax-Exempt vs. Taxable Interest.

Holders of tax-exempt bonds are not required to treat interest payments as “gross income” for federal income tax purposes—i.e., this interest is “excluded” from income subject to tax. Because this interest is exempt, holders are willing to accept a lower rate of interest on their investment than is otherwise available for taxable investments (the interest rate on comparable term bank CDs and U.S. Treasury obligations is generally higher because most purchasers must pay income tax on the interest income). Thus, if other factors are disregarded, with respect to both taxable and tax-exempt obligations of comparable term, even though the interest rates differ, the investor receives the same amount of money.

B. Federal Subsidy.

This differential between tax-exempt and taxable interest rates is viewed by the tax rules as a federal subsidy afforded to state and local governments that is designed to lower the cost of financing qualified public projects. If an issuer can borrow at 5% rather than 7%, the cost of repaying the loan for a public project will be lowered. This form of subsidy, however, presents an opportunity for abuse—the opportunity to “borrow low and invest high,” thereby earning a spread or profit called arbitrage.

C. Classic Arbitrage.

Example: Issuer wishes to build a courthouse costing $1M, but doesn’t want to increase the local tax levy to raise the money. It issues $10M of bonds with a 5% interest rate and a 5-year maturity. It takes the proceeds from the sale of the bonds and invests them in a 7% Treasury obligation maturing in 5 years. For each of the 5 years, Issuer will earn a 2% spread or profit (the difference between the 5% interest rate it is paying on the bonds and the 7% interest rate it is earning on its investments). This amounts to $200,000 per year of arbitrage profit. In 5 years, the total profit will be $1M—enough to pay for building the courthouse. At that point, the Issuer can “cash in” the investment and use the proceeds to repay and retire the bonds. No local tax receipts will ever have been used to pay the debt.


D. Purpose of Arbitrage Rules.

The arbitrage rules are designed to limit the opportunity for an issuer to earn this spread so that issuers will borrow only to finance projects rather than to create arbitrage. Bonds which receive a federal subsidy through other measures (e.g. Build America Bonds) may also be subject to arbitrage rules.

E. Format of Arbitrage Rules: Two General Categories.

The arbitrage rules are divided into two general categories: (1) yield restriction rules (“Can you earn it?”), and (2) rebate rules (“Can you keep it?”).

1. The Yield Restriction Rules. These rules date back to the late 1960s, and represent the first attempt to limit arbitrage. In general, these rules govern the circumstances in which an issuer is allowed—and not allowed—to invest the proceeds of a bond offering at a rate higher than the borrowing rate (the interest rate on the bonds).

2. The Rebate Rules. These rules date from the early and mid-1980s, and represent a more recent attempt to control arbitrage. In general, these rules provide that, in most cases, any investment spread (i.e., positive arbitrage) earned must be surrendered, or “rebated,” to the Treasury Department (the “Treasury Department”).

These two sets of rules are intended to regulate the same event—arbitrage earnings—although with different approaches. One may argue that the yield restriction rules are no longer needed, but this argument has not yet been accepted in the Internal Revenue Code of 1986, as amended (the “Code”), or by the Internal Revenue Service (the “IRS”). Instead, tax practitioners must apply two independent sets of rules to every potential arbitrage situation.

F. Code and Regulations.

The arbitrage rules are found in Code § 148 and in § 1.148 of the Treasury Regulations (“Treas. Reg.” or “Treas. Regs.”). Practitioners must be aware of the history involved in “building” arbitrage law, which has been incremental: an earlier version of the Code or the Treasury Regulations may apply to a bond issue that is outstanding. To complicate matters, over the past several years the IRS and Treasury have issued proposed regulations, also found under § 1.148, which have not yet been finalized, but which in some cases permit the issuer to elect to apply the proposed rules. This session, however, discusses only current law.

II. IDENTIFICATION OF “GROSS PROCEEDS.”

A. Same Definition for Both Rules.

To apply the yield restriction rules and the rebate rules, one must identify the “gross proceeds” of the bond issue. Both sets of rules use the same definition of “gross proceeds.”

B. Categories of “Gross Proceeds.”

There are two general categories of “gross proceeds”: (1) actual “proceeds,” which consist of “sale proceeds” from the issuance of the bonds and “investment proceeds” from


earnings on such proceeds, and (2) “replacement proceeds,” which consist of other amounts that are “treated” as proceeds.

1. “Sale Proceeds” and “Investment Proceeds.” This category includes the proceeds received from the sale of the bonds and investment proceeds earned on the sale proceeds.

a. For a refunding issue, this category can also include “transferred proceeds”, which are unexpended sale or investment proceeds of the refunded bonds that are “transferred” to the refunding bonds.

Example 1. Unexpended construction fund.

Example 2. Unexpended escrow fund.

Example 3. Unexpended sale proceeds in a debt service reserve fund.

See definition of “proceeds” in Treas. Regs. §1.148-1(b).

2. “Replacement Proceeds.” This category consists of other money of the issuer or another party that has a “nexus” to the bonds.

Example. Issuer borrows $1M to build a courthouse. The bonds have a 20-year maturity and a 5% rate. The actual proceeds, including investment earnings, are spent within a short time on the courthouse. Instead of structuring the bond issue with level debt service (essentially the same payment each year that will pay both principal and interest, similar to a conventional home mortgage), the issuer structures the deal with a “bullet maturity”—all principal on the bonds comes due in 20 years. The issuer takes the annual revenues that it would have used to pay principal and invests those revenues each year in 7% Treasury obligations that mature when the bonds mature. The issuer will now earn a 2% spread each year on the revenues it would normally have used to pay the bonds. This will substantially reduce the required debt service payments on the bonds. These accumulated revenues are “replacement proceeds.”

See definition of “replacement proceeds” in Treas. Regs. §1.148-1(c).

This plan of financing, commonly referred to as an “invested sinking fund,” was popular in the mid- to late-1970s and resulted in an extension of the arbitrage rules to other amounts, including portions of the issuer's revenues, as well as the actual proceeds.

In general, under current law the arbitrage rules are applicable to invested amounts, as well as actual bond proceeds, if there is a sufficient nexus between the invested amounts and the bond issue. This nexus between invested amounts and a bond issue can exist under three principles:

a. Prior Dedication Principle. Under the prior dedication principle, the invested amounts and the bonds are linked because the issuer had previously dedicated the invested amounts to the very purpose for which the issuer


subsequently borrowed the money. The Treasury Regulations emphasize that it is not enough that the invested fund was merely available for the same purpose, or that there was a preliminary earmarking of the invested fund for the same purpose. It must be clear that the invested fund would have been used for the same specific purpose absent the borrowing. For example, if an issuer solicits contributions for a new cancer center but then borrows instead for that purpose and invests the contributions at a higher yield, the nexus would be established and the campaign contributions would be “replacement proceeds.”

b. Sinking Fund Principle. Under the sinking fund principle, the invested amounts have the required nexus if the fund is established with the reasonable expectation that the fund will in fact be used to pay debt service on the bonds. Look to the issuer's expectations. If the issuer actually expects to pay debt service from another source, then an invested fund that could have been used for debt service or other purposes but is not reasonably expected by the issuer to be used to pay debt service will not constitute a sinking fund, and amounts in the fund will not be “replacement proceeds.” If such a fund is pledged as security, however, it might have the required nexus under the pledged fund principle, which is discussed next.

c. Pledged Fund Principle. Under the pledged fund principle, the invested amounts have the required nexus if they are pledged (directly or indirectly) to the payment of the bonds. The pledge can exist by formal declaration or where the bondholders have a reasonable assurance that the invested fund will be available if needed to pay the bonds (even if the borrower encounters financial difficulties). Look to the bondholders’ expectation. A pledge is considered a clear indication that the invested fund could have been used for the purpose of the borrowing and, unless other permitted uses of the fund could deplete it, the only purpose for maintaining the fund is to support the borrowing. For example, a Repair and Replacement Fund funded from revenues may be pledged, but its primary purpose is to finance capital improvements and maintenance expenses. There may be no reasonable expectation that amounts in that Fund would be available to pay debt service if the issuer encountered financial difficulties.

A pledge to a guarantor of the bonds (e.g., a bank issuing a letter of credit to secure bonds) is treated the same as a direct pledge to the trustee or bondholders.

A negative pledge in the bond documents requiring the borrower to maintain a specified amount in available cash may also be treated as a pledged fund if certain safe harbors are not satisfied. In general under the safe harbor, the amount must be reasonable for the purposes for which it was established, must be tested no more frequently than every six months, and there may be no restrictions on spending the amounts between the testing dates.


C. Application of Yield Restriction and Rebate Rules.

Once the “gross proceeds” of an issue are identified, you must apply both the yield restriction rules and the rebate rules to determine whether compliance has been achieved in the investment of those gross proceeds.

III. THE YIELD RESTRICTION RULE AND ITS EXCEPTIONS.

A. General Rule.

The general yield restriction rule is that gross proceeds may not be invested at a yield materially higher than the yield on the bonds. This rule requires calculations and interpretations necessary to determine yield on the bonds and yield on investments made with proceeds. The following are highlights:

1. Yield on Bonds. The “yield” on an issue of bonds is determined under Treas. Regs. §1.148-4 and is computed using a present value (or economic accrual) method. Key components of this determination include: (a) the definition of the target “issue price” of the bonds, and (b) the deduction of bond insurance premiums, letter of credit fees, and other “qualified guarantee” payments from the purchase price in (a). Yield is determined by calculating the rate (i.e., the yield) necessary to make the present value (discount) of the debt service payments over the life of the bonds equal to the adjusted issue price, or target, calculated as of the issue date.

a. In the case of variable rate bonds, actual payments of debt service are considered to determine yield, which in effect requires a retroactivedetermination. In the case of fixed yield bonds, anticipated payments can be used, which permits a prospective determination of yield upon issuance of the bonds.

b. The underwriter's discount and expenses of issuance cannot be taken into account to determine yield. If these items could be taken into account, they would have the effect of increasing the bond yield and thus would permit recovery of these costs through a higher permitted investment yield; however, the policy of the Treasury Regulations is that these items paid by the issuer may not be recovered by the issuer through a higher investment yield.

c. A “qualified hedge,” such as certain interest rate swap agreements, may, under certain circumstances, be taken into account to determine yield on the bonds.

2. “Materially Higher Standard.” The permissible maximum investment yield on the gross proceeds is called the “materially higher standard,” which is defined in the Treasury Regulations in various ways:

a. 1/8% above the bond yield is the general rule.

b. 1/1000% above the bond yield is the rule for advance refunding bond proceeds and replacement proceeds.

c. Other special rules.


3. Yield on Investments. Yield on investments of gross proceeds also is determined using a present value (or economic accrual) method. See Treas. Regs. §1.148-5.

a. FMV. The most important rule to remember is that investments must be purchased for fair market value (“FMV”). This in effect prohibits deflection of arbitrage profits to a third party.

b. How FMV is determined.

i. Reference is made to the “generally offered price” for certain investments generally available to the investing community on identical terms, such as bank CDs, mutual funds.

ii. Bidding may be required for other investments that do not have independently established prices, such as guaranteed investment contracts (“GICs”). See Treas. Regs. §1.148-5(d)(6)(iii) for safe harbor bidding procedures for GICs and yield-restricted defeasance escrows, effective March 1, 1999.

iii. United States Treasury State and Local Governments Series obligations (or SLGs) purchased directly by state and local government issuers from the U.S. Treasury are always treated as purchased at FMV.

c. No Reduction for Costs of Investing. In general, the costs associated with investing may not be used to reduce yield. There are, however, certain circumstances in which “qualified administrative costs” may be taken into account to reduce the yield on the investment. E.g., certain broker's fees for a GIC.

d. Yield Reduction Payments Under Treas. Regs. §1.148-5(c). For certain investments, issuers can make yield reduction payments in cases where the issuer is not able to purchase yield-restricted investments, or does not know the yield (as is the case for a variable yield bond). These payments have the effect of reducing the yield on yield-restricted investments and provide an important area of coordination between yield restriction and rebate rules and are similar in effect to rebate payments. Note: Yield reduction payments are NOT always a permitted way to bring investments' yield down to the bond yield.

e. Allocations to Expenditures. Generally, proceeds are treated as invested until they are allocated to expenditures, which may or may not be exactly coterminous with the issuer’s cash outlay. For example, amounts are treated as spent when a check is sent if there is an expectation that funds will be withdrawn from the checking account within 5 days, and account earnings attributable to the actual number of days until the account is drawn on are ignored.


B. Exceptions to the Yield Restriction Rule.

1. General. The Code and Treasury Regulations contain numerous exceptions to the general rule requiring yield restriction. See Treas. Regs. §1.148-2. The more important ones are:

a. 3-Year Temporary Period for Construction Proceeds. Unrestricted yield on investment of sale proceeds (including investment earnings) for 3 years after issuance if the issuer reasonably expects that (i) 85% will be spent within that period, (ii) substantial binding commitments to spend 5% are made within 6 months after issuance, and (iii) work and expenditure of bond proceeds will proceed with due diligence. The three years may be extended to up to five years if both the issuer and a licensed architect or engineer certify that a longer period is necessary to complete the capital project.

b. Reserve Fund. Unrestricted yield on investment of a reasonably required reserve or replacement (“4R”) fund.

i. Funding Limitation. Generally, absent significant original issue discount (“OID”) or original issue premium (“OIP”), sale proceeds of no more than 10% of the stated principal amount of the bonds may be used for this purpose.

ii. Size Limitation. A 4R fund is limited to the smallest of three measures: (x) maximum annual debt service (“MADS”), (y) 125% of average annual debt service (“AADS”), or (z) generally (absent significant OID or OIP), 10% of the stated principal amount of the bonds.

iii. Is It “Reasonably Required”? See Rev. Proc. 84-26 for “unusual facts and circumstances test” for general obligation (“GO”) bonds.

c. Bona Fide Debt Service Fund. This exception applies if the fund is designed to accumulate revenues on an annual basis for matching against annual debt service requirements (e.g., revenue bond debt service or bond fund). The fund must be depleted at least once each year except for a reasonable carryover amount equal to 1/12 of annual debt service.

d. Miscellaneous Other Rules. Special rules exist for pooled financings, refunding proceeds, minor portion, etc.

2. Rebate Analysis. Even if a fund meets one of these exceptions to yield restriction, the fund must still be analyzed under the rebate rules (i.e., Can I keep it?) to determine if there is arbitrage that must be rebated.

C. Arbitrage certificate.

1. The issuer must certify expectations as to use of proceeds (e.g., for 3-year expenditures to qualify for temporary period).


2. Tax counsel often include certifications related to other tax matters (e.g., private activity bond rules), and the document may be called No Arbitrage Certificate, Tax Compliance Agreement, Tax Regulatory Agreement, or other variations.

IV. THE GENERAL REBATE RULE AND MECHANICS.

A. General Rule.

Even if the issuer is permitted to earn a higher yield under the yield restriction rules and related exceptions, the arbitrage profit from investments must be paid, or “rebated,” to the Treasury Department, unless there is an exception to the rebate requirement. In other words, if the amount actually earned is greater than the amount that would have been earned if the proceeds had been invested at the bond yield, that excess must be rebated absent a rebate exception.

1. Rebate applies to “gross proceeds,” which is the same as the extended definition of proceeds discussed above. Thus, “replacement proceeds” are included.

2. Once again, rebate requires calculation of bond yield and investment yield. Rules are essentially the same as for yield restriction.

3. Note that there is no such thing as “materially higher” for this purpose. Everything over the bond yield is subject to rebate unless there is an exception that is applicable.

5. The rebate rules make a distinction between “nonpurpose” and “purpose” investments. Purpose investments are investments which are made to carry out the governmental purpose of the issue and are subject to a separate rebate requirement. Examples include mortgages acquired in a qualified single-family mortgage bond or loans acquired or otherwise financed in a student loan bond program or other obligations acquired in conduit-type financings permitted under the law.

B. Payment of Rebate.

Rebate amounts are required to be paid as follows:

1. At least 90% must be paid not later than 60 days after each interim computation date (any date selected that is not later than 5 years after the issue date, and every 5 years thereafter).

2. 100% must be paid not later than 60 days after the final computation date (the date the entire issue matures or is fully redeemed).

3. Rebate amount paid with an IRS Form 8038-T.

4. Failure to pay the correct rebate amount when due causes the bonds to be “arbitrage bonds” (i.e., taxable) unless:

a. The IRS determines failure was not caused by willful neglect, and


b. The issuer promptly pays penalty to the Treasury Department (50% or 100% plus interest, depending on type of bond issue).

The Treasury Regulations contain rules for waiver of penalty in cases where late payment is paid promptly after discovery, and nonpayment is accidental.

5. Treasury Regulations allow recovery of rebate overpayments if the issuer convinces the IRS it has made an overpayment. There are some limitations on when issuer may get money back. Final Treasury Regulations released in November 2014 require that a claim for a refund must be filed no later than two years after the final computation date for the issue to which the overpayment relates.

C. Basic Computation Principles.

Computation of rebate amount—in general:

1. Uses a future value (or economic accrual) method. See Treas. Regs. §1.148-3(j) for examples.

2. Identify dates and amounts of payments for and receipts from each investment of gross proceeds during the computation period ending on the computation date.

3. Future value those amounts, by assuming that interest is earned and compounded over the period, to the computation date, at a rate equal to the bond yield.

4. Rebate amount: if the future value of the receipts on the investments (i.e., earnings, sales, capital gains, maturities) exceeds the future value of the payments on the investment (i.e., purchase prices), that excess is the rebate amount. By “future valuing” at the bond yield, if the issuer's actual rate of return is lower than the bond yield, the future value of the receipts will NOT be greater than the future value of the payments, so no rebate will be owed. This situation is commonly referred to as “negative arbitrage” and has generally been the rule in the recent period of very low interest rates.

D. Accounting for Expenditures.

1. As with yield restriction, earnings on proceeds cease to be considered proceeds for rebate purposes when they are allocated to expenditures. Not all withdrawals of funds are treated as expenditures for arbitrage and rebate purposes. For example, transferring funds from a bond proceeds fund to a water and sewer account (even if controlled by the operating arm of the issuer rather than the financial department) is not an “expenditure.”

2. In general, payments for capital expenditures are treated as spent when paid to an unrelated third party or as a reimbursement for prior expenditures which meet the rules of Treas. Reg. §1.150-2.

3. Amounts used to pay working capital expenditures (salaries, insurance, etc.) are not treated as spent (and thus, still subject to arbitrage and rebate rules) unless


they fit within the de minimis exceptions of Treas. Reg §1.148-6(d) or the issuer establishes that there are no other available amounts to pay expenditures (“proceeds spent last” rule).

4. The issuer is generally given up to 18 months after the financed project is placed in service to make a “final allocation” of bond proceeds, but no later than the end of the first five-year rebate computation period.

V. EXCEPTIONS TO REBATE RULE.

A. Summary.

There are five important exceptions to the rebate requirement: (1) the “small issuer” exception, (2) the 6-month spending exception, (3) the 18-month spending exception, (4) the 24-month spending exception, and (5) the “bona fide debt service fund” exception.

B. Small Issuer Exception.

The bond issue is “completely” exempt from the rebate requirement under this exception. The issue is still subject to the yield restriction rules. All the other exceptions are “partial” only. See Code §148(f)(4)(D) and Treas. Regs. §148-8.

1. The exception applies if:

a. The issuer is a governmental unit with general taxing powers;

b. No part of the issue is a private activity bond (i.e., only available for governmental bonds);

c. 95% of proceeds are used for local governmental purposes (i.e., no “pooled financing”); and

d. The issuer reasonably expects, as of the issue date, that the aggregate face amount of all tax-exempt bonds (other than private activity bonds) issued by it and “subordinate entities” during the same calendar year will not exceed $5,000,000.

2. $5,000,000 Size Limitation.

a. Tax-exempt private activity (i.e., non-governmental) bonds are not counted.

b. Current refunding bonds are not counted (see below).

c. Must apply aggregation rules (very complicated).

i. Issuer and all entities (other than “political subdivisions”) that issue bonds “on behalf of” that issuer are treated as a single issuer.


ii. Bonds issued by a “subordinate entity” are also aggregated. An entity is subordinate to another entity (the “superior entity”) if it is controlled by the superior entity. The control test is satisfied if either

(x) the superior entity can approve and remove a majority of the subordinate entity's governing body without cause, or

(y) the superior entity can require the use of funds or assets of the subordinate entity for any purpose of the superior entity.

iii. A “political subdivision” that is subordinate does not have to worry about bonds issued by a superior entity—it only worries about bonds that are issued by entities that are subordinate to it (i.e., you count [or aggregate] up but not down). In general, a political subdivision is an entity with substantial taxing, eminent domain, and police powers.

d. Anti-abuse rule: an entity “formed or availed of” to avoid the $5M limit, and all entities that would benefit from the avoidance, are treated as one issuer.

e. $5,000,000 increased by up to an additional $10,000,000 for bonds issued after 1997 to finance public school construction .

3. Ability to use this exception can be “allocated” by the superior entity to the subordinate entity (e.g., from a county to its sanitary district that otherwise qualifies but does not have general taxing power).

4. The Code contains complicated provisions on how to treat refundingbonds under the $5,000,000 exception. In general, once original bonds qualify for the small issuer exception, refunding bonds issued in a subsequent year as a current refunding (i) remain entitled to the small issuer exemption without “counting” again, and (ii) do not count against the $5,000,000 limit in that subsequent year. Advance refunding bonds count against the $5M limit in the year issued and can be entitled to the small issuer exception only if they fit within that year's $5,000,000 limit (always review Code §148(f)(4)(D) and Treas. Regs. §1.148-8 carefully).

5. The test is based on the issuer’s reasonable expectation at the time of issuance of the bonds. Therefore, if the issuer issues $4,000,000 in bonds that are subject to the exception, but later in the year issues another $5,000,000 for an unexpected need (for example, to fund a litigation judgment), the first issue will not lose rebate exception treatment.

C. 6-Month Spending Exception.

The general rule is that if all proceeds are spent within 6 months after their issue date, no rebate is due. See Code §148(f)(4)(B) and Treas. Regs. §1.148-7(c).


1. Applies to all types of bonds—governmental, Code §501(c)(3), private activity bonds (“PABs”).

2. Available for refunding as well as new money issues. This is the only spending exception for refunding issues.

3. This does not apply to or affect proceeds on deposit in a debt service reserve fund. Those proceeds do not have to be spent, but they are subject to rebate. Thus, where a reserve fund is included in the issue, this is only a partial exemption.

4. Has a carry over spending exception: governmental and Code §501(c)(3) bonds (i.e., not PABs) can expend 5% of proceeds over an additional 6 months.

5. Cannot meet the test by retiring principal with proceeds.

6. Special rules apply for tax and revenue anticipation notes or bonds (“TRANs”)―cumulative cash flow deficit.

D. 18-Month Spending Exception.

The general rule is that if all proceeds are spent within 18 months after issue date, no rebate is due. See Treas. Regs. §1.148-7. Note: This exception was added by the 1993 Treasury Regulations and is not part of the Code.

1. Applies to all types of bonds―governmental, Code §501(c)(3), PABs.

2. Applies only to bonds issued after June 30, 1993.

3. Does not apply to or affect proceeds deposited in a debt service reserve fund. Those proceeds do not have to be spent, but they are subject to rebate. Thus, where a reserve fund is included in the issue, this is only a partial exemption.

4. For bonds issued to finance capital projects, including acquisitions (i.e., not limited to “construction,” as is the 24-month exception).

5. Basic requirements:

a. Issue must qualify for 3-year temporary period exception from yield restriction.

b. Available proceeds (which includes interest earnings) must be spent for governmental purpose within 18 months after issue date according to following progress benchmarks:

i. At least 15% within 6 months;

ii. At least 60% within 12 months;

iii. 100% within 18 months (except allowed additional 12 months to spend “reasonable retainage”); and


iv. There is also a de minimis exception to total expenditure, equal to the lesser of 3% of available proceeds or $250,000.

6. The regulation provides that the amount of investment earnings included in “available proceeds” is “estimated earnings,” based on reasonable expectations at closing, for the first two benchmarks. The estimated earnings are treated as earned upfront for purposes of calculating the 6-month spending benchmarks. Actual earnings must be used for the last benchmark.

7. Cannot meet the test by retiring principal with proceeds.

8. Cannot mix the 18-month exception with the 24-month exception.

E. 24-Month or “2-Year” Spending Exception.

The general rule is that if all proceeds are spent within 24 months after issue date, no rebate is due. See Code §148(f)(4)(C) and Treas. Reg. §1.148-7(f).

1. Applies only to governmental, Code §501(c)(3) bonds, and certain PABs issued for governmentally owned projects (e.g., solid waste facilities or airports [i.e., not to PABs in general]).

2. Applies only to bonds issued after December 19, 1989.

3. Applies only to a “construction issue”:

a. The issuer must reasonably expect that 75% of available construction proceeds be spent on construction expenditures for issue to qualify as a construction issue.

b. Can “bifurcate” the issue by election to treat a portion as a construction issue.

i. Election must be in the Non-Arbitrage or Tax Certificate.

ii. Remainder of issue can meet 6-month exception (but not 18-month exception).

iii. All “construction expenditures” must be in the 24-month portion. That is, cannot include only that part that is expected to meet the spend-down benchmarks in the 24-month portion of the issue.

c. “Construction expenditures” are

i. Capital expenditures (chargeable to capital account);

ii. For cost of real property (other than acquisition of land or other existing real property) or constructed personal property, such as


(x) Buildings, improvements to land, other inherently permanent structures, including wiring, plumbing, HVAC, pipes, ducts, etc.

(y) Constructed tangible personal property such as subway cars, fire trucks, etc., if:

(1) substantial portion is complete more than 6 months after construction began or contract entered into,

(2) issuer could not have reasonably expected, with exercise of due diligence, completion to have occurred within that 6 months, and

(3) if issuer does the work itself, not more than 75% of capitalizable cost is for acquisition of components, raw materials, or supplies.

4. Available construction proceeds (“ACP”), which includes interest earnings, must be spent for a governmental purpose within 24 months after the issue date according to following progress benchmarks:

i. At least 10% within 6 months;

ii. At least 45% within 12 months;

iii. At least 75% within 18 months; and

iv. 100% within 24 months (except allowed additional 12 months to spend “reasonable retainage”).

5. Interest earnings included in ACP for the first three benchmarks are the “estimated earnings,” based on reasonable expectations at closing, with the estimated earnings treated as earned upfront. Actual earnings must be used for the last benchmark. However, in the case of the 24-month exception, the issuer may elect in the Non-Arbitrage or Tax Certificate to use actual earnings for all benchmarks.

a. Earnings on a reserve fund during the 24-month period will be included in ACP unless an election is made in the Non-Arbitrage or Tax Certificate to exclude them.

b. In any event, even if no election is made, after the 24-month period, the issuer must pay rebate on the reserve fund earnings. Thus, this can only be a partial exemption if a reserve fund is involved.

6. Election of 1-1/2% penalty in lieu of rebate.

a. Issuer of a construction issue may elect on or before the issue date to pay 1-1/2% penalty to the United States in lieu of calculating the rebate amount on ACP if the required spending schedule is not met. NOTE: This election is


rarely made as it can result in an issuer paying rebate when it otherwise would not have been paid if the election was not made.

b. Computed separately for each spending period, including each 6-month period after the end of 4th spending period during which any unspent ACP remains.

c. Penalty equals 1-1/2% of “under expended” proceeds (even if rebate would have been $0).

d. Payable within 90 days after the end of each spending period with IRS Form 8038-T.

e. The issuer may elect to terminate the 1-1/2% penalty by making an additional penalty termination payment and taking the following actions:

i. Elect to terminate penalty within 90 days after the earlier of the end of the initial temporary period or substantial completion;

ii. Within 90 days after the end of the initial temporary period, pay penalty equal to 3% of unexpended ACP at the end of the initial temporary period times the number of years (to 2 decimals) in the initial temporary period;

iii. Not invest the unexpended ACP in higher yielding investments; and

iv. Use the unexpended ACP to redeem bonds at the earliest possible redemption date.

F. Multipurpose issue rules.

Refunding portions and new money portions are generally treated as separate issues for purposes of these exceptions. The refunding portion may be entitled to a rebate spending exception under the 6-month spending exception only, provided the issue is properly bifurcated. Once the new money portion is identified, it must be treated as a single issue.

G. Bona Fide Debt Service Fund Exception.

In general, these funds are exempt from rebate requirements, but there are special qualification requirements that are not applicable in the yield restriction rules:

1. Fixed rate governmental bonds with an average maturity of at least 5 years meet the test under §148(f)(4)(A).

2. Otherwise, the earnings must meet one of these tests:

a. Earnings do not exceed $100K per year, or

b. Average annual debt service is not more than $2.5M.


H. Drawdown Loans in Bank Direct Purchase Transactions

An increasing number of transactions are being done as bank direct purchases. In many of these, the bank allows the borrower to draw down funds as needed, with a requirement that all funds be drawn by some date (typically the end of the three year temporary period). To the extent funds are drawn down in this manner, there are no proceeds to be invested.

VI. THE SINGLE ISSUE RULE.

A. Single Issue.

Treas. Reg. §1.150-1(c) provides that bonds are treated as part of a single issue if all of the following requirements are met:

1. The bonds are sold at substantially the same time (less than 15 days apart).

2. The bonds are sold pursuant to the same plan of financing (e.g., to finance a single facility or related facilities).

3. The bonds are payable from the same source of funds determined without reference to guarantees from parties unrelated to the obligor. Note: tax-exempt bonds and taxable bonds are not part of the same issue.

B. Treatment as Separate Issues.

Bonds that would otherwise constitute a single issue may be treated as separate issues if each separate issue finances a separate purpose and would qualify as a tax-exempt issue in its own right, but this separate treatment does not affect the application of the arbitrage rules and other provisions of the tax laws to the single issue.

C. Draw-down Loans.

1. Bonds issued pursuant to a draw-down loan (typical in direct bank loans for construction) are treated as part of a single issue, with an issue date being the first date on which the aggregate draws under the bond exceed the lesser of $50,000 or 5% of the issue price.

2. There are special rules relating to treating each draw as a separate issue with respect to bonds with sunset (termination) dates found in Notices 2010-81 and 2011-63.

VII. HEDGE BONDS.

A. Definition.

The term “hedge bond” as defined in Code §149(g) refers to any bond for which:

1. The issuer does not reasonably expect at the time of issuance of the bonds to spend at least 85% of the proceeds within three years of issuance to carry out the governmental purpose of the issue (and therefore, is not getting a temporary period exception to yield restriction), or


2. The issuer invests more than 50% of the proceeds of the bond issue in nonpurpose investments having a substantially guaranteed yield for four years or more.

B. Purpose of the Hedge Bond Rule.

The hedge bond rule is intended to address situations where an issuer might issue bonds without a present need for financing to hedge against a potential rise in interest rates at a future time when financing is needed. The rule is in the nature of an anti-abuse rule.

C. Spending Requirements.

A hedge bond will not be tax-exempt unless the issuer reasonably expects at the time of issuance that the following spending requirements will be met:

1 year 10% 2 years 30% 3 years 60% 5 years 85%

D. Exceptions to Hedge Bond Rules.

1. Investment of bond proceeds in Non-AMT bonds - bonds whose proceeds are invested in tax-exempt bonds that are not subject to alternative minimum tax are generally exempt from the hedge bond rules.

2. In general, a refunding bond shall be treated as meeting the hedge bond requirements only if the original bond met such requirements. However, a refunding bond will be treated as a hedge bond unless there is a significant governmental purpose for the issuance such as saving debt service or to escape burdensome document provisions (but not to hedge against future increases in interest rates).

VIII. ABUSIVE ARBITRAGE DEVICE.

A. Definition.

Any action is an “abusive arbitrage device” if the action has the effect of –

1. Enabling the issuer to exploit the difference between tax-exempt and taxable interest rates to obtain a material financial advantage; and

2. Overburdening the tax exempt bond market.

Treas. Reg. §1.148-10 provides generally that an abusive arbitrage device makes the bonds taxable.

B. Exploitation.

Exploitation of tax-exempt versus taxable rates involves the structuring of a transaction for a principal purpose of obtaining a material financial advantage in violation of Code §148. In this analysis, substance over form will be considered.


C. Overburdening.

An action overburdens the tax-exempt bond market if it results in issuing more bonds, issuing bonds earlier, or allowing bonds to remain outstanding longer than is reasonably necessary to accomplish the governmental purpose of the bonds. Factors indicating overburdening include the failure to qualify for a temporary period under Treas. Reg. §1.148-2(e)(2) and failure to satisfy the 120% maturity limitation test of Treas. Reg. §1.148-1(c).



01. Arbitrage & Rebate

General Concept• “Arbitraging” difference between taxable vs. tax‐exempt interest

• Purpose of arbitrage rules

Arbitrage Overview

• Two rules: Yield Restriction and Arbitrage Rebate

• Based on “gross proceeds”– Same for both rules


Gross Proceeds Sale Proceeds Investment Proceeds Replacement Proceeds

Sinking funds Pledged funds “Negative pledges”

Transferred Proceeds

Determination of Yield• Issue price• Fixed versus variable rate issues• Original issue discount and premium• Qualified guarantees• Qualified hedges ‐ Integration and super‐integration

Yield Restriction• General Rule• “Materially higher”• “Yield reduction payments”• Temporary periods:

– Construction– 4R Fund– Minor portion– Bona fide debt service fund


Role of Tax Certificate

• Expectations• Expansion over time to include private activity and other rules

• For the “issue”• Multipurpose issue rules

Rebate Requirement

• Future value method• Computation dates• Procedure for payment• Failure to make timely payment

Accounting For Expenditures

• Capital expenditures• Reimbursement expenditures• Working capital and PSL or “proceeds spent last”

• Final allocation of proceeds to expenditures


Spending Exceptions From Rebate

• Small issuer

• 6 ‐month spending exception


• Two ‐ year spending exception

Hedge bonds

• Expectation to spend the money in three years and no long term investment strategy – out of the rule

• Otherwise: 5 year expenditure benchmarks or 95% investment in tax‐exempt bonds

Abusive arbitrage device

• Overburdening• Exploitation


Spending Exceptions From Rebate

• Small issuer



• Two ‐ year spending exception

Hedge bonds

• Expectation to spend the money in three years and no long term investment strategy – out of the rule

• Otherwise: 5 year expenditure benchmarks or 95% investment in tax‐exempt bonds

Abusive arbitrage device

• Overburdening• Exploitation



02. Refunding & Reissuance

Faculty:Aviva M. Roth Orrick, Herrington & Sutcliffe LLP – Washington, DC Perry E. Israel Law Office of Perry Israel – Sacramento, CA

I. Introduction

A. Overview of key terms.

1. Refunding is the term used to describe a refinancing of municipal debt. A refunding issue is defined in Treasury Regulations (“Regs.”) §1.150-1(d) as an issue the proceeds of which are used to pay principal of, or interest or redemption price on, another issue generally having the same or related obligor.

2. Reissuance (or a “deemed refunding”) occurs when changes made to the terms of an existing municipal obligation are so significant as to amount virtually to the issuance of a new obligation under federal tax principles with the modified issue treated as refunding the original obligation.1

Cf. Obligations that do not refund another obligation are commonly referred to as “new money” obligations.

II. Refundings

A. What happens in a refunding?

1. A refunding involves the issuance by a state or local governmental entity of new bonds, the proceeds of which are used to pay debt service (principal, interest or call premium) on other bonds. The refunded bonds may be redeemed or retired (fully paid and cancelled) at the time of the refunding or the refunding bond proceeds may be placed in a defeasance escrow to provide for the payment of the refunded bonds. For example, most fixed rate tax-exempt bonds are sold with a no-call period (typically around ten years from the issue date) that provides the issuer with a lower cost of funds but does not permit an issuer to “redeem” the bonds until the end of the no-call period. An issuer, however, may find it financially advantageous to issue refunding bonds prior to the date that the refunded

1 Under rules covered further below, a reissuance would not be treated as a “refunding” if certain limited exceptions to the “refunding” definition were to apply (e.g., the “6-month” acquisition rule discussed below). For most purposes, however, it is useful to think of reissuances as a “subset” of refunding transactions.


bonds are callable and invest the proceeds of the refunding bonds in escrow until the call date of the refunded bonds.

2. Proceeds of the refunding bonds placed into a defeasance escrow for the refunded bonds are invested, and the escrowed amounts, plus earnings thereon, are used to pay debt service through the call or retirement date of the refunded bonds. Generally when the escrow is established, the refunded bonds have been defeased, and bondholders will look to the funds and investments held in the escrow account instead of to the issuer and the original security payment. Some refundings (e.g., a crossover refunding described in IV.C below) do not defease the refunded bonds. .

3. Defeasance:

i. Note the distinction between a discharge of the lien of the bond documents2 (upon defeasance) versus a discharge of the bonds (tax lingo for “payment” of the bonds). For tax purposes, a defeased bond continues to be outstanding and subject to tax requirements (e.g., rebate must be calculated and paid with respect to the refunded bonds) until they are fully and finally paid and redeemed.

ii. Legal Defeasance. A Legal Defeasance involves a formal release by the bondholder or trustee of the lien of the bond documents (remember that the lien benefits the bondholder) on the pledged assets or revenues in exchange for the pledge of cash or securities (i.e., the defeasance escrow) sufficient to repay the bond. The moneys that are used to fund the defeasance escrow do not need to be refunding bond proceeds. A Legal Defeasance is accomplished only through the procedures provided in the bond documents governing the bonds to be defeased and in the absence of a defeasance provision, a bond cannot be legally defeased.

iii. Economic Defeasance. If the refunded bonds cannot be legally defeased or if the defeasance provisions have not been fully complied with, the refunded bonds may be defeased on an economic basis if sufficient securities or cash are deposited in an escrow account to retire the bonds. That kind of economic defeasance does not, however, provide for the release of the security, which means the bondholders will still have a lien on the assets or revenues securing the bonds.

iv. For a defeasance, the issuer may need to hire bond counsel to render an opinion to assure that the refunding bonds or the refunded bonds, or both, comply with all applicable tax rules and continue to be tax-exempt bonds.

v. Escrow cash flow must be verified (usually by a certified public accountant) as to mathematical accuracy and sufficiency to defease

2 A lien may be created by resolution, ordinance, indenture or other document.


the refunded bonds. The opinion of bond counsel in connection with the defeasance would be based on this verification. An example of an economic defeasance that does not qualify as a Legal Defeasance is where the bond documents require a defeasance escrow to be invested only in U.S. Treasury Obligations, but the issuer, instead, invests in corporate securities (e.g., bank certificates of deposit).

vi. The type of escrow investment that must be acquired to fund the defeasance escrow depends on the defeasance requirements of the bond documents. Typically, bond documents will require the investment in direct U.S. government obligations or guaranties, Treasury STRIPS, SLGS (State and Local Government Series) or U.S. Governmental Obligations (Treasuries). If the period during which the escrow is maintained is short, the bond documents may permit the defeasance moneys to be kept uninvested.

B. Why Engage in a Refunding?

1. To achieve debt service or interest cost savings when rates drop. In a high-to-low refunding, the issuer exercises an in-the-money call right on a callable prior issue (“prior issue” is defined in III.A below) before the issue’s stated maturity date. The higher the coupon on the prior issue as compared to the current market yields, the greater the interest savings.Many issuers have established prerequisites of absolute dollar amounts of interest rate savings, a required percentage level of savings (expressed as a percentage of refunded or refunding bonds), or both, to undertake a refunding.

2. To restructure cash flow to obtain benefits. During recessionary periods, many issuers undertake refundings to defer existing debt service, particularly within the current or immediately succeeding fiscal year, which has the effect of freeing up existing cash flow for other purposes.

3. To eliminate restrictive covenants in bond documents. This type of refunding generally is limited to revenue bonds because general obligation bonds usually have few, if any, meaningful covenants imposed upon an issuer other than the obligation to pay the bonds. The bonds to be refunded tend to be older bonds or bonds issued under older parity bond documents, because the bond covenants sought to be removed reflect outdated covenant structures that do not reflect modern financial practices.For example, if outstanding debt of an issuer is secured by a first lien on certain assets or revenue source, but the issuer wishes to issue additional debt secured by those same assets or revenues, this can be achieved by simultaneously issuing the additional debt and a refunding that defeases the outstanding debt.

4. To roll over short-term debt at its maturity. For various market and state-law reasons, an issuer may choose to issue debt (e.g., one-year notes) that


has a term which is shorter than the period over which the issuer decides to finance the expenditures in question. The concept of a refunding includes subsequent obligations which are issued to pay off the prior debt at its maturity (and thereby extend the period of financing).

III. Types of Refunding.

A. Net Defeasance.

1. The net cash refunding defeasance is the most common type of refunding. The proceeds of refunding bonds are placed into an escrow and invested at a yield not in excess of the yield on the refunding bonds. The proceeds of the refunding bonds, plus earnings thereon, are sufficient to pay the principal of and interest and call premium on the outstanding prior issue when due and payable. Issuance plus administrative costs must be paid from refunding bond proceeds, from this escrow cash flow or from separate funds of the issuer or borrower.

2. The issuer pays interest on and principal of the refunding bonds from a source other than the escrow (e.g., revenues or other security source previously used to pay debt service on the prior issue).

3. Government obligations (usually Treasuries) are bought in the open market (if they can be purchased at fair market value at or below bond yield) or SLGS, if available.

B. Full Cash Defeasance.

1. A full cash defeasance may also be referred to as a gross defeasance or gross refunding. A full cash defeasance typically is undertaken only if a defeasance of the refunded bonds is necessary and the prior bond documents or local law require an initial deposit to the escrow of the full amount of the principal of and interest and call premium on the prior bonds, disregarding any interest that may be earned on the refunding escrow.

2. Full cash defeasances are not used frequently anymore because complex investment and issuance rules limit the benefits of such a transaction. A full cash defeasance in connection with an advance refunding under post-November 1992 documents may require a ruling from the Internal Revenue Service if Reg. §1.148-10(c)(5) is to apply. Prior to the existence of Reg. §1.148-10, all gross refundings required rulings from the Internal Revenue Service. See Reg. §1.103-15(c).

3. Full cash defeasances have also been used in recent years in connection with short-term escrows for current refundings in order to avoid the high cost of acquiring verification reports or purchasing escrow securities relative to the prevailing low rates at which escrow funds may be invested.


C. Crossover Refunding.

1. In a crossover refunding, the proceeds of the refunding bonds are placed into an escrow and invested at a restricted yield.

2. Interest on the governmental obligations in the escrow is used to pay interest, but not principal, on this same refunding bond issue until the redemption or retirement date of the refunded bonds, and the revenues of the issuer continue to pay the debt service on the refunded bonds until the redemption date, at which point in time the principal of and interest on the escrow securities crossover to pay the principal of the outstanding refunded bonds to retirement or call. In this way, the refunding bond issue pays for itself through the period to the redemption date of the refunded bonds, after which time the debt service on the refunding bonds is paid out of the revenue stream that would have been used to pay the debt service on the refunded bonds. As a result, until the redemption date of the refunded bonds, the interest on the prior issue continues to be a liability of the issuer and the prior bonds are not defeased and removed from the issuer’s balance sheet. This is why the crossover structure is occasionally used:the issuer or borrower will have greater flexibility to invest the escrow in non-defeasance securities (i.e., in securities other than the typical direct Treasury obligations required for defeasance). As a result, the issuer or borrower may be able to earn a higher escrow yield in a crossover refunding, which may be an attractive alternative, especially at a time when a “traditional” advance refunding escrow investments would generate substantial negative arbitrage.

3. This method defers the realization of savings until after the crossover date.No defeasance is achieved. Also keep in mind the first call date rule (Code §1.149(d)(3)(A)) and the hedge bond rules (Code §149(g); Regs. §1.149(g)-1(c)).

IV. Tax Definition of Refunding

A. Definition of Refunding. Regs. §1.150-1(d) sets forth the definition of a refunding for all purposes of Sections 103 and 141 through 150 of the Internal Revenue Code of 1986, as amended (the “Code”). A refunding issue is generally defined in Regs. §1.150-1(d) as an issue the proceeds of which are used to pay principal of or interest or redemption price on another issue (the “prior issue”) having the same or related obligor. A “prior issue” may be issued before, at the same time as, or after a refunding issue. The prior issue may be a taxable or a tax-exempt issue.

B. Uses of Refunding Bond Proceeds. Refunding bond proceeds can be used to pay issuance costs, accrued interest, capitalized interest on the refunding issue, and to fund a reserve fund if properly allocable to the refunding issue.


C. Exceptions to General Definition of Refunding.

1. Certain Payments of Interest. The bond issue will not be a refunding bond issue if the only debt service paid with proceeds of the bond issue (determined without regard to multipurpose rules of Regs. §1.148-9(h)) is:

i. payment of interest that accrues on another bond issue within a year of the issuance of the source bonds;

ii. payment of capitalized interest alone; or

iii. payment of interest that falls within one of seven de minimisexceptions under the working capital expenditure rules set forth in Regs. §1.148-6(d)(3)(ii)(A).

2. Different Obligors. If the obligor on the new bond issue is unrelated to the obligor on the refunded bond issue, then the new issue is not a refunding, but is treated as an acquisition with “new money” obligations of the property that was financed with the original obligations. Example: County issues bonds to refinance prior obligations that were issued by unrelated City to finance a sewage plant. Result: Not a refunding. The transaction is treated as an acquisition by County of the sewage plant with “new money” bonds of County.

i. Definition of “obligor.” In non-conduit financings, the “obligor” is the issuer of the bonds. In conduit financings, the “obligor” generally is the conduit borrower (sometimes called the “true obligor”) under the purpose investment (conduit loan), except in certain financings of program obligations such as student loan and qualified mortgage loan financings. Example: County issues conduit bonds and lends the proceeds to 501(c)(3) Hospital; Hospital later refinances the original bonds with obligations issued by City. Result: Transaction is a refunding because Hospital (the conduit borrower with respect to both issues of obligations) is viewed as the “obligor” under both issues.

ii. Related parties; controlled group. As noted above, a bond issue will be treated as a refunding only if it pays certain debt service on the prior obligation of the same or a related obligor. The obligors of different bond issues will be regarded as “related” if (i) they are part of the same controlled group in the case of governmental or qualified 501(c)(3) bonds or (ii) in the case of other private activity bonds, they are parties described in Code §144(a)(3) (basically, a greater than 50% common ownership situation).

Generally, a “controlled group” means a group of entities under common management. See Regs. §1.150-1(e). For purposes of this definition, control focuses on the possession of rights or powers over the appointment and removal of members of the governing body of an entity or its financial decisions.


Proposed Regs. address the situation in which the parties become related in the course of an acquisition, an issue raised primarily by mergers and acquisitions of hospital systems (where the objective is generally to avoid refunding treatment, because of the restriction on more than one advance refunding or arbitrage restrictions). SeeProp. Regs. §1.150-1(d)(2)(ii), 67 FR 17309 et seq. (April 10, 2002) (adding new rules re “affiliated” persons).

3. Conduit Refundings. In some pooled bond transactions, the proceeds of the bond issue (Issue A) are loaned to several conduit borrowers. If a conduit borrower uses proceeds of another issue to repay the loan (Issue B), Issue B is treated as (i) a refunding of the loan and (ii) a refunding of Issue A if the original issuer reasonably expects to use the repayment amounts of the loan to pay debt service on the original bonds and not to recycle the repayment amounts (make a new conduit loan).

4. Certain Acquisitions. Certain transactions involving both the repayment of a prior bond issue and a transfer of interests in the assets securing such issue will be treated as a sale of the assets rather than as a refunding for federal tax purposes, although not necessarily for state law purposes.

The “6-month rule.” In general, if within six months before or after a person assumes (in connection with an asset acquisition) an existing obligation of an unrelated party the assumed loan is refinanced, the refinancing will not be considered a refunding. Regs. § 1.150-1(d)(2)(v). Example: If a housing project is sold to a new, unrelated owner and the new owner assumes the bond obligations, the parties will generally avoid making changes to the bond documents (that could constitute a “deemed refunding” under the reissuance rules) within six months of the transfer of ownership of the project, so as to avoid having the transaction treated as an acquisition of the project with “new money” bonds.

D. Consequences of Not Being a Refunding. If an issue does not satisfy the definition of a refunding or fits an exception to that definition (e.g., a transaction treated as an acquisition under the “6-month” rule), it is a “new money” issue for federal tax purposes and must satisfy all the applicable tax requirements to establish its tax-exemption (e.g., requiring private activity bond volume cap, meeting rehabilitation requirements or subjecting the project and proceeds to more stringent requirements than may have applied with respect to the prior bond issue).

E. Two Kinds of Refundings.

1. Current Refunding: A current refunding occurs when refunding bond proceeds are used to retire or call other bonds within 90 days after the date of issuance of the refunding bonds.


2. Advance Refunding: An advance refunding occurs when refunding bond proceeds are used to retire or call other bonds more than 90 days after the date of issuance of the refunding bonds. If any of the bonds of a refunded issue are called or retired more than 90 days after the date of issuance, the entire refunding becomes an advance refunding (see paragraph I below regarding limitations on the issuance of refunding bonds).

F. Transferred Proceeds. Transferred proceeds are unspent proceeds of a refunded issue that get reallocated to the refunding issue as the refunding bond proceeds pay principal on the refunded bonds. Transferred proceeds can include unspent original bond proceeds included in project funds as well as moneys in the debt service fund or debt service reserve fund for the refunded bonds. It is important in a refunding to trace the chain of refunding back to the original issue that financed an asset. If there are any proceeds remaining unspent in the chain of refundings (e.g., an advance refunding escrow funded with a prior issue of bonds that has not been spent), transferred proceeds will be created. Transferred proceeds can arise in both current and advance refundings. See Regs. §1.148-9(b) for the basic operating rules for transferred proceeds.

Things to watch for: An escrow fund established with the proceeds of the refunded bonds is the most obvious candidate for transferred proceeds. However, be careful about the possibility of cascading transferred proceeds - meaning proceeds that transfer through several generations of refundings. This can occur, for example, if refunded bonds effected a current refunding of a prior generation of refunding bonds, and the prior generation refunding bonds created an escrow for refunding purposes that still exists. That escrow probably transfers all the way up to the refunding bonds and must be taken into account for yield restriction purposes. In that example, the yield on the remaining escrow will have to be restricted to the yield on the refunding bonds as the proceeds transfer (as the refunding bonds pay the refunded bonds). That yield restriction is typically accomplished through the payment of a transferred proceeds penalty calculated at the time the bonds are priced or structured by the underwriter.

G. Rebate. For a discussion of the basic rebate requirement – see the General Tax Outline. Also note that final retirement of refunded bonds triggers a final rebate computation and potential rebate payment for the refunded bonds. In a current refunding, this will occur within 90 days of the refunding bonds closing date. For an advance refunding it will occur when the refunded bonds are finally paid from the escrow established at closing. Generally, rebate will be due within 60 days following the date the refunded bonds are discharged.

H. Basic Rules for Current Refundings.

1. Proceeds must be used to pay debt service on the prior issue within 90 days after the date of issuance of the refunding bonds.

2. Proceeds of the refunding bonds are entitled to a general temporary period of 90 days during which such proceeds may be invested without yield limitation (and are eligible for 6-month rebate exception).


3. As compared to advance refundings, there are relatively few limitations on current refundings. However, as a general rule, most of the requirements for tax-exemption that applied to the refunded bonds will apply to the refunding bonds.

I. Basic Rules for Advance Refundings. (Code §149(d); Regs. §1.148-9).

1. Cannot advance refund bonds other than governmental bonds and qualified 501(c)(3) bonds. This prohibition generally will include all AMT bonds,3 single family and multifamily housing bonds, most bonds for airports and docks and wharves, pollution control revenue bonds and other bonds issued for the benefit of private parties.

2. Can advance refund an original new money bond (or any successor current refunding bonds) issued after 1985, only once.

3. Can advance refund an original new money bond (or any successor current refunding bonds) issued prior to 1986, only twice (although all advance refundings of an original new money issued prior to March 15, 1986, will be treated as only one advance refunding for the two-refunding limit).

4. Does not preclude refunding with taxable bonds or defeasance with other than borrowed moneys.

5. Temporary period (for arbitrage purposes) on refunded bond proceeds ends on date refunding bonds are issued.

6. Temporary period of refunding bond proceeds is 30 days (usually waived).

7. Proceeds of the refunding bonds are subject to yield restriction based on the yield on the refunding issue. See Regs. §1.148-6(b)(1) for general ordering rules. Generally, bond proceeds are allocable to only one issue at a time (and therefore limited to the yield on only one bond issue at a time). While it is possible for bond proceeds to be both replacement proceeds of one issue and sale proceeds of another (e.g., Series 2007 Bond proceeds deposited to an escrow to pay Series 2004 Bonds could be replacement proceeds of the 2004 issue and sale proceeds of the 2007 issue at the same time), these ordering rules will allocate such proceeds to only one bond issue at a time. The general ordering rules provide that when that happens, the proceeds are treated as sale proceeds of the 2007 issue. The escrow is therefore limited to the yield on the Series 2007 Bonds and not the Series 2004 Bonds. The practical effect of the rule is a limit on the profitability of an advance refunding. Present value savings only arises from exercise of an “in-the-money” call.

3 An AMT bond is any tax-exempt private activity bond (as defined in Code §141) but not a qualified 501(c)(3) bond and not certain housing bonds. Interest on an AMT bond is included in determining whether a bondholder owes an alternative minimum tax. See Code §§55, 56 and 57 for more information regarding the calculation of a bondholder’s alternative minimum tax, in particular Code §57(a)(5)(C).


8. The issuer must redeem the refunded bonds if the advance refunding creates present value debt service savings (first call date rule – to limit the amount of doubling up in the tax-exempt market resulting from advance refundings):

i. for refunded bonds issued before 1986, at the first call date at 103% or lower; or

ii. for refunded bonds issued after 1985, at the first call date.

9. “An abusive arbitrage device.” An advance refunding may not be used as a device to obtain material financial advantage apart from debt service savings (certain prohibited devices, e.g., a debt service flip-flop, a construction fund flip-flop, the failure to account for any insurance premium rebate in connection with a refunding, a reduced coupon refunding, a short term taxable/long term tax-exempt refunding structure, and any other abusive devices used by market participants). See Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986 (the “Blue Book”) at 1214-1216.

10. Under Regs. §1.149-9(h) (the multipurpose rules), for purposes of Code §§148 and 149(d), an otherwise single issue may be characterized as several issues. Specific rules are provided for the allocation of bonds to refunding purposes. If a multipurpose issue is to be refunded, the portions allocable to the different purposes must be analyzed separately to determine if they are eligible to be advance refunded.

11. The allocation of bond proceeds and non-bond proceeds (or prior bond proceeds) to investments in a refunding escrow (a mixed escrow) are subject to complex rules. Bond proceeds in a mixed escrow cannot be spent faster than other funds in the escrow. Certain types of funds transferred from the prior issue to the escrow account (debt service funds, construction funds) must be allocated to the earlier expenditures. SeeRegs. §1.148-9(c). Example: Refunded bonds have funds on deposit under the indenture in a bond fund (principal and interest fund) or a debt service reserve fund. Typically, those proceeds of the refunded bonds will be transferred to the escrow account for the refunded bonds at closing of the refunding bonds and, in that case, the special mixed escrow rules will apply to the structuring of the escrow. This is another reason it is important to identify remaining proceeds of a refunded bond issue during the structuring phase of a refunding bond issue.

12. Yield limited to the yield on the refunding bonds plus 0.001% but subject to rebate at bond yield, so spread is usually not used.

13. SLGS. SLGS are frequently used as investments in the escrow account for advance refundings. Not to be confused with tough-skinned mollusks without shells, the term SLGS (not written with a “u,” and properly written with a capitalized and not lower case trailing “S”) is an acronym


for “Treasury Securities – State and Local Government Series.” SLGS are special purpose securities that the Department of the Treasury issues to state and local governments to assist in complying with the arbitrage regulations. The arbitrage regulations prohibit an issuer from artificially lowering the yield of investments (by paying more than the fair market price) (sometimes called “yield burning”) to meet the yield limitations of the regulations. The yield burning prohibition can be problematic if investment rates in the open market for permitted escrow investments are too high. SLGS are a solution to this problem. When an issuer orders SLGS from the Treasury Department’s Bureau of the Fiscal Service,4 the issuer may specify the maximum yield of the SLGS such that the yield on the issuer’s escrow portfolio is within applicable limits. The Department of the Treasury will fill the order and set the SLGS rates accordingly, but SLGS rates will never be set higher than approximately one basis point below the then estimated U.S. Treasury borrowing rate for a security of comparable maturity. The regulations provide that SLGS are always purchased at a fair market price, which means there is no yield burning concern when SLGS are acquired.

14. rities of the CUSIP held by each Participant. ding (i.e., bond proceeds or other moneys) of reasonably required reserve funds of refunding issues, particularly in the context of a parity reserve fund. Refunding issue cannot exceed amount required by more than 1% of issue (“excess gross proceeds”).

V. Alternatives to Advance Refundings.

A. d Bond Sale. A forward bond sale is a transaction in which an underwriter or bank agrees today to purchase fixed rate current refunding bonds on the call date and the parties agree today on all of the terms of the bonds to be issued on such call date. This structure presents questions regarding the yield and issue price of the bonds.

B. Forward Swap. Another derivative product is the forward interest rate swap in which the issuer currently contracts for an interest rate swap, from a floating rate to fixed rate, which does not take effect until the call date of the bonds to be refunded. On the call date, the issuer issues a floating rate current refunding issue and, simultaneously, the interest rate swap becomes effective, thereby converting the floating rate bonds to a fixed rate issue. The issuer has, effectively, locked in the fixed interest rate by negotiating and contracting for the swap in advance.

C. Swaption. In exchange for the issuer's receipt of an up-front payment, the issuer grants a counterparty the right (but not the obligation) to enter into a floating-to-fixed-rate swap on the call date. If the swaption is exercised, the issuer issues a floating rate current refunding on the call date, receives a floating rate under the

4 The Bureau of Public Debt historically administered SLGS investments. That responsibility was recently transferred to the new Bureau of the Fiscal Service within the Department of the Treasury. For more information regarding the Bureau of the Fiscal Service and SLGS, visit http://www.treasurydirect.gov/govt/resources/faq/faq_slgs.htm.


swap, and pays the fixed rate under the swap. If the swaption is not exercised, the issuer keeps the premium and may refund the bonds at a later date. One difference between the swaption and a forward swap is that the interest-rate savings under a swaption are reflected in the up-front premium payment received by the issuer, while in the case of a forward swap the savings are represented in the lower locked-in future fixed rate on the swap.

D. Option. The issuer executes a call option. In exchange for an up-front payment, the issuer grants a purchaser the option to buy fixed rate bonds from the issuer on or after the call date of the bonds to be refunded. The new bonds, when and if issued, will be used to currently refund the prior issue. The amount of the up-front payment is a function of the interest rate fixed for the new issue of bonds and the length of the options.

E. Call Waivers. In a typical advance refunding, the issuer may capitalize the interest savings by selling additional bonds in the window created by the lower debt service on the refunding bonds. A similar economic result can be obtained by receiving an up-front payment from the existing bondholders in exchange for a waiver of the call feature. The bondholder should be willing to pay an amount equal to the difference between the current price of the bond priced to the call date and the current price of the bond priced to maturity. Under Regs. §1.1001-3, the call waiver may be considered a reissuance of the bonds.

F. Convertible or “Cinderella” Bonds. This structure involves issuing new bonds which are taxable until the call date of the bonds to be refunded (or to some date within 90 days of the call date), when the new bonds become tax-exempt (or are converted or reissued as tax-exempt). State law may treat this as a continuation of the taxable bond. Federal tax law treats the taxable issue as being refunded by a new tax-exempt issue. Bond counsel needs to be sure that the rate applicable to the bonds after they convert to tax-exempt is not above the market rate (as of the original date of issuance) of comparable tax-exempt bonds. Separate issue questions may need to be considered to determine what is the issue date of the converted tax-exempt bonds.

G. Tenders for Prior Bonds. As an alternative to causing the defeasance of bonds that are not subject to call, the issuer may be able to request the voluntary tender of bonds by bondholders. This process may be time consuming and may require negotiation with bondholders. If the bonds are registered in the name of a securities depository, such as Cede & Co., as nominee for DTC, the issuer may need to engage a tender agent to identify the beneficial bondholders before tender offers can be made. Tender offers usually also involve the preparation of non-tax disclosure documents and tender agreements and the payment of incentives.

VI. Reissuance (“Deemed” Refundings)

A. Introduction.

1. Recognition of Gain or Loss. In general, for all purposes, not limited to tax-exempt bonds, Code §1001 and the Treasury Regulations promulgated


thereunder provide that gain or loss on the sale of property or on the exchange of property for other property differing materially either in kind or extent must be recognized. When changes are made to a debt obligation that are so material as to amount virtually to the issuance of a new obligation, an exchange is deemed to occur. Whenever an exchange is deemed to occur under Code §1001 with respect to a tax-exempt bond, a reissuance is deemed to have occurred and a new bond is considered to have been issued for purposes of Code §103.

2. Simultaneous Exchange. A reissuance is treated as a retirement of the existing bond and the simultaneous issuance of a new bond, the proceeds of which are used immediately to retire the existing bond. The reissued bond therefore generally is considered to be a current refunding issue for purposes of federal tax law, although under circumstances described in Regs. §1.150-1(d)(2)(ii) and (v), relating to certain issues with different obligors and asset acquisitions, the reissued bond may not be considered a refunding issue.

3. Why we care. (Sometimes we don’t.) The occurrence of a reissuance may have one or more of the following federal tax consequences:

i. Because a reissuance is, by definition, a taxable exchange under Code §1001, bondholders may need to recognize taxable gain or loss.

ii. Upon the deemed discharge of the original bonds, arbitrage rebate on the bonds must be determined and paid to the United States under Code §148(f), generally within 60 days. (Absent the reissuance, it is possible that future negative arbitrage would have offset any rebatable arbitrage accrued as of the date of the reissuance.)

iii. A new “TEFRA” hearing and public approval may be required with respect to the bonds under Code §147(f) (if the average maturity of the bonds is extended). (A new allocation of volume cap is not usually required. See Code §146(i).)

iv. Certain more favorable, “grandfathered” treatment under prior law may be lost, particularly in the case of bonds issued prior to enactment of the Tax Reform Act of 1986 (e.g., as regards the minimum tax and “bank-qualified” treatment of bonds under Code §§57 and 265(b)(3))

v. A new 8038 (or 8038G) form must be filed with the IRS for the “reissued” bonds under Code §149(e).

vi. The issue price and yield of the deemed new issue must be determined.


vii. Qualified hedges are deemed terminated in a refunding or reissuance, although proposed Regulations released on September 16, 2013 (REG 148659-07) allow for the continuation of a qualified hedge from the refunded bonds to the refunding bonds.

4. Applicable Rules. In general, the determination as to whether particular modifications to the terms of an obligation constitute a “reissuance” (and thus, in most cases, a refunding) will be made under the rules set forth in Regs. § 1.1001-3 (the “Regulations”), discussed in the following section.However, certain variable rate “tender bonds,” which employ structures commonly used for tax-exempt floating-rate obligations, may be instead governed, at least in part, by the rules set forth either in IRS Notices 88-130 or 2008-41 (as amended by Notice 2008-88), as discussed further below.

B. Reissuance Regulations.

1. General Rule. The general rule of Reg. §1.1001-3 is that a modification to the terms of a debt instrument will result in a deemed exchange of the original instrument for a new instrument if the modification is significant. Thus, the Regulations provide for a two-step analysis: first, whether a modification has occurred; and second, whether the modification is significant. The Regulations also provide several special rules applicable only to tax-exempt obligations.

2. Definition of Modification.

i. Subject to one main exception for certain alterations (or changes) which occur by operation of the terms of a debt instrument, Regs. §1.1001-3(c)(1)(i) generally defines modification broadly as any change or alteration in a legal right or obligation (including the addition or deletion of a right or obligation) of the issuer or holder of a debt instrument.

ii. A modification may be evidenced by amendment of the instrument, conduct of the parties or otherwise, and may be effected directly between a holder and issuer or indirectly through one or more transactions with third parties. A modification occurs at the time the parties agree upon the modification, not when the modification goes into effect.

iii. In general, the Regulations apply broadly to debt modifications, regardless of form. The Regulations focus mainly on issuer-holder transactions involving negotiations between issuers and holders to modify the terms of a debt instrument. Regs. §1.1001-3(a)(1) provides that the Regulations apply to a debt modification that an issuer and holder accomplish indirectly through one or more transactions with third parties, but that the Regulations are


inapplicable to exchanges of debt instruments between holders, or holder-holder transactions.

3. Exceptions to Definition of Modification.

i. An alteration that occurs by operation of the original terms of the debt instrument, either automatically or by the unilateral exercise of an option by the issuer or holder, is not a modification.

ii. An alteration is automatic if it occurs on the happening of an event not within the control of the parties, such as resetting the interest rate on variable rate bonds to match the current market rate.

iii. The exercise of a right is unilateral only if:

a. it does not create a right in the other party to alter or terminate the debt instrument or to put the debt instrument to a person who is related to the issuer (exception provided for tender option bond as set forth in Notice 88-130),

b. it does not require the consent of the other party or a person related to the other party, or the consent of a court or arbitrator, and

c. it does not require consideration, unless the amount thereof is de minimis, is fixed on the issue date, or is based on a formula that uses objective financial information.

iv. An obligor’s failure to perform its obligations under a debt instrument is not itself a modification.

v. Absent a written or oral agreement to alter any other terms of a debt instrument, a holder’s agreement to stay collection or to waive enforcing an acceleration or similar default right is not a modification, provided that the period of such forbearance does not exceed two years, plus such additional period during which the parties are conducting good faith negotiations or during which the issuer is involved in bankruptcy proceedings.

4. Changes That Are Always Modifications.

i. Regs. §1.1001-3(c)(2) provides that a change that results in the substitution of a new obligor on a recourse obligation, the addition or deletion of a co-obligor resulting in a change in payment expectation, or a change in the recourse or nonrecourse nature of an instrument is always a modification, even if it occurs by operation of the original terms of the debt instrument.

ii. A change that results in a debt instrument or property right that is not debt for federal income tax purposes is always a modification.


iii. The exercise of an option to reduce the amount, or to defer the payment, of scheduled principal or interest is always a modification, even if the exercise would be considered unilateral under the rules described above.

5. Definition of Significant Modification.

i. To the extent not covered by a specific rule described below, a modification is significant if, based on all the facts and circumstances, the legal rights and obligations being altered and the degree to which they are being altered are economically significant. All such modifications not subject to a specific rule are considered collectively in making this determination.

ii. The following special rules apply for determining whether certain modifications are treated as significant under the Regulations:

a. Change in Yield. Regs. §1.1001-3(e)(2) provides that a change in the yield on the debt instrument is significant if the change exceeds the greater of (A) 25 basis points, or (B) 5 percent of the annual yield of the unmodified debt instrument. In the case of a variable rate instrument, this test is applied by treating the yield on the instrument as being the yield on an equivalent fixed rate debt instrument.

b. Deferral of Payments. Regs. §1.1001-3(e)(3)(i) provides that a change in the timing and/or amounts of payments is significant if the change results in a material deferral of payments due under the debt instrument, taking into account all of the facts and circumstances. The Regulations further provide that a deferral of payments will not be treated as significant if it does not exceed a safe-harborperiod beginning on the original due date of the first scheduled payment that is deferred and extends for the shorter of (A) 5 years, or (B) 50 percent of the original term of the instrument.

c. Change in Obligor. Regs. §1.1001-3(e)(4) provides that a change in the obligor of a nonrecourse debt instrument is not significant. (As noted below, however, most tax-exempt bonds are characterized as “recourse” obligations under these rules.)

A change in obligor on a recourse obligation is significant, except (A) such a change resulting from a transaction to which Code §381(a) applies (i.e., an acquisition of substantially all of the assets of the old obligor) if the new obligor is the acquiring corporation, or (B) in the case of tax-exempt bonds, the new obligor is related to the original


obligor and the collateral continues to include the original collateral.

The addition or deletion of a co-obligor is significant if it results in a change in payment expectations (i.e., results in either a substantial enhancement or a substantial impairment of the obligors’ capacity to meet the payment obligations under the debt instrument). See Notice 2008-41.

In the case of a tax-exempt bond, the term “obligor” refers only to the actual issuer of the bonds and not to any conduit borrower. (Note that this definition of “obligor” differs from that used in the definition of a “refunding” under Regs. §1.150-1(d), discussed above, which treats the conduit borrower, rather than the governmental issuer, as the “obligor” of a conduit bond.) Example: City issues manufacturing IRBs to finance a factory owned by Company A. Company A later sells the factory to unrelated Company B, which agrees to assume A’s obligation to pay the outstanding bonds. Result: Since the “obligor” here is only the actual issuer – the City – the substitution of Company B for Company A as conduit borrower does not result in a “change in obligor.” There is no reissuance. However, see “Change in Security” below.

d. Change in Security. Regs. §1.1001-3(e)(4) provides that a modification that releases, substitutes, adds, or otherwise alters a substantial amount of the collateral for, a guarantee on, or other form of credit enhancement for a nonrecourse obligation is significant. Such modification with respect to a recourse obligation is significant only if it results in a “change in payment expectations.” (As noted below, most tax-exempt bonds are characterized as “recourse.”) A substitution of collateral is not significant if the collateral is fungible or if it involves the substitution of a similar commercially available credit enhancement contract. Under Notice 2008-41, a change in collateral or security will trigger a reissuance for either a recourse or a non-recourse debt only if it results in a change in payment expectation.

If a change in security is not significant, there is no need to examine the change in security’s effect on bond yield under the yield tests. Notice 2008-41, §3.1 and §7, Example (1).

e. Change in priority. Regs. §1.1001-3(e)(4)(v) provides that a change in the priority of a debt instrument relative to other debt of the issuer is significant if it results in a change


in payment expectations. Thus, it is possible to change a debt instrument from senior to subordinated, or vice versa, without triggering a reissuance.

f. Change in Recourse Nature of Debt Instrument. Regs. §1.1001-3(e)(5)(ii) provides that a change in the nature of a debt instrument from recourse to nonrecourse, or vice versa, is significant, with the following two exceptions: (A) a defeasance of a “tax-exempt bond” by operation of the terms of the original bond; and (B) a change from recourse to nonrecourse where the instrument continues to be secured only by the original collateral (disregarding substitutions of fungible collateral) and there is no change in payment expectations.

Note the following three considerations in connection with the exception described in (A) above:

I. A tax-exempt bond is treated as recourse debt unless (x) it finances a conduit loan and both the bond and the conduit loan are nonrecourse debt instruments, or (y) it has been defeased with government securities. As a result, tax-exempt bonds will almost always be treated as “recourse” obligations under these rules.

II. In FSA 200035020 (Field Service Advice), the Internal Revenue Service concluded that the defeasance of tax-exempt bonds with amounts realized from the sale of property at an inflated price did result in a change in payment expectations was a reissuance.

III. In AM 2014-009 (Advice Memorandum), the Internal Revenue Service determined that build America bonds are not “tax-exempt bonds” for purposes of the exception in (A). The defeasance of build America bonds may, therefore, lead to a reissuance of the bonds.

g. Changes in Debt Status. A modification that results in a property right that is not debt (e.g., equity) for federal income tax purposes is significant.

h. Changes in Financial Covenants. Regs. §1.1001-3(e)(6) provides that a modification that adds, deletes, or alters customary accounting or financial covenants is not significant.


6. General Rules.

i. Regs. §1.1001-3(f) provides certain rules of application for testing the significance of modifications. A modification generally is tested as to whether it is significant at the time the parties agree to it, even if it is not immediately effective. However, where a modification is subject to certain closing conditions requiring the approval of a third party, the modification is not taken into account until such approval has been obtained.

ii. Multiple modifications to different terms of a debt instrument (as contrasted with a series of modifications of the same term of a debt instrument over time), none of which individually would constitute a significant modification, do not collectively constitute a significant modification.

iii. Multiple changes of the same kind over any period of time must be aggregated to test their significance and will constitute a significant modification if, had they been done as a single modification, the changes would have constituted a significant modification. A special exception exists for purposes of testing whether a particular modification causes a significant change in yield, by allowing an issuer to disregard any prior yield change that occurred more than five years before the modification being tested.

VII. Notices 88-130, 2008-27, 2008-41, and 2008-88 – Special Reissuance Rules for Certain Tender Bonds

A. Background. Pending the eventual issuance of regulations, Treasury and the IRS have issued several notices providing interim guidance for determining when bonds subject to a tender right, such as Variable Rate Demand Bonds (VRDBs) and certain Auction Rate Securities (ARSs), will be deemed reissued for federal tax purposes.

1. Notice 88-130, 1988-2 C.B. 543, provides generally that obligations satisfying the definition of “qualified tender bonds” set forth in the Notice will not be treated as reissued merely because of the existence or application of tender rights, because of a change between interest-rate modes provided for under the applicable bond documents, or upon the occurrence of certain other changes implemented pursuant to the terms of the initial bond documents.

i. Notice 88-130 pre-dated the §1.1001-3 Regulations, which were issued in 1996 (following the publication of Proposed Regulations in 1992). The principal drafter of Notice 88-130 provided a useful explanation of the Notice’s background and operation in Margaret C. Henry, Reissuance Revisited, 42 TAX NOTES at 100-105 (January 2, 1989).


ii. Notice 88-130 provided comfort with respect to two particular areas of uncertainty: (i) that the typical tender and (temporary) repurchase feature of tender bonds would not result in a reissuance and (ii) that changes to the terms of bonds occurring “automatically” under the original bond terms (e.g., upon a conversion from one interest rate mode to another) were not “changes” that would generally result in a reissuance.

iii. When adopted in 1996, the §1.1001-3 Regulations left the Notice 88-130 rules intact and expressly provided that the Regulations “[do] not apply for purposes of determining whether tax-exempt bonds that are qualified tender bonds [as defined in Notice 88-130] are reissued for purposes of sections 103 and 141 through 150.” Regs. §1.1001-3(a)(2) (emphasis added). The Explanation of Provisions accompanying the publication of the Regulations noted that “Notice 88-130 . . ., which provides special rules for qualified tender bonds, will continue to apply” to those obligations in lieu of the Regulations. 61 FR 32930 (June 26, 1996). However, most counsel interpret this to mean that certain aspects of Section 1.1001-3 of the Regulations will provide guidance as to whether changes to a tender option bond trigger a reissuance.

iv. Notice 88-130 did not address auction-rate securities. As a result, there was some uncertainty whether auction rate securities were within the definition of “qualified tender bonds” subject to the Notice.

v. A summary of the rules set forth in Notice 88-130 is provided further below in Part VII.C of this outline.

2. Notice 2008-27, 2008-10 I.R.B. 543 (March 10, 2008). On February 19, 2008, Treasury and the IRS released Notice 2008-27 in order to “modif[y] certain special reissuance standards for ‘qualified tender bonds’ under IRS Notice 88-130.” Notice 2008-27 was primarily issued in response to rating agency downgrades of municipal bond insurers and disruptions in the auction-rate bond markets. These developments had increased the need for guidance as to whether auction-rate securities were “qualified tender bonds” and as to the reissuance consequences of various transactions, such as converting from an auction-rate mode to another interest-rate mode, or replacing bond insurance with another form of credit enhancement. Treasury and the IRS used the opportunity of responding to specific market developments to provide additional, more general guidance in the Notice as to the relationship between the “tender bond” rules and the reissuance rules of Regs. §1.1001-3. This Notice is superseded by Notice 2008-41.

3. Notice 2008-41, 2008-15 I.R.B. 742 (April 14, 2008). On March 25, 2008, Treasury and the IRS released Notice 2008-41 to clarify, amend, supplement, and supersede the guidance provided in Notice 2008-27.


While Notice 2008-41 generally followed the approach taken in Notice 2008-27, the later notice addressed certain specific questions that had arisen under Notice 2008-27 and extended the period of certain temporary relief provisions (which under Notice 2008-27 were effective until July 1, 2008) until October 1, 2008.

i. Issuers of tax-exempt bonds may rely on the rules of Notice 2008-41 with respect to any actions taken with respect to such bonds on or after November 1, 2007. Alternatively, issuers may continue to rely on the rules of Notice 88-130. [Notice §8] (In most instances, however, the 2008-41 rules are more favorable, assuming the goal is to avoid a reissuance.)

ii. Notice 2008-41 states that it applies “solely for purposes of §103 and §§141 through 150 of the Code.” (A similar caveat was contained in Notices 88-130 and 2008-27).

4. Notice 2008-88, 2008-42, 42 I.R.B. 933 (October 1, 2008). Notice 2008-88 generally extended until December 31, 2009 certain temporary provisions of Notice 2008-41, which, under Notice 2008-41, would have expired on October 1, 2008. In addition, the later Notice expands the coverage of Notice 2008-41 to expressly cover issues of tax-exempt commercial paper. Notice 2008-88 is retroactively effective as of March 25, 2008 (the effective date of Notice 2008-41). Except as amended by Notice 2008-88, Notice 2008-41 remains in effect.

B. Notice 2008-41 – Summary of Provisions (as amended by Notice 2008-88)

1. Definitions [Notice §3.2 ]

i. A Qualified Tender Bond is a tax-exempt bond that has all the following features:

a. Interest rate mechanism. During the term of each interest-rate mode authorized under the bond documents, the bond bears interest at either a fixed interest rate or at a variable rate that constitutes either a “qualified floating rate” on a variable rate debt instrument for tax-exempt bonds under Regs. §1.1275-5(b) or an “eligible objective rate” under Regs. §1.1275-5(c)(5). Permitted rate-setting mechanisms that qualify as “qualified floating rates” include “mechanisms that reasonably can be expected to measure contemporaneous variations in the cost of newly-borrowed funds,” such as references to the SIFMA and other interest-rate indexes, tender-option based rate-setting mechanisms, or the use of Dutch auction processes. Permitted “eligible objective rates” include certain inflation-indexed rates as well as “qualified inverse floating” rates.


b. Interest payable at least annually. Interest on the bond is unconditionally payable at periodic intervals at least annually.

c. Maximum term. The final maturity date of the bond is not later than the earlier of 40 years after the issuance date of the bond or “the latest date that is reasonably expected as of the issue date . . . to be necessary to carry out the governmental purpose of the bond (with the 120 percent weighted average economic life of financed facilities test under Section 147(b) being treated as a safe harbor for this purpose).”

Cf. Notice 88-130 limited the maximum term of qualified tender bonds to 35 years.

d. Tender Provisions. The bond is subject to an optional tender right or mandatory tender requirement which allows or requires a bondholder to tender the bond for purchase in one or more prescribed circumstances under the terms of the bond.

ii. A Qualified Interest Rate Mode Change is a change in the interest-rate mode on a bond that is authorized under the original terms of the bond.

In order for a mode change to be “qualified,” the terms of the bond must also require that the bond be resold at par upon a conversion to a new interest-rate mode (unless the conversion is to an interest rate that is fixed to maturity).

iii. A Qualified Tender Right is either an option or a requirement on the part of a bondholder to tender a bond for purchase at par (and any accrued interest) either at specified times (e.g., an ongoing tender option in connection with the rate-setting process) or as a mandatory requirement upon the occurrence of certain events (e.g.,a conversion from one interest-rate mode to another) on one or more tender dates prior to maturity, which tender option or requirement is set forth in the original terms of the bond.

Where bonds are acquired by the issuer or its agent, the terms of a “qualified tender right” must require the issuer or its agent to use at least best efforts to remarket the bond upon a purchase pursuant to the tender right.

2. General Rules [Notice §3.1, §3.2(3b)(b)]

i. Neither a “qualified interest rate mode change” nor a “qualified tender right” (or the exercise of such a right) will be


treated as a “modification” under Regs. §1.1001-3. (Recall that in order for a reissuance to occur under the §1001 Regulations, there must generally be a “modification” that is “significant.”)

Because the interest-rate variance directly related to (and resulting from) a “qualified interest rate mode change” is not a “modification,” that variance need not be tested under the (25 basis point) change-in-interest-rate rules of Regs. §1.1001-3(e)(2).

ii. Bonds purchased by or on behalf of a governmental issuer pursuant to a qualified tender right are not treated as retired if remarketed within 90 days. [Notice §3.2(3)(b), as modified by §3.2 of Notice 2008-88, as modified by Section 3 of Notice 2010-7] (Under general tax principles, debt is usually treated as extinguished when acquired by its issuer.)

The requirement to remarket within 90 days only applies to purchases by governmental issuers or their agents. Bonds purchased by third-party guarantors, third-party liquidity providers, or by nongovernmental conduit borrowers may be held by such parties for an unlimited holding period without triggering a retirement of the bonds when purchased pursuant to the exercise of a qualified tender right. [Notice §3.2(3)(b), last paragraph]

iii. Go read the §1001 Regulations for everything else. In circumstances not specifically addressed by Notice 2008-41 (as amended), the determination of whether tax-exempt bonds are reissued as a result of any modification to the bonds is to be made based on whether the modification in question is a “significant modification” under the rules of Regs. §1.1001-3.

It was not clear under Notice 88-130 whether, and when, qualified tender bonds were also subject to the provisions of the Regulations. In addition, there was concern that Notice 88-130 imposed a “hair-trigger” test for reissuances that could be met by minor modifications that would not be “significant” under the Regulations. Notice 2008-41 (as amended) expressly makes the Regulations the “default” rules for situations not covered by the Notice and makes clear that qualified tender bonds are not intended to be subject to “hair-trigger” reissuance standards that are more stringent than those generally set forth for other obligations in the Regulations.

3. Special Rules. Notice 2008-41 (as amended) also set forth several special rules which addressed particular questions arising under recent market disruptions.

i. Modifications of Security or Credit Enhancement. [Notice §6.1]Modifications to the security or credit enhancement on a tax-


exempt bond are “significant” under Regs. §1.1001-3(e)(4)(iv)(B) only if the modifications result in a “change in payment expectations” under §1.1001-3(e)(4)(vi), whether the bonds are recourse or non-recourse obligations. A reissuance will result under this standard only if the obligor’s capacity to meet its payment obligations go from “primarily speculative” to “adequate” or vice versa.

ii. Modifications of Qualified Hedges. [Notice §5.1] A modification of a swap or other qualified hedge will not result in a termination of the hedge if the modification is not reasonably expected to change the yield on the related bonds over their remaining term by more than 0.25% or 25 basis points and the yield on the bonds is adjusted to reflect the modifications to the hedge.

iii. “Program Investment” Restrictions. [Notice §5.2] Where bonds have been issued to finance “program investments,” a conduit borrower’s purchase of an auction-rate bond in order to facilitate liquidity under adverse market conditions will not be regarded as violating the provisions of Regs. §1.148-1(b), which restrict the ability of a conduit borrower to purchase bonds in an amount “related” to the amount of the conduit borrower’s purpose investment that was financed by the program in question.

C. Notice 88-130. As was noted above, the reissuance rules of Notice 2008-41 for qualified tender bonds largely replace the rules that were set forth in Notice 88-130 and are generally more favorable (assuming the goal is to avoid the occurrence of a reissuance). However, when a reissuance is the desired outcome, it may be easier to achieve under Notice 88-130 instead of Notice 2008-41.Notice 2008-41 makes clear that issuers may still choose to rely on the rules of Notice 88-130. Accordingly, the following summary of those rules is provided:

1. Definitions

i. Subject to a Tender Right. A bond is subject to a tender right if the holder may or must in all events tender the bond for purchase or redemption at par (plus accrued interest) pursuant to the terms of the bond on one or more tender dates before the final stated maturity date.

ii. Tender Bond. A tender bond is any bond that is subject to a tender right if all interest (other than in the event of a remote contingency) accrues at a tender rate and is due at periodic intervals of one year or less.

iii. Tender Rate. Interest on a bond that is subject to a tender right accrues at a tender rate if (i) with respect to interest to the first tender date, the interest rate is set on or after the sale date at the lowest rate necessary to market the bond at par (plus accrued


interest) on the issue date; and (ii) with respect to interest between tender dates, under the terms of the bond the interest rate is reset for each period at the lowest rate necessary to remarket the bond at par (plus accrued interest) at the beginning of the period.Reasonable maximum and/or minimum rates are permissible if they are not designed to front-load or back-load interest.

iv. Qualified Tender Bond. A qualified tender bond is any tender bond with a final stated maturity date no later than the earlier of (i) 35 years after the issue date, and (ii) the latest date reasonably expected (as of the issue date) to be required to carry out the governmental purpose of the issue. Clause (ii) will be deemed to be met if the weighted average maturity of the issue does not exceed 120% of the average reasonably expected useful life of the facilities being financed.

v. Change. A change is any discretionary alteration in the legal rights or remedies of a holder of a bond that occurs after the issue date.An alteration to the terms of a bond is discretionary unless all of the elements of the alteration are entirely outside the control of the issuer, any true obligor (e.g., borrower), any holder, any related person, anyone acting on behalf of any such person or any combination of the foregoing.

a. An alteration in the period between tender dates that occurs at the option of the issuer is a change.

b. Alterations that occur automatically as a result of other discretionary alterations are not changes.

c. The resetting of the interest rate to a tender rate from another tender rate pursuant to the terms of a bond is not a change.

d. The replacement of a credit enhancer with a credit enhancer with a different rating is a change, even if the documents permit such a replacement.

vi. Qualified Tender Change. A qualified tender change is a change in the period between tender dates (including the final period to maturity) that occurs pursuant to the original terms of the bond.

vii. Qualified Corrective Change. A qualified corrective change is any one of the following:

a. A change that does not materially alter the rights or remedies of a holder. Such changes do not include any changes in the final stated maturity date, the interest rate, the payment dates or the security.


b. A change that corrects the terms of the bond to eliminate a result that could not reasonably have been intended on the issue date.

c. A change that is necessary solely by reason of circumstances occurring after the issue date which:

I. could not have been reasonably anticipated on the issue date;

II. are not related to bond market conditions or the creditworthiness of the issue; and

III. are not within the control of the issuer, any true obligor, any holder, any related person, anyone acting on behalf of any such person or any combination of the foregoing.

viii. Qualified Tender Purchase. A qualified tender purchase is any purchase of a qualified tender bond pursuant to a tender right if:

a. such purchase occurs pursuant to the terms of the bond;

b. the terms of the bond require that best efforts be used to remarket the bond; and

c. the bond is remarketed no later than 30 days after the date of purchase.

2. General Rules.

i. A qualified tender bond will be treated as retired (i.e., reissued) only if:

a. in a transaction or series of transactions there is any change to the terms of the bond (other than a qualified corrective change) in connection with a qualified tender change, which qualified tender change increases the period between tender dates from a period not exceeding one year to a period exceeding one year or vice versa (ie, the hair trigger);

b. there is a change in the period between tender dates that is not a qualified tender change;

c. there is a change to the terms of the bond (other than a qualified corrective change) which would cause a disposition of the bond under Code §1001 without regard to the existence or exercise of the tender right;


d. the bond is purchased or otherwise acquired by or on behalf of the issuer or a true obligor which is a governmental unit or an agency or instrumentality thereof; or

e. the bond is otherwise retired or redeemed.

ii. A qualified tender bond will not be treated as retired merely by reason of

a. the existence of the tender right;

b. a qualified tender purchase;

c. a qualified tender change;

d. a qualified corrective change; or

e. any combination of the foregoing.

iii. A bond which is subject to a tender right, but is not a qualified tender bond, is treated as retired on the first day that:

a. there is a change to the terms of the bond that results in a disposition of the bond for purposes of Code §1001;

b. the bond is purchased or otherwise acquired by or on behalf of the issuer or a true obligor which is a governmental unit or an agency or instrumentality thereof; or

c. the bond is otherwise retired or redeemed.

iv. For purposes of 2.ii. and 2.iii. above, a bond will be treated as purchased or otherwise acquired by or on behalf of a person if the bond is purchased or otherwise acquired (other than pursuant to the terms of a third party guarantee) by that person (or by any other person in consideration of any payment provided directly or indirectly by such first person in a manner that liquidates the holder’s investment).

v. Except for bonds originally sold on or before December 14, 1988, a bond that is subject to a tender right but is not a qualified tender bond will be treated as if purchased on each tender date pursuant to the tender right (regardless of whether the tender right is exercised).

vi. Any reissuance which occurs as a result of a change occurs on the date the terms of the bond are altered, even though the effect of that alteration may occur later (e.g., the addition to the terms of a bond of a new tender and interest rate mode results in a reissuance on the date the terms of the bond are amended, even though the issuer does not elect at such time to convert the bonds to that mode).



02. Refundings & Reissuance

Overview

• Refundings/Reissuance in General • Tax Rules Applicable to Refundings• Tax Rules Applicable to Reissuance

Terms and Concepts

“Refunding” =• Proceeds of a new bond issue used to pay debt service on a prior issue of the same (or related)

obligor• Opposite of “New Money” issue

“Reissuance” =• Changes to terms of existing bond issue which are sufficiently significant as to amount, in

substance, to the replacement of the original issue with a “new” issue• Treated for tax purposes as a “deemed” or “constructive” refunding of the original bond issue

Don’t confuse refunding and reissuance with:“Reimbursement” =

• Use of new money bond proceeds to pay issuer back for expenditures made in anticipation of a bond issue


Reasons to Refund• Reduce interest expense if interest rate on new (refunding) bond issue is lower than

interest rate on prior (refunded) bond issue– Savings arise after redemption (call) of prior bond issue

• Obtain cash-flow benefit from restructuring debt service to stretch out principal payments

• Eliminate restrictive covenants– Similar benefits achieved through amendments of bond documents without the

issuance of new debt can result in a “reissuance”• Roll over short-term debt at its maturity

Mechanics of a Refunding3.5% bonds issued to refund bonds bearing interest at 5%:

• Proceeds of refunding issue are either used directly to pay debt service on refunded issue, or are held in escrow pending such use.

• Creation of refunding escrow may defeaserefunded bonds for indenture and state law purposes. For tax purposes, however, refunded bonds remain outstanding until fully paid (discharged).

• As prior issue is discharged, any remaining proceeds of prior issue become “transferred proceeds” of refunding issue for tax purposes

new(refunding)

issue

escrow

3.5%

5%prior(refunded)

issue

3.5%

Types of Refundings

• Net Defeasance– Proceeds of refunding bonds and investment earnings used to pay principal,

interest and call premium on outstanding refunded bonds when due

• Full Cash Defeasance– Proceeds of refunding bonds used to pay principal, interest and call premium on

outstanding refunded bonds when due without regards to investment earnings• Crossover Refunding

– Proceeds of refunding bonds in escrow used to pay interest on refunding bonds and principal of refunded bonds on retirement date of refunded bonds. Interest on refunded bonds paid from other proceeds.


Tax Law Definition of “Refunding”

From Treas. Reg. 1.150-1(d):

(1) Payment of Debt ServiceCertain limited payments of interest on refunded bonds are ignored:– up to one year of interest– capitalized interest– certain de minimis amounts (Treas. Regs. 1.148-6(d)(3)(ii)(A))NOTE: “Prior” issue may be issued before, after or at same time as refunding issue.

Proceeds of “refunding” issue are used:(1) to pay interest, principal, or redemption premium

(2) on “prior” issue of the same or related obligor

Tax Law Definition of “Refunding”Refunding structure

(2) Same (or Related) Obligor: Refunding issue must have same obligor asrefunded issue (or related obligor)

– “obligor” of conduit financing is conduit borrower (not actual issuer)

– in non-conduit financing, “obligor” is actual issuer of bonds

Obligor

Refunding issue

Refunded issue

Tax Implications of Refunding vs. New Money Determination

• New Money issue may need to satisfy volume cap, “TEFRA” hearing, and other tax law requirements that would not apply to a refunding issue

• Refunding issue, if treated as advance refunding, may not be permitted on a tax-exempt basis, or may be subject to less favorable tax treatment – Also, sometimes you want refunding and not new money treatment

Current and Advance Refundings“Current Refunding” =

• Payoff of refunded bonds occurs not later than 90 days after issuance of the refunding bonds

“Advance Refunding” =• Payoff of refunded bonds occurs more than 90 days after issuance of the

refunding bonds• Proceeds of refunding bonds may be held in escrow pending use to pay debt

service on refunded bonds• Only “governmental” and 501(c)(3) bonds may be advance refunded (i.e., no

private activity bonds other than 501(c)(3) bonds)• Bonds issued after 1985 that may be advance refunded may be advance refunded

only once

Arbitrage Restrictions on Advance Refundings

• Generally, no “temporary periods” or other exceptions to the arbitrage yield-restriction rules

• Advance refunding proceeds may not be invested more than 0.001% above yield on refunding bonds (therefore, need to yield restrict)

• Proceeds usually invested in SLGS

Reissuance• Changes to the terms of a bond issue that are sufficiently significant to justify treating

the modification as resulting in a “deemed” or “constructive” taxable exchange of “old” for “new” (“reissued”) bonds

– Tested under the rules of IRC 1001 (taxable sales, exchanges and other dispositions that result in the recognition of gain or loss) and Treas. Reg. 1.1001-3 (modifications of debt instruments)

– Variable rate “tender bonds” may also be tested under rules set forth in IRS Notice 2008-41 (or Notice 88-130)

Watch for negotiations between parties in private placement


Current and Advance Refundings“Current Refunding” =

• Payoff of refunded bonds occurs not later than 90 days after issuance of the refunding bonds

“Advance Refunding” =• Payoff of refunded bonds occurs more than 90 days after issuance of the

refunding bonds• Proceeds of refunding bonds may be held in escrow pending use to pay debt

service on refunded bonds• Only “governmental” and 501(c)(3) bonds may be advance refunded (i.e., no

private activity bonds other than 501(c)(3) bonds)• Bonds issued after 1985 that may be advance refunded may be advance refunded

only once

Arbitrage Restrictions on Advance Refundings

• Generally, no “temporary periods” or other exceptions to the arbitrage yield-restriction rules

• Advance refunding proceeds may not be invested more than 0.001% above yield on refunding bonds (therefore, need to yield restrict)

• Proceeds usually invested in SLGS

Reissuance• Changes to the terms of a bond issue that are sufficiently significant to justify treating

the modification as resulting in a “deemed” or “constructive” taxable exchange of “old” for “new” (“reissued”) bonds

– Tested under the rules of IRC 1001 (taxable sales, exchanges and other dispositions that result in the recognition of gain or loss) and Treas. Reg. 1.1001-3 (modifications of debt instruments)

– Variable rate “tender bonds” may also be tested under rules set forth in IRS Notice 2008-41 (or Notice 88-130)

Watch for negotiations between parties in private placement


Reissuance: Why it Matters• Taxable exchange (bondholders may need to recognize taxable gain or loss)

• Arbitrage rebate must be calculated and paid (within 60 days) following deemed discharge of “old” obligation (change to new yield)

• New “TEFRA” hearing may be required

• More favorable tax treatment of original obligations may be lost (e.g., re AMT, “bank-qualified” obligations, etc.) – change in law risk

• New 8038 or 8038-G form must be filed with IRS

• Swaps/hedges deemed terminated (but note 2013 Proposed Regulations)

Testing for Reissuance Under §1.1001-3From Treas. Reg. 1.1001-3:

(1) “Modification”: Any alteration to the legal rights or obligations of the issuer or holder of an obligation (whether by amendment of bond documents, conduct of the parties, or otherwise)

– Does not include modification that occurs automatically under the original terms of the obligation upon the happening of events outside the control of the parties (e.g., resetting variable rate to track market rate)

– Does not include exercise of unilateral right by a party

Two-part test: An obligation is “reissued” if there is (1) a “modification” to its terms that is (2) “significant.”

Testing for Reissuance Under §1.1001-3(2) “Significant” modifications include the following:

• Yield: Change that exceeds greater of 0.25% or 5% of prior yield

• Deferral of payments by more than lesser of 5 years or 50% of original term (e.g.,10-year maturity could be extended to 15 years, 20-year maturity to 25 years)

• Obligor: Change in obligor of a recourse obligation– “Obligor” for this purpose means only the actual issuer (change

in conduit borrowers does not produce a reissuance)

– Tax-exempt bonds are treated as “recourse” (unless the bonds (i) finance a conduit loan and (ii) both the bonds and the conduit loan are non-recourse)

• Security: Change in security only if it results in a significant change in “payment expectations”


Reissuance: Why it Matters• Taxable exchange (bondholders may need to recognize taxable gain or loss)

• Arbitrage rebate must be calculated and paid (within 60 days) following deemed discharge of “old” obligation (change to new yield)

• New “TEFRA” hearing may be required

• More favorable tax treatment of original obligations may be lost (e.g., re AMT, “bank-qualified” obligations, etc.) – change in law risk

• New 8038 or 8038-G form must be filed with IRS

• Swaps/hedges deemed terminated (but note 2013 Proposed Regulations)

Testing for Reissuance Under §1.1001-3From Treas. Reg. 1.1001-3:

(1) “Modification”: Any alteration to the legal rights or obligations of the issuer or holder of an obligation (whether by amendment of bond documents, conduct of the parties, or otherwise)

– Does not include modification that occurs automatically under the original terms of the obligation upon the happening of events outside the control of the parties (e.g., resetting variable rate to track market rate)

– Does not include exercise of unilateral right by a party

Two-part test: An obligation is “reissued” if there is (1) a “modification” to its terms that is (2) “significant.”

Testing for Reissuance Under §1.1001-3(2) “Significant” modifications include the following:

• Yield: Change that exceeds greater of 0.25% or 5% of prior yield

• Deferral of payments by more than lesser of 5 years or 50% of original term (e.g.,10-year maturity could be extended to 15 years, 20-year maturity to 25 years)

• Obligor: Change in obligor of a recourse obligation– “Obligor” for this purpose means only the actual issuer (change

in conduit borrowers does not produce a reissuance)

– Tax-exempt bonds are treated as “recourse” (unless the bonds (i) finance a conduit loan and (ii) both the bonds and the conduit loan are non-recourse)

• Security: Change in security only if it results in a significant change in “payment expectations”

Testing for Reissuance under Notice 2008-41Definitions

• “Qualified Tender Bonds” (“QTBs”): (1) Bear interest at either a fixed rate or a periodically reset “qualified floating rate” or “eligible objective rate” (§1275-5); (2) Pay interest at least annually; (3) Have a maturity of not more than 40 years; and (4) Are subject to optional or mandatory tender provisions

• “Qualified Interest Rate Mode Change”: a change between interest rate modes that is authorized under the terms of the bond when originally issued

• “Qualified Tender Right”: includes option on the part of a bondholder to tender bond at specified times and requirement of bondholder to tender bonds for purchase upon occurrence of certain events

Testing for Reissuance under Notice 2008-41• General Rule: No Reissuance of a QTB if:

– Qualified Interest Mode Change; or

– Exercise or Existence of Qualified Tender Right

• Issuer may repurchase QTB without causing the bonds to be treated as retired, if the bonds are remarketed within 90 days

– No limit for bonds purchased by nongovernmental conduit borrowers, third party guarantors and liquidity providers

• Other changes (and the determination of whether a particular modification is “significant”) are tested under Treas. Reg. 1.1001-3

Testing for Reissuance under Notice 88-130Definitions

• “Tender Right”-- similar to Qualified Tender Right under Notice 2008-41• “Tender Bond” -- any bond subject to a Tender right all interest on which accrues at a tender rate and

is due at periodic intervals of one year or less• “Tender Rate” -- lowest rate necessary to market/remarket the bond at par (plus accrued interest) • “QTB”-- a bond with a maturity of not more than 35 years• “Change”-- any change in the legal rights or remedies of a bondholder unless all of the elements of the

alteration are entirely outside the control of the parties• “Qualified Tender Change” -- a change in the period between tender dates that occurs pursuant to the

original terms of the bond• “Qualified Corrective Change”-- a change that does not materially alter the rights or remedies of a

holder, and addresses unforeseen circumstances or unintended results• “Qualified Tender Purchase” -- any purchase of a QTB pursuant to a tender right if (1) it occurs

pursuant to bond documents, (2) the terms of the bond require that best efforts be used to remarket the bond; and (3) the bond is remarketed no later than 30 days after the date of purchase


Testing for Reissuance under Notice 88‐130• A QTB is not reissued as a result of :

– the existence of the tender right -- a Qualified Tender Purchase– a Qualified Tender Change --a Qualified Corrective Change

• Reissuance of QTB is caused by:– Any change to bond terms in connection with a Qualified Tender Change

increasing the period between tender dates from a period not exceeding one year to a period exceeding one year or vice versa (ie, the hair trigger)

– A change other than a Qualified Tender Change, in the period between tender dates

– A change to the bond terms which by itself triggers a reissuance under §1001– Acquisition of the bond by or on behalf of the issuer or a true obligor which is a

governmental unit or an agency or instrumentality thereof


Testing for Reissuance under Notice 88‐130• A QTB is not reissued as a result of :

– the existence of the tender right -- a Qualified Tender Purchase– a Qualified Tender Change --a Qualified Corrective Change

• Reissuance of QTB is caused by:– Any change to bond terms in connection with a Qualified Tender Change

increasing the period between tender dates from a period not exceeding one year to a period exceeding one year or vice versa (ie, the hair trigger)

– A change other than a Qualified Tender Change, in the period between tender dates

– A change to the bond terms which by itself triggers a reissuance under §1001– Acquisition of the bond by or on behalf of the issuer or a true obligor which is a

governmental unit or an agency or instrumentality thereof



03. Avoiding Private Activity

Faculty:Perry E. Israel Law Office of Perry Israel – Sacramento, CA Alison J. Benge Pacifica Law Group LLP – Seattle, WA

I. INTRODUCTION

A. Regulations Addressing Private Activity Tests

1. Rules regarding the private activity tests described in I.R.C. § 141 are set forth in Treasury Regulations §§1.141-0 through 1.141-16 (the “Regulations”). Bonds issued prior to May 16, 1997, are subject to earlier versions of the regulations and special rules may apply to bonds issued to refund such earlier issued bonds. However, as a general rule, most issuers will want to apply the current Regulations.

2. New regulations relating to allocation and accounting, including rules relating to “mixed-use” projects and partnerships were published in the Federal Register on October 27, 2015.

B. Two Ways to have Private Activity Bonds

1. General rule. A bond is a “private activity bond” if the issuer of the bond reasonably expects on the issue date that the bond issue will meet either (a) both private business tests (the “Private Business Tests”) or (b) the private loan test (the “Private Loan Test”), as described below.

2. Private Business Tests: The private business tests are met if (a) there is more than the lesser of 10% or $15 million private business use (the “Private Business Use Test”) AND (b) there is more than the lesser of 10% or $15 million private payments or private security interest (the “Private Payments or Private Security Test”).

3. Private Loan Test: The private loan test is met if more than 5% (or $5 million if less) of the proceeds is treated as being loaned to nongovernmental entities.


4. Unrelated or disproportionate use. If the private business use is “unrelated” or is related but “disproportionate” to the governmental use, then 5% (rather than 10%) applies for purposes of the Private Business Tests described above. Private business use is unrelated if the use is for a different purpose than the governmental use. Private business use is disproportionate to the extent that the amount of proceeds spent for the use exceeds the amount of proceeds spent for the governmental use to which the private business use is related.

5. Special rule for qualified 501(c)(3) bonds. In general, the Regulations also apply to qualified 501(c)(3) bonds issued under I.R.C. § 145, with conforming changes to test compliance with the Private Business Tests based on a 5% (instead of a 10%) limitation for non-exempt uses (and for private payments or security).

C. Reasonable Expectations/Deliberate Actions (Regs. §1.141-2(d))

1. In General. Bonds are private activity bonds if either:

a. the issuer “reasonably expects,” as of the issue date, that the bonds will meet either the Private Business Tests or the Private Loan Test at any time over the term of the issue; or

b. the issuer takes a “deliberate action” subsequent to the issue date that causes the bonds to meet the Private Business Tests or the Private Loan Test. Generally, a “deliberate action” is a voluntary act taken by the issuer subsequent to the issue date of the bonds (see the change in use rules—we’ll get to these later).

2. Exceptions to the Reasonable Expectations Test

a. Special rule for bonds issued with mandatory redemptions. An issuer may disregard an action that is “reasonably expected” as of the issue date the effect of which will violate the Private Business Tests or the Private Loan Test if, as of the issue date, all of the following apply:

(1) the issuer reasonably expects to use the financed property for a qualified use for a substantial period of time (note: a “substantial period of time” is not defined in the Regulations);

(2) the issuer is required to redeem ALL “nonqualified bonds” within 6 months of the deliberate action (note: this requires the issuer to contribute its own funds if the property is sold at a loss);


(3) the issuer has not entered into “any arrangement” with a private user as of the issue date; and

(4) the mandatory redemption provision of the bonds meets the conditions for the taking remedial action under the change in use provisions (i.e., the preliminary conditions for taking a remedial action under Treas. Reg. § 1.141-12(a)).

Example. A City issues bonds to rehabilitate an existing hospital that it currently owns. On the issue date of the bonds, the City expects that it will use the hospital for a governmental use for a substantial period of time. On the issue date of the bonds, the City is planning to finance a new City hospital with an uncertain placed in service date. The City reasonably expects that when the new hospital is placed in service, it will sell or lease the rehabilitated hospital to a private user. The bond documents provide that all of the outstanding bonds may be redeemed within 6 months of the sale or lease to a private party. Assuming the issuer can satisfy the conditions for taking remedial action under Treas. Reg. § 1.141-12(a), the City satisfies the reasonable expectations test. (See Treas. Reg. § 1.141-2(g), example 2).

b. Dispositions of Personal Property in the Ordinary Course of an Established Program. Certain dispositions of personal property in the “ordinary course of an established governmental program” are not treated as a deliberate action if all of the following apply:

(1) the weighted average maturity of the bonds financing the personal property is not greater than 120% of the reasonably expected actual use of that property for governmental purposes;

(2) the issuer reasonably expects on the issue date that the fair market value of the property on the disposition date will not exceed 25% of its cost; and

(3) the property is no longer suitable for its governmental purposes.

Under this exception, the issuer is required to deposit the disposition proceeds in a commingled fund with other governmental revenues that it reasonably expects to spend on governmental programs within 6 months from the date of deposit.

Example. A City may finance police cars and later dispose of them at a public auction when they are no longer suitable for police use. Under this exception, the City may generally dispose of the cars without jeopardizing the tax-exempt status of the bonds issued so long as the sale proceeds are recycled into governmental programs.


c. Special Rule for General Obligation Bonds that Finance 25 or more Separate Purposes. The Regulations also contain a special rule which allows an issuer of a bond issue for certain general governmental programs that finance at least 25 purposes (but that do not “predominantly” finance fewer than 4 purposes) to rely solely on “reasonable expectations” as of the issue date for private activity bond status, without regard to future deliberate actions assuming a number of qualifications are satisfied.

3. Remedial Actions. An issuer that takes a deliberate action that causes the Private Business Tests or the Private Loan Test to be met may be able to take remedial actions under Regulations §1.141-12.

II. PRIVATE BUSINESS USE TEST (Regs. §1.141-3)

A. In General. In general, the Private Business Use Test is met if a “nongovernmental person” directly or indirectly uses more than 10% of the proceeds of a bond issue in the aggregate (counting all private business uses together).

1. Who is a Nongovernmental Person? A nongovernmental person is an entity other than a state or local government, or an instrumentality of a state or local government. For example a “nongovernmental person” would include any of the following:

a. the federal government;

b. a section 501(c)(3) organization;

c. any for-profit concern or non-profit concern that is not a section 501(c)(3) organization (e.g., a corporation or partnership).

2. How does Private Business Use Generally Occur? Under the Regulations, a nongovernmental person will generally be a user of bond proceeds and bond-financed property as a result of:

a. ownership (meaning ownership for federal tax law purposes);

b. a lease/sublease;

c. a nonconforming management contract (see below);

d. a “take or pay” contract and certain other output contracts;

e. a research agreement with a nongovernmental person (see below);

f. a joint venture;


g. other types of arrangements that convey a “special legal entitlement” or, in some cases, a “special economic benefit” with respect to the bond-financed property.

3. Exception for General Public Use. I.R.C. § 141(b)(6) provides that use of bond-financed property as a member of the “general public” is NOTtreated as private business use. In other words, nongovernmental persons may use bond-financed property in their trade or businesses and the use will be ignored if the property meets certain “general public use” requirements.

a. General Public Use Property. Under the Regulations, general public use property is property that

(1) is intended to be available and

(2) in fact is reasonably available

for use on the same basis by natural persons not engaged in a trade or business. Note that, in all events, an arrangement cannot be treated as general public use if it has a term, including renewal options, greater than 200 days.

Example - Airport Parking Garage. City issues bonds to finance a City owned parking garage at the City airport. The City reasonably expects that more than 10% of the actual use of the garage will be used by employees of the commercial airlines. The airline employees’ use of the garage will be on the same basis as passengers and other members of the general public using the airport. The airlines have no priority rights to the parking garage, and the rent that the airlines pay to the City for the lease of airport terminal space is not adjusted to take into account revenues generated by the parking garage (i.e., the airlines don’t get a benefit of lower rent payments if parking revenue goes up). Although the airlines may receive an “economic benefit” from the use of the parking garage, the economic benefit is not enough to cause the airlines to be private business users because the parking garage is available to members of the general public. (See Treas. Reg. § 1.141-3(f), example 9). (Compare Internal Revenue Service Chief Counsel Memorandum 200143031 – private business use where lease with private carrier gave carrier interest in net profits generated by the parking garage.)


b. General Public Use Property in Cases in which a Nongovernmental Person has a “Special Legal Entitlement.” Even if bond-financed property qualifies as “general public use property,” the use of the property or facility by a nongovernmental person in a trade or business will be viewed as a private business use if a “special legal entitlement” is provided to the nongovernmental person.

What is a “Special Legal Entitlement”? Although the term is not defined in the Regulations, it appears to be the ability to control the bond-financed property in some manner or a special right to receive a portion of the net profits generated by the bond-financed property.

Example 1 – City Parking Lot. A Corporation (i.e., a nongovernmental person) and a City enter into a plan to finance the construction of a parking lot adjacent to the Corporation’s factory. Pursuant to the agreement, the Corporation conveys the site for the parking lot to the City “subject to” a covenant running with the land that the property will only be used for a parking lot. In addition, the City agrees that the Corporation will have a right to approve rates charged by the City for use of the parking lot. The parking lot will otherwise be available for use by members of the general public. The bond issue will meet the private business use test because a nongovernmental person has “special legal entitlements” for beneficial use of the financed facility that are comparable to an ownership interest. (See Treas. Reg. § 1.141-3(f), example 5)

Example 2 – Naming Rights. A bond-financed arena and convention center have a contract with a private party. Such contract sells the naming rights to the private party for a term of years in exchange for certain dollar amounts each year. The private party can select the name of the facility and have such name used in all identification of the facility (e.g., advertising, communications, third party contracts, signs, schedules, programs and other writings). In Private Letter Ruling 200323006, the Internal Revenue Service determined that the contract provided special legal entitlements to control the use of the facility. Note that the private business use was simultaneous with the governmental use. The Internal Revenue Service ultimately found that the private use did not cause more than ten percent of the bonds to be used for private business use. The Internal Revenue Service measured the fair market value of the contract against the fair market value of the facility for each year of the contract.

4. Special Study of Private Use: Management Contract Guidelines. A management contract between a governmental person and a nongovernmental person with respect to bond-financed property may result in private use. The Regulations adopt a “facts and circumstances approach” in determining whether such use gives rise to private business use.


a. The Regulations provide that the following types of arrangements are not management contracts that give rise to private business use:

(1) Incidental Services – Contracts for services that are solely incidental to the primary function of the bond-financed property, such as janitorial services, hospital billing or equipment repair.

(2) Hospital Admitting Privileges – The mere granting of admitting privileges by a governmental hospital to a doctor, if such privileges are available to all qualified physicians in the area.

(3) Operation of Public Utility Property – A contract to provide for the operation of “public utility property” (as defined in I.R.C. § 168(i)(10)) if the only compensation is the “reimbursement” of actual and reasonable administrative expenses of the provider.

(4) Direct Cost Arrangements – A contract in which the only compensation is the reimbursement to the service provider for actual and direct expenses paid by the provider to unrelated parties.

b. Revenue Procedure 97-13. Under Rev. Proc. 97-13, as modified by Rev. Proc. 2001-39 and Notice 2014-67, the Internal Revenue Service has established “safe harbor” management contract guidelines that, if satisfied, will not cause the use under the management contract to result in private business use. Rev. Proc. 97-13 is generally effective for management contracts entered into, materially modified or extended (other than pursuant to a renewal option) on or after May 16, 1997. In addition, issuers may elect to apply Rev. Proc. 97-13 to contracts entered into before the general effective date.

(1) No Compensation based on Net Profits. Both the Regulations and Rev. Proc. 97-13 provide that no portion of the compensation to the manager may be based on a percentage of “net profits.” The safe harbors provide that compensation based on any of the following will not be viewed as based on a percentage of net profits:

(a) percentage of gross revenues or a percentage of expenses of a facility (but not both);

(b) a capitation fee (a fixed periodic amount payable for each person for whom services are provided);


(c) a per-unit fee (a fee based for each unit of service provided (e.g., ton of waste, car parked));

(d) periodic fixed fee (a stated amount for services rendered for a stated period of time).

Capitation fees, per-unit fees and periodic fixed fees may automatically increase based on a “specified, objective, external standard that is not linked to output or efficiency of a facility” (e.g.,CPI).

(2) Types of Permitted Contracts

(a) 95% fixed fees – up to a 15-year contract. If at least 95% of the compensation paid during each year of the contract term is based on periodic fixed fees, the maximum term of the contract (including renewal options) cannot exceed the lesser of 80% of the economic life of the facility or 15 years.

(b) 80% fixed fees – up to a 10-year contract. If at least 80% of the compensation paid during each year of the contract term is based on periodic fixed fees, the maximum term of the contract (including renewal options) cannot exceed the lesser of 80% of the economic life of the facility or 10 years.

(c) Public utility property managed pursuant to 95% or 80% fixed fee – up to a 20-year contract.Management contracts for public utility property can be for a term of up to 20 years, subject to the 80% economic life requirement.

(d) 50% fixed fee or 100% capitation fee – up to 5-year contract. If at least 50% of the compensation paid during each contract year is based on periodic fixed fees or 100% capitation fees or a combination of fixed fee or capitation fees, the maximum term cannot exceed 5 years (including renewal options).The contract must be cancelable by the issuer without cause or penalty at the end of 3 years.

(e) Per-unit fee or combination of per-unit fee and fixed fee – up to 3-year contract. If all of the compensation is based on a per-unit fee or a combination of a per-unit fee and a fixed fee, the maximum term is 3 years (including renewal options) without cause or penalty. The contract


must be cancelable by the issuer without cause or penalty at the end of 2 years.

(f) Percentage of revenue or expense – up to 2-year contract. If all of the compensation is based on a percentage of revenue or expense, or a combination of a per-unit fee and a percentage of revenue or expense fee, the maximum term is 2 years. The contract must be cancelable by the issuer without cause or penalty at the end of the first year of the contract. This type of contract is generally only available for contracts regarding the services to third parties (e.g., radiology services) or in start-up situations.

(g) Percentage of revenue or expense, fixed periodic fee, stated amount, capitation, per-unit fee, or any combination – up to 5-year contract. No requirement that it be cancelable prior to term. (New in Notice 2014-67.) Probably will mean that people won’t use (d), (e), or (f) above anymore.

(3) Renewal Options. A renewal option is a provision under which the service provider has a legally enforceable right to renew the contract. Thus, a contract that automatically renews absent cancellation by either party (i.e., an “evergreen” contract) is not a contract with a renewal option. Note that if the issuer but not the service provider has a legally enforceable right to renew the contract, the contract does not include a renewal right.

(4) Overlapping Boards/Prohibited Relationships. In order to fit within a Rev. Proc. 97-13 safe harbor, a service provider may not have a relationship with the qualified user (for this purpose generally a section 501(c)(3) conduit borrower) that limits the qualified user’s ability to exercise its rights under the contract. Under Rev. Proc. 97-13 this requirement will be satisfied if:

(a) Not more than 20% of the voting power of the governing body of the qualified user in the aggregate is vested in the service provider and its directors, officers, shareholders and employees;

(b) Overlapping board members do not include the chief executive officers of the service provider or its


governing board or the qualified user or its governing board; and

(c) The qualified user and the service provider are not related parties under Treas. Reg. § 1.150-1(b).

(5) Special Rules for Productivity Rewards. In general, may have stated dollar amount incentives based on increases or decreases in gross revenues or reductions in expenses (but not both). Also, a special rule exists for Accountable Care Organization shared savings programs.

5. Research Contracts. Certain types of sponsored corporate research may result in private business use. The Regulations adopt a facts and circumstances approach to determine whether such use gives rise to private business use. An arrangement that results in the sponsor being treated as the lessee or owner of the bond-financed property for federal income tax purposes will result in private business use unless one of the exceptions of Treas. Reg. § 1.141-3(d) applies.

Until recently, Rev. Proc. 97-14 had been the principal guidance establishing “safe harbor” guidelines regarding research agreements. In response to NABL requests clarifying the rights under the federal Bayh-Dole Act, the Internal Revenue Service published Rev. Proc. 2007-47 on June 26, 2007, which superseded Rev. Proc. 97-14.

Rev. Proc. 2007-47 contains two safe harbors. The first is for “corporate sponsored” research agreements and has the following requirements: (1) any licensee of the sponsor must be permitted to use the results of the research on the same terms that the owner of a bond-financed facility would allow an unrelated party; and (2) the sponsor must pay a competitive price for the right to use the research funded by that sponsor, and the price must be determined at the time such research is available for use.

The second safe harbor is for industry or federally sponsored research agreements. This safe harbor requires (1) the research to be performed by the owner of bond-financed property in a manner determined by such owner, (2) title is in the bond issuer, and (3) sponsors are entitled to no more than a non-exclusive, royalty-free license to use the product of the research. Rights of the federal government under the Bayh-Dole Act are permitted so long as (1) and (2) are met and the license granted to any third party is no more than a non-exclusive, royalty free license.

6. Other Private Business Use Exceptions

a. Agents. Private business use excludes use of bond proceeds by a private business solely in the capacity as an agent for a


governmental unit (e.g., a nongovernmental person that issues “on behalf of” a governmental unit). See Rev. Rul. 63-20.

b. Use Incidental to Financing Arrangements. Private business use excludes use solely incidental to financing arrangements (e.g., the nominal ownership by a private business of bond-financed property in a sale-leaseback to a governmental unit as a lessee).

c. Short-Term Non-Ownership Arrangements. The Regulations provide the following short-term use exceptions:

(1) 100-Day Rule. This exception covers certain arrangements involving terms of use, including all renewal options, of not more than 100 days in the aggregate, of property that is not generally available for general public use, but is available at generally applicable or uniformly applied rates. This exception is applicable if the principal purpose of financing the property is other than providing that property to such user.

(2) 50-Day Rule. This exception covers certain arrangements for terms of use, including renewal options, of not more than 50 days in the aggregate, if negotiated at arm’s-length and the compensation represents fair market value. This exception is applicable if the principal purpose of financing the property is other than providing that property to such user.

(Note: The general public use exception described in section 3 above is also subject to a maximum use term of 200 days. It may be easiest to think of the 200-day, 100-day and 50-day exceptions collectively as the “short-term use” exceptions - each having special requirements for application.)

d. Incidental Use. Consistent with the position taken in Internal Revenue Service Notice 87-69, the Regulations exclude from private business use certain incidental uses (such as kiosks, vending machines, etc.) of up to 2.5% of the proceeds of the bonds and certain qualified improvements.

B. Property not available to the General Public – Special Economic Benefit

1. In General. For bond-financed property that is not available for general public use, the Regulations provide that private business use of such property arises if a nongovernmental person derives a “special economic benefit” from the property, based on all the facts and circumstances, even if the private user has no special legal entitlements with respect to the financed property.


The following factors are taken into account in determining whether special economic benefit gives rise to private business use:

a. whether the financed property is functionally related or physically proximate to property used in the trade or business of a nongovernmental person;

b. whether a small number of nongovernmental persons receives a special economic benefit; and

c. whether the cost of the bond-financed property is being depreciated by any nongovernmental person.

Example – Solid Waste Facility. A City issues obligations to finance a solid waste disposal facility on land that it owns adjacent to a factory owned by Corporation. The City will own and operate the facility, and the Corporation will have “no special legal entitlements” to use the facility. The City, however, expects that the Corporation will be the only user of the facility and the facility will not reasonably be available for use on the same basis by natural persons not engaged in a trade of business. Under all of the facts and circumstances (e.g., the facility is functionally related and physically proximate to property used in the Corporation’s trade or business), the Corporation derives a special economic benefit from the facility and the Corporation’s use is treated as a private business use. See Treas. Reg. § 1.141-3(f), example 7.

III. MEASUREMENT OF PRIVATE BUSINESS USE (Regs. §1.141-3(g))

A. Private Use Generally is Measured over Time. With one exception (described below), the 10% private business use test limit generally is measured based on the “average percentage of private business use” over a “measurement period.”

1. Measurement Period. The “measurement period” begins on the later of (a) the issue date of the bonds, or (b) the date the financed property is placed in service. The measurement period ends on the earlier of (a) the last day of the reasonably expected economic life of the property (determined on the issue date), or (b) the final maturity date of the bonds (disregarding optional redemptions).

2. Average Percentage of Private Business Use. Generally, the measurement of private business use involves a two-step process: (a) finding the percentage of private business use in each 1-year period (determined as a percentage of actual use); and (b) finding the average of these 1-year percentages.

Example – Assume a City issues bonds to finance a 20-story office building. The office building has an expected economic life of 20 years. The City expects to lease a number of the floors out to private business users for the term of the bonds and the term of the bonds exceeds the expected economic life of the building.


Under the Regulations, the City could lease two floors for the term of the bonds to a private party (e.g., 2/20) or the City could lease ALL of the floors to the private user for a period not to exceed 2 years.

B. Measuring Private Business Use. The Regulations contain a number of special rules for measuring private use for instances in which (a) use of the facility occurs at different times, (b) use of the facility in which governmental use and private use occur simultaneously, (c) the private business use occurs in discrete portions, and (d) private use which has a greater value than governmental use.

C. Exception to Use Over Time. For property “owned” by a private business user, the “highest-one-year-use percentage test” applies to measure private business use, and no averaging over the measurement period is permitted.

D. Mixed-use property and Qualified Equity (Regs. §1.141-6(b))

1. For property that is both financed with tax-exempt bonds and with “qualified equity,” private business use will first be allocated in each year to the qualified equity before it is allocated to bond proceeds. Note that qualified equity is allocated to private business use on an annual basis and not over the measurement period in the aggregate.

2. “Qualified equity” must be non-tax-exempt bond proceeds that is spent on the same “project” with the time period beginning when reimbursement would be allowed and ending when the project is placed in service.

3. Special rules relate to partnerships between governmental and nongovernmental persons that essentially treat that partnership as a private user to the extent of the nongovernmental persons’ interests in the partnership.

E. There are special rules for “output facilities.” See Regulations §1.141-7 and -8.

IV. PRIVATE PAYMENT OR SECURITY TEST (Regs. §1.141-4)

A. In General. In general, the Private Payment or Security Test is met if payment of more than 10% of debt service on the bond issue is directly or indirectly (a) secured by any interest in property used or to be used for a private business use or payments in respect of such property or (b) to be derived from payments (whether or not to the issuer or any related party) in respect of property, or borrowed money, used or to be used for a private business use.

B. Present Value Calculation

1. Private Payment Test/Private Security Test. The private payment test is met if the present value of all private payments over the term of the bond issue exceeds 10% of the present value of the debt service on the bond issue. The private security test is met if the fair market value of the


pledged property determined as of the first date such property secures the bonds exceeds 10% of the present value of the debt service on the bond issue.

a. Fixed Rate Issues. For purposes of a fixed yield issue, the bond yield on the issue is used as the discount rate.

b. Variable Rate Issues. To determine the reasonably expected yield on a variable yield issue at any time, the issuer may assume that the future interest rate on the issue will be the then-current interest rate.

c. Adjustments. Bond debt service is adjusted upward to include certain amounts treated as part of bond yield for arbitrage purposes (e.g., qualified guarantee payments and qualified hedge fees), and is adjusted downward for certain debt service paid from bond proceeds (e.g., capitalized interest or funded reserve funds).

C. Private Payments

1. Payments Taken into Account. The Regulations provide that private payments include direct and indirect payments, made by private business users (whether or not to the issuer), to the extent allocable to that private business use. In addition, payments are only taken into account for the period of time that the financed property is actually used for a private business use.

2. Private Payments Cannot Exceed Private Use. The Regulations limit private payments to the percentage of private business use. For example, if a private business uses 7% of a financed facility, the amount of private payments taken into account may not exceed the present value of 7% of the debt service on the bonds, even if the use arrangement in question requires the user to make payments to the issuer with a present value equal to 8% of the present value of debt service on the bonds.

3. Operating Expenses Excluded. The Regulations exclude from private payments those amounts properly allocable to ordinary and necessary business expenses (under I.R.C. § 162) that are directly attributable to the operation and maintenance of the property. General overhead or administrative expenses do not qualify for this exclusion.

4. Generally Applicable Taxes Excluded. The Private Payment or Security Test excludes “generally applicable taxes.” A generally applicable tax must have a uniform tax rate that is applied to all persons of the same classification in the jurisdiction and a generally applicable manner of determination and collection.

5. Payments In Lieu of Taxes (PILOTs)


a. General. PILOTs are treated as a generally applicable tax if the payment (i) is commensurate with and not greater than amounts imposed by a statute for a tax of general application, and (ii) the payment is for a public purpose and is not a special charge.

b. Special Charges. A payment for a special privilege granted or service rendered is not a generally applicable tax. A tax or a payment in lieu of tax that is limited to the property of persons benefited by an improvement is not a generally applicable tax.

c. Private Letter Rulings. PLR 107-899-06 and PLR 110-172-06 provide that payments in lieu of taxes made by a private party in connection with the use of baseball stadiums in New York City do not constitute private payments or private security with respect to bonds issued by an agency of the State of New York to finance construction of those baseball stadiums. Because the PILOTs in question are designated for the public purposes of promoting tourism and economic development and are calculated with respect to generally applicable ad valorem taxes, they do not constitute a special charge as defined in Treas. Reg. § 1.141-4(e)(5).

d. Proposed Regulations. On October 19, 2006 the Internal Revenue Service issued proposed amendments to Treas. Reg. § 1.141-4(e)(5). The proposed Regulations omit the sentence previously contained in Treas. Reg. § 1.141-4(e)(5) that states “For example, a payment in lieu of taxes made in consideration for the use of property financed with tax-exempt bonds is treated as a special charge.” The proposed regulations also state that a PILOT is “commensurate” with generally applicable taxes “only if the amount of such payment represents a fixed percentage of, or reflects a fixed adjustment to, the amount of generally applicable taxes that otherwise would apply to the property in each year if the property were subject to tax.”

6. Private Payment Allocations

a. In General. The Regulations provide that, in general, private payment allocations among different sources are based on all the facts and circumstances and focus on the nexus between the payment and both the financed property and source of funding.

b. Discrete Portions. Payments for the use of a “discrete portion” (e.g., 1 floor of a 10-story building) are generally allocable to the source of funding of that discrete portion.

c. Allocations Among Two or More Sources. Unless a special rule applies (e.g., planned arrangements or equity allocations described


below), if a private payment is made for the use of property financed with two or more sources of funding, that payment must be allocated between those sources in a manner that reasonably corresponds to the relative amounts of those sources of funding that were expended on the property.

d. Certain Planned Arrangements. Private payments made for the use of property under an “arrangement” entered into in connection with a bond issue that finances that property generally is allocated to that bond issue. An “arrangement” generally exists if the private payments correspond to debt service on the issue and if the issuer enters into the arrangement during the three-year period beginning 18 months before the issue date.

e. Equity Allocations. Allocations of private payments to equity are permissible if the issuer adopts an official intent resolution similar to those used for reimbursement bonds within 60 days after the expenditure and makes the allocation within 18 months after the later of the expenditure or the placed in service date.

f. Output Contracts. Payments under an output contract that result in private business use of a mixed-use project are allocated to the same source of funding allocated to the private business use from such contract.

D. Private Security. Private security includes an interest in property used or to be used for private business use or any payments from such property that secure a bond issue (e.g., securities or unimproved land), whether or not the bond issue finances that security. Similar to the rules for private payments, private security is taken into account only to the extent it is provided directly or indirectly by a user of the proceeds of the bonds.

V. PRIVATE LOAN TEST (Regs. §1.141-5)

A. In General. I.R.C. § 141(a)(2) provides that bonds are private activity bonds if more than the lesser of 5% or $5 million of the bond proceeds are to be used (directly or indirectly) to make or finance loans (excluding certain permitted tax assessment loans) to nongovernmental persons.

1. Amount is not Discounted. Unlike the private payment test, the amount of proceeds loaned is not discounted to reflect the present value of the loan payments.

2. Certain Prepayments may be treated as Loans. Unless certain narrow exceptions can be satisfied, the use of bond proceeds to finance a prepayment for goods or services may be viewed as a loan. The exceptions are similar to those contained in the arbitrage regulations regarding investment property.


B. Exception for Loans to Finance Taxes or Assessments

1. Under federal tax law, real property assessments that are deferred and paid over time are generally treated as loans. Thus, bonds that are issued to finance improvements to be paid by assessments could be seen as meeting the private loan test.

2. I.R.C. § 141(c)(2) contains an exception for loans that enable the borrower to finance any tax or assessment of general application where the tax or assessment finances a specific essential governmental function. Issues arise as to what is “of general application” and what is an “essential governmental function.”

VI. ALLOCATION AND ACCOUNTING RULES (Regs. § 1.141-6)

A. General Rule. The allocations of proceeds and other sources of funds to expenditures under the arbitrage rules (Regs. §1.148-6(d)) apply for purposes of applying the private activity bond tests. Allocations generally may be made using any reasonable, consistently applied accounting method.

B. Sources of funding are allocated to a “project”—one or more facilities or capital projects financed in whole or in part with proceeds of the issue.

C. There are special rules for eligible mixed-use projects, discussed above.

VII. CHANGE IN USE AND REMEDIAL ACTIONS (Regs. § 1.141-12)

A. General Rule. An action that causes the Private Business Tests or Private Loan Test to be met is not treated as a deliberate action if the issuer takes a specified remedial action and all of the following requirements are met.

1. Reasonable Expectations. The issuer reasonably expected on the date of issue that the issue would not meet either the Private Business Tests or the Private Loan Test for the entire term of the bonds. If the issuer reasonably expects to take deliberate action during the term of the bonds and the special redemption requirements described in I.C.2 – “Exceptions to the Reasonable Expectations Test” above are met, the term of the bonds for this purpose may be determined taking into account such redemption provisions.

2. Maturity not Unreasonably Long. The term of the issue must not be longer than reasonably necessary for the governmental purposes of the issue.

3. Fair Market Value Consideration. Except with respect to the alternative use of facility remedial action described in B.3. below, the terms of any agreements that result in satisfaction of either the Private Business Tests


or the Private Loan Test are bona fide and arm’s-length and the new user pays fair market value for its use.

4. Disposition Proceeds. The issuer must treat any disposition proceeds as gross proceeds for the purposes of I.R.C. § 148.

5. Proceeds Expended. Except with respect to the redemption or defeasance remedial action, the proceeds of the issue affected by the deliberate action must have been expended before the deliberate action.

B. Alternatives for Remedial Action

1. Redemption or Defeasance of Nonqualified Bonds

a. If there is a transfer exclusively for cash, the requirements are satisfied if the disposition proceeds are used to redeem a pro rataportion of the nonqualified bonds within 90 days of the deliberate action or establish a defeasance escrow within such period. If the deliberate action does not involve a transfer exclusively for cash, funds other than proceeds of a tax-exempt bond must be used to redeem all the nonqualified bonds within 90 days of the deliberate action or a defeasance escrow must be established within such period.

b. If a defeasance escrow is established, the issuer must notify the Internal Revenue Service of the establishment of the defeasance escrow within 90 days of the date the escrow is established.

c. Notwithstanding the foregoing, the establishment of a defeasance escrow will not be considered a remedial action if the period between the issue date and the first call date is more than 10.5 years.

d. The final regulations promulgated in 2015 allow issuers to take anticipatory remedial action. The requirements for redemption or defeasance of the nonqualified bonds within 90 days of the deliberate action are met if the issuer declares its official intent to redeem or defease all of the bonds that would become nonqualified bonds in the event of a subsequent deliberate action that would cause the private business tests or the private loan financing test to be met and redeems or defeases such bonds prior to that deliberate action. The issuer must declare its official intent on or before the date on which it redeems or defeases such bonds, and the declaration of intent must identify the financed property or loan with respect to which the anticipatory remedial action is being taken and describe the deliberate action that potentially may result in the private business tests being met.


2. Alternative Use of Disposition Proceeds. Use of disposition proceeds for an alternative use is a remedial action if all of the following apply:

a. The deliberate action involves a transfer exclusively for cash;

b. The issuer reasonably expects to spend the disposition proceeds within 2 years of the deliberate action;

c. The disposition proceeds are used in a manner that does not cause the issue to meet either the Private Business Tests or the Private Loan Test; and

d. Any disposition proceeds not so used are used for another remedial action.

3. Alternative Use of Facility. Alternative use of a facility is treated as a remedial action if all of the following are met:

a. The facility is used in an alternative manner (i.e., use by a nongovernmental person for a qualifying purpose or use by a section 501(c)(3) organization);

b. The nonqualified bonds are treated as reissued as of the date of deliberate action for purposes of I.R.C. §§ 55-59, 141-147, 149 and 150, and the nonqualified bonds satisfy all the applicable requirements for qualified bonds throughout the remaining term of the nonqualified bonds;

c. The deliberate action does not involve a transfer to a purchaser that finances the acquisition with proceeds of tax-exempt bonds; and

d. Any disposition proceeds other than those arising from an agreement to provide services are used to pay debt service on the bonds on the next debt service payment date or are deposited in a yield restricted escrow within 90 days of receipt to pay debt service on bonds on the next available debt service payment date.

4. Other Remedial Action

a. In General. The Commissioner may provide additional remedial actions.

b. Rev. Proc. 97-15. This procedure establishes an Internal Revenue Service closing agreement program applicable to failures to meet the requirements for excludability of interest from gross income in I.R.C. §§ 141 through 150 that can be remediated under Treas. Reg. §§ 1.141-12, 1.142-2, 1.144-2, 1.145-2 or 1.147-2. The


revenue procedure has no effect on the application of I.R.C. § 150(b) and (c).

c. Payment in Lieu of Taxability. In the case of a closing agreement providing that the interest on the bonds will not be includible in the gross income of bondholders, Rev. Proc. 97-15 requires, among other things, that the issuer agree to redeem the nonqualified bonds on the next redemption date and pay a closing agreement amount equal to an estimate of the federal tax liability that is not required to be paid by holders with respect to interest accruing on the nonqualified bonds, as computed in accordance with Rev. Proc. 97-15.

d. AMT Payments. In the case of a closing agreement providing that the interest on bonds will not be treated as an item of tax preference for purposes of the alternative minimum tax, Rev. Proc. 97-15 requires, among other things, that the issuer pay a closing agreement amount equal to an estimate of the federal tax liability that is not required to be paid by holders because of this treatment, as computed in accordance with the Rev. Proc. 97-15.

e. Voluntary Closing Agreement Program. Violations that cannot be remediated under the existing remedial action procedures described above or other tax-exempt bond closing agreement programs such as the program set forth in Rev. Proc. 97-15 may be resolved by entering into a closing agreement under the Voluntary Closing Agreement Program (VCAP) described in Notice 2008-31. VCAP is not available if the bond issue is under examination.

5. Definition of Nonqualified Bonds. The nonqualified bonds are a portion of the outstanding bonds in an amount that, if the remaining bonds were issued on the date on which the deliberate action occurs, the remaining bonds would not meet the private business use test or private loan financing test, as applicable. The amount of private business use equals the highest percentage of private business use in any one-year period commencing with the deliberate action. Allocations to nonqualified bonds must be made on a pro rata basis, except that for the purposes of the remedial action, the issuer may treat any bonds as the nonqualified bonds so long as (i) the remaining weighted average maturity of the issue, determined as of the date on which the nonqualified bonds are redeemed or defeased (the “Determination Date”), and excluding from the determination the nonqualified bonds redeemed or defeased by the issuer as described above, is not greater than (ii) the remaining weighted average maturity of the issue, determined as of the Determination Date, but without regard to the redemption or defeasance of any bonds (including the nonqualified bonds) occurring on the Determination Date.


VIII. ANTI-ABUSE RULES (Regs. § 1.141-14)

The Regulations state that the Commission has the authority to take action to reflect the substance of the transaction if the issuer enters into one or a series of transactions with a principal purpose of transferring to nongovernmental persons other than the general public significant benefits of the tax-exempt financing in a manner that is inconsistent with the purposes of Section 141 of the Code. This may include treating separate issues as a single issue for purposes of the private activity bond tests, reallocating proceeds to expenditures, property, or bonds, reallocating payments, or adjusting the measurement of private business use. You should familiarize yourself with the examples contained in Treas. Reg. § 1.141-14(b).





• Governmental Bonds (“GBs”) finance facilities to be owned and used by state or local governments

• Tax-exempt unless issuer violates other rules (e.g., arbitrage)• Private Activity Bonds (“PABs”) finance facilities to be used

by private parties• Taxable except for permitted categories

• Any bond issued by a state or local government is a GB unless it is a PAB

Governmental Bonds vs. PABs


• See I.R.C. § 141• A “Private Activity Bond” is a bond that is part of an issue of

which:• A “private business user” uses more than 10% of the proceeds and

pays more than 10% of the debt service (or $15 million, if less)

OR

• A “private loan” is made of more than 5% of the proceeds (or $5,000,000, if less)

Technical Definition of PABs





• Governmental Bonds (“GBs”) finance facilities to be owned and used by state or local governments

• Tax-exempt unless issuer violates other rules (e.g., arbitrage)• Private Activity Bonds (“PABs”) finance facilities to be used

by private parties• Taxable except for permitted categories

• Any bond issued by a state or local government is a GB unless it is a PAB

Governmental Bonds vs. PABs


• See I.R.C. § 141• A “Private Activity Bond” is a bond that is part of an issue of

which:• A “private business user” uses more than 10% of the proceeds and

pays more than 10% of the debt service (or $15 million, if less)

OR

• A “private loan” is made of more than 5% of the proceeds (or $5,000,000, if less)

Technical Definition of PABs


• Private business users include all of the following:• Corporations, partnerships or any other entity engaged in business• Exempt organizations (but I.R.C. § 145 permits Private Activity Bonds

for 501(c)(3) orgs for facilities used in their exempt purposes)• Federal government and federal government agencies• Natural persons engaged in a trade or business

• Special rule for partnerships between governments and nongovernmental persons

Private Business Users


• Defined in Treas. Reg. § 1.141-3(b):

• Private ownership of the financed facility• Lease of the facility to a private business user• Nonqualified management contract (RP 97-13)• Nonqualified “output contract”• Nonqualified research contract (RP 2007-47)• Joint Ventures• Any other comparable “special legal entitlement”• Special economic benefit (in some cases)



• Described in Rev. Proc. 97-13, major modification in Notice 2014-67:

• Contract for the private management of part or all of a bond-financed financed facility

• Exceptions:• “Incidental” services such as janitorial services, equipment repair or hospital billing

billing• Disguised leases

• If the management contract is a “qualified management contract,” it does it does not cause “private business use”

• Medicare Shared Savings Program rule

Management Contract



Contract is “qualified” if it has certain compensation and termination characteristics:

Qualified Management Contracts


• No arrangements for more than 200 days of use (e.g., parking permits)

• Private lease for up to 100 days of use is okay if the facility is not used by the general public on same basis as other users (e.g., prison)

• Private lease for up to 50 days of use at arm’s-length, negotiated rate is okay (e.g., auditorium/convention center)

Exception: General Public Use


• General rule: Look at the average over the life of the facility (or life of the bonds, if shorter) (space-time analysis)

• Special rules for refunding bonds:• Can use combined measurement period with prior issue• Can use new measurement period if prior issue complies with

private business use limitations• See the “Refunding/Reissuance” panel • Other allocations are possible




Contract is “qualified” if it has certain compensation and termination characteristics:

Qualified Management Contracts


• No arrangements for more than 200 days of use (e.g., parking permits)

• Private lease for up to 100 days of use is okay if the facility is not used by the general public on same basis as other users (e.g., prison)

• Private lease for up to 50 days of use at arm’s-length, negotiated rate is okay (e.g., auditorium/convention center)

Exception: General Public Use


• General rule: Look at the average over the life of the facility (or life of the bonds, if shorter) (space-time analysis)

• Special rules for refunding bonds:• Can use combined measurement period with prior issue• Can use new measurement period if prior issue complies with

private business use limitations• See the “Refunding/Reissuance” panel • Other allocations are possible



• Remember: Bonds can be governmental bonds if debt service is paid from public sources

• Public sources of debt service are:• “Generally applicable taxes”• Tax increments or some PILOTs

• Public sources of debt service are not• Private user’s payments for use of facility• Guarantee of taxes by private user

Private Payment/Private Security Test


• For publicly-owned, “essential governmental function”facilities

• Debt service payable from mandatory, “equal basis”assessments against property owners

• Property owner can guarantee the bonds, but there may be no expectation to pay

• Permitted under statutory exception to private loan test

Tax Assessment Bonds


• Reasonable, consistently applied accounting method to track private business use and private payments

• Allocate to “project”• Mixed-use project and “qualified equity”

• Project financed with bonds and another source• Timing rules for “qualified equity”• Allocate private business use first to qualified equity annually

Allocation and Accounting



• Bonds are private activity bonds based on expectations on the date of issuance or subsequent “deliberate action”

• Exceptions to this rule:• “General Obligation” bonds financing at least 25 separate projects,

with total governmental projects in next six months to exceed bond proceeds by 25%

• Sales of equipment/vehicles below 25% of cost

Deliberate Actions


• A change in use is not treated as a “deliberate action” if the issuer takes one of several “remedial actions”

• New rule clarified “anticipatory remedial action”

Change in Use


• Can only take remedial action if:• Reasonable expectations test was met• Maturity of the bonds is not unreasonably long• Fair market value consideration paid• Disposition proceeds are “gross proceeds”

• Types of remedial action:• Redeem or defease “nonqualified bonds”• Alternative use of disposition proceeds• Alternative use of the facility• Other remedial actions (Rev. Proc. 97-15)

Remedial Actions



• Bonds are private activity bonds based on expectations on the date of issuance or subsequent “deliberate action”

• Exceptions to this rule:• “General Obligation” bonds financing at least 25 separate projects,

with total governmental projects in next six months to exceed bond proceeds by 25%

• Sales of equipment/vehicles below 25% of cost

Deliberate Actions


• A change in use is not treated as a “deliberate action” if the issuer takes one of several “remedial actions”

• New rule clarified “anticipatory remedial action”

Change in Use


• Can only take remedial action if:• Reasonable expectations test was met• Maturity of the bonds is not unreasonably long• Fair market value consideration paid• Disposition proceeds are “gross proceeds”

• Types of remedial action:• Redeem or defease “nonqualified bonds”• Alternative use of disposition proceeds• Alternative use of the facility• Other remedial actions (Rev. Proc. 97-15)

Remedial Actions


• Rule: IRS can reallocate payments between sources and uses if issuer uses bonds in a manner that is “inconsistent with the purposes of section 141” (Treas. Reg. § 1.141-14)

• For example, the IRS may claim that an allocation of private business use and other use is not reasonable

Anti-Abuse Rules


• Example 4, Treas. Reg. § 1.141-14(b)• 1997: (1) City issues GO bonds to finance purchase of land; (2)

to corporation. Result: Meets only private business use test• 1998: (1) City issues tax increment bonds to finance public

(2) Corporation guarantees debt service. Result: Meets only private payments test

• Anti-Abuse Rules: 1997 and 1998 bonds treated as a single issue. taxable because, taken together, they meet private business use private payments test

Example of Anti-Abuse Rules






04. Qualified 501(c)(3) Bonds

Faculty:Alison J. Benge Pacifica Law Group LLP – Seattle, WA Stephen E. Weyl Hinckley, Allen & Snyder LLP – Boston, MA Rod Kanter Bradley Arant Boult Cummings LLP – Birmingham, AL

I. BASIC REQUIREMENTS OF SECTION 145.

A. Hybrid Status of 501(c)(3) Bonds. Prior to the 1986 Tax Act, financings for 501(c)(3) entities were treated the same as financings for governmental entities. 501(c)(3) organizations were exempt persons for purposes of the private activity bond test (the “industrial development bond test” prior to the 1986 Act). The 1986 Act removed 501(c)(3) organizations from the exempt entity category and created a new exemption category under Section 145. This category has some features of governmental bonds and some features of private activity bonds – hence the reference to hybrid status.

B. Section 145(a)(1): Ownership requirement. All property to be financed must be owned by a Section 501(c)(3) organization or a governmental unit. Distinguish from 95% use requirement discussed in I.C. below.

(1) What are the requirements to be a Section 501(c)(3) organization?

(a) General Rule:

(i) The organization must:

a) Be organized and operated exclusively for exempt purposes (No Private Benefit);

b) Permit no part of its net earnings to inure to the benefit of any private shareholders or individuals (essentially “insiders” (i.e., those in a position of significant influence or control, such as officers and directors)) or other private parties other than members of charitable classes of persons (No Private Inurement);

c) Not engage in substantial lobbying activity; and

d) Not engage in any political campaign activity.


(b) Evidence of 501(c)(3) status:

(i) A determination letter issued by the IRS in response to the filing of a Form 1023 application; or

(ii) Participation in a group ruling (e.g., many hospitals operated by a Catholic order and certain housing organizations). For organizations created since 1969, filing Form 1023 or similar application for inclusion in a group ruling is a requirement for exempt status.

(c) Private Benefit vs. Private Inurement.

(i) Private Benefit is a broader concept than Private Inurement.

(ii) IRS Regulations prohibit more than an insubstantial part of a Section 501(c)(3) organization’s activities from furthering private interests. This rule applies regardless of the amount of charitable or exempt activities the organization conducts.

a) Private benefit is allowed so long as it is purely “incidental” to the organization’s exempt purpose:

Contrast: Rev. Rul. 70-186 Organization formed to preserve and enhance lake as a public recreational facility funded by lake front property owners, community members and bordering municipalities. Lake is used extensively by public. IRS approved since benefits are primarily aimed at general public with improved public recreational facilities.

Rev. Rul. 75-286 Organization formed to preserve and beautify city block and improve the public facilities located on the block and funded by block parties and member contributions. Membership is limited to residents of block and business owners on the block. IRS did not approve since the primary interest being served is the private interest of the block residents to increase their property value.

b) Benefit need not be a transfer of funds to private interests or payment of excessive or above fair market value payments which is usually the case in private inurement.

c) Benefit does not have to involve parties affiliated with the Section 501(c)(3) organization.

(iii) Initial determination will be made during 1023 application process based on facts presented to IRS but initial determination does not guarantee that private benefit will not occur once the organization is actually operating. Even though stated purposes in organizational documents evidence primarily public benefit, need to look at actual activities and actual beneficiaries as well as any changes in purposes.


(d) Due diligence and reliance on opinions of 501(c)(3) counsel.

(i) What should you review?

Examples: 1023 application; IRS Form 990 (annual information return) and 990-T (exempt organization business income tax return); corporate minutes; agreements between organization and employees, directors or interested parties.

(ii) What opinion should you (i) require of Section 501(c)(3) organization’s counsel if you’re bond counsel/underwriter counsel or (ii) be willing to give if you’re Section 501(c)(3) counsel?

a) 501(c)(3) opinion based solely on IRS determination letter.

b) 501(c)(3) opinion based on IRS determination letter plus due diligence and nothing has come to counsel’s attention that would cause counsel to believe that IRS will revoke determination letter.

c) 501(c)(3) opinion stating that as a matter of fact entity is an organization described under Section 501(c)(3) of the Code.

See NABL Paper: “The 501(c)(3) Opinion in Qualified 501(c)(3) Bond Transactions” (2014).

(2) Who or what really “owns” the bond-financed property?

(a) Partnerships, joint ventures and limited liability companies present special issues.

(i) Separate entities from their members, partners, joint venturers

a) Partnerships cannot be Section 501(c)(3) organizations even if all of their partners are Section 501(c)(3) organizations.

b) The IRS has stated in several private letter rulings that joint ventures or “joint operating agreements” may create a partnership for purposes of the Code and result in the “deemed” creation of a separate entity.

(ii) “Look through” treatment

a) Private letter rulings have applied an “aggregate” approach to joint venture/partnerships consisting exclusively of Section 501(c)(3) organizations to allow a “look through” for purposes of testing private business use and unrelated trade or business use by a Section 501(c)(3) organization. The IRS has not yet ruled on a fact pattern involving ownership.

b) Private letter rulings have also given “look through” treatment to LLCs with two 501(c)(3) participants because the Code would treat them as a partnership.


i) Single member LLCs with a 501(c)(3) member were not addressed by the PLR but under the Code, the default classification would disregard the LLC as an entity separate from its single member. Statements in IRS CPE Material (Chapter E) indicate that an LLC with a single 501(c)(3) member should be treated as a 501(c)(3).

c) Final Treasury Regulations on private use analysis now treat a partnership as an aggregate of its partners, rather than as an entity. The new definition applies for private use analysis and for the ownership test for 501(c)(3) financings.

C. Section 145(a)(2): Use Requirement.

(1) At least 95% of net proceeds (i.e., net of debt service reserve fund but including certain earnings on the investment of bond proceeds) must be used only by Section 501(c)(3) organizations engaged in exempt activities, or by states or local governmental units. Use by the federal government is not a “good” use as the federal government is considered a private party for this purpose.

(a) Use of property equals use of proceeds. Multiple uses of the same property must be allocated.

(b) Costs of issuance count against the 5% “bad money” limitation. See Treasury Regulations Section 1.145-2(c)(2); costs of issuance may not exceed 2% of the bond proceeds.

(2) Use by a Section 501(c)(3) organization engaged in an “unrelated trade or business” (without regard to whether the Unrelated Business Income Tax (“UBIT”) tax applies) is not a “good” use, so it counts towards the 5% “bad money” limitation together with other private use.

(a) An activity will be characterized as an “unrelated trade or business” if it is:

(i) A trade or business;

(ii) Regularly carried on; and

(iii) There is no substantial causal relationship to furthering the organization’s exempt purposes (merely raising income to support exempt purposes is not a substantial causal relationship).

See Section 513(a) of the Code.

(b) “Unrelated trade or business” does not include:

(i) Activities conducted by the organization primarily for the convenience of the organization’s members, students, patients, officers or employees (e.g., certain hospital gift shops, cafeterias, campus bookstores).


(ii) Activities in which substantially all the work in carrying on the trade or business is performed for the organization without compensation.

(iii) The selling of merchandise, substantially all of which has been received by the organization as gifts or contributions.

(c) Common unrelated trade or business activities that may arise in a bond transaction include:

(i) Hospital lab work or pharmacy sales to persons who are neither patients nor employees of the hospital. Rev. Rul. 85-110, 1985-2 C.B. 166; Rev. Rul. 68-374, 1968-2 C.B. 242; Rev. Rul. 68-375, 1968-2 C.B. 245; Rev. Rul. 68-376, 1968-2 C.B. 246.

(ii) Providing administrative or other support services to Section 501(c)(3) organizations (B.S.W. Group, Inc. v. Comm’r, 70 T.C. 352 (1978); Rev. Rul. 69-528, 1968-2 C.B. 127) or to for-profit affiliates is a business activity and not an exempt purpose for a 501(c)(3) organization.

(iii) Rental of museum or school or other 501(c)(3) entity facilities after hours or during non-use by the 501(c)(3) for private events. PLR 9702003.

(iv) Operation of a parking lot open to the public or open during hours that the exempt organization is closed. Rev. Rul. 69-269, 1969-1 C.B. 160.

(3) Just as with ownership, joint ventures raise private use issues. See I(B)(2)(a) above.

(4) Common types of “use” include leases (note that both lessee and lessor are users), management contracts, “other” service agreements, and cooperative research agreements.

(5) The regulations on private activity bonds and Revenue Procedures 97-13, as amplified by IRS Notice 2014-67 (relating to management contracts) and 97-14, as modified and superseded by Revenue Procedure 2007-47 (relating to research agreements), provide safe harbors for service and other management contacts and research agreements.

(a) Management Contracts: Under the Treasury Regulations, a management contract is a management, service, or incentive payment contract between the exempt person and a service provider under which the service provider provides services involving all, a portion of, or any function of, a facility. § 1.141-3(b)(4). A management contract does not include a contract for services solely incidental to the primary functions of a financed facility (e.g.,janitorial, office equipment repair, hospital billing, or similar services), the mere granting of admitting privileges by a hospital to a doctor, or a contract to provide for services if the only compensation is the reimbursement of the service provider for actual and direct expenses paid to unrelated third parties.


In addition, although structured as a management contract, an arrangement may also be characterized as a lease under federal income tax principles, and thus would result in private use regardless of the form of compensation.

(i) Safe Harbors: Generally, a management contract will not result in private use if it meets certain term and termination limits, based on the form of compensation chosen. A management contract will result in private use if compensation is based, in whole or in part, on a share of net profits from the operation of the facility. Rev. Proc. 97-13 sets forth safe harbors where private use will not be found.

(ii) Under Rev. Proc. 97-13, in order to meet the safe harbors, the service provider must not be in a position to substantially limit the borrower’s ability to exercise its rights under the contract because of its role or relationship with the borrower. A provision in the Rev. Proc. establishes that there is no such substantial limitation if (1) the service provider and its officers and directors do not have more than 20% of the voting power of the governing body of the exempt person, (2) overlapping board members do not include the CEOs, and (3) the service provider and the exempt person are not related parties.

(iii) Compensation must be reasonable and must not be based on a percentage of net profit. The following are not considered arrangements based on net profit: (1) a percentage of gross revenues or a percentage of expenses, but not both; (2) a capitation fee (a fixed fee per person, regardless of services performed); or (3) a per-unit fee (a fixed fee based on the service provided). In addition, (1) a one-time productivity award based on increases or decreases in gross revenues or total expenses (but not both) or (2) a productivity award based on the quality of the services provided under the management contract, rather than increases in revenues or decreases in expenses of the facility if amount of the productivity award is a stated dollar amount, a periodic fixed fee, or a tiered system of stated dollar amounts or periodic fixed fees based solely on the level of performance achieved with respect to the applicable measure does not cause compensation to be treated as based on a percentage of net income.

(iv) Length of contract term depends on the type of compensation. Longer term contracts are permitted where the relative portion of fixed compensation is increased: generally, if compensation is (1) 95% fixed, the term can be up to 15 years (or 80% of useful life, if shorter); (2) 80% fixed, up to 10 years (or 80% of useful life, if shorter); (3) 50% fixed fee, or all based on a capitation fee, or a combination of capitation fee and fixed fee, up to 5 years, as long as the exempt user has the right to cancel without penalty or cause at the end of the third year; (4) all based on per-unit fee, or a combination of fixed fee and per-unit fee, up to 3 years, as long as the exempt user has the right to cancel without penalty or cause at the end of the second year; and (5) all based on a percentage of fees charged or a combination of a per-unit fee and a percentage of revenue or expense fee, up to 2 years, as


long as the exempt user has the right to cancel without penalty or cause at the end of the first year. Under IRS Notice 2014-67 if the compensation for services is based on a stated amount; periodic fixed fee; a capitation fee; a per-unit fee; or a combination of the preceding or a percentage of gross revenues, adjusted gross revenues, or expenses of the facility (but not both revenues and expenses) the term can be up to 5 years. Such contract need not be terminable by the qualified user prior to the end of the term.

(v) Renewal options solely in the hands of the exempt user are not counted in determining the term of the contract. Additionally, automatic renewal provisions subject to cancellation by either party are also not counted. Other renewal options count toward the maximum term of the contract.

(vi) Reimbursement of the service provider for actual and direct expenses paid by the service provider to unrelated third parties is not by itself treated as compensation. How should expenses (i.e., salary and benefits) of service provider’s employees be treated? Consider PLR 200205009.

(b) Cooperative Research Agreements: Governed by Rev. Proc. 2007-47 (formerly Rev. Proc. 97-14). The issue is whether the business (or federal governmental) entity that provides the funding for (i.e., sponsors) the research gets particular benefits from the research. This is an issue primarily for universities and specialty healthcare facilities such as cancer centers.

(6) What happens if use of bond-financed facilities changes from a “good” use to a “bad” use after bonds are issued?

(a) The borrower must have the reasonable expectation at the issue date that the facilities won’t have 5% or more “bad” use. After issuance, if the borrower takes a deliberate action that results in 5% or more “bad” use, then the bonds cease to be qualified 501(c)(3) bonds.

(b) “Use” is generally measured over time on an average annual basis under Treasury Regulations Section 1.141-3(g).

(c) Under Treasury Regulations Section 1.141-6, effective January 24, 2016, any “bad” use of a facility may be allocated first to qualified equity and then any remaining “bad’ use is allocated to bond proceeds. Qualified equity means proceeds of bonds that are not tax-advantaged bonds and funds that are not derived from proceeds of a borrowing that are spent on the same project as the bonds, under the same plan of financing.

(d) If the measurement and allocation rules do not provide relief, Treasury Regulations Sections 1.141-2, 1.141-12, and 1.145-2 provide that, so long as certain remedial actions are taken, change in use of a bond-financed facility from a qualifying use to a non-qualifying use will not cause interest on the bonds to become taxable.


(e) Generally, under Treasury Regulations Section 1.141-12, remedial actions include (1) prompt redemption of the “non-qualified bonds” following the change in use, (2) allocation of the proceeds of an asset disposition giving rise to the change in use to new 501(c)(3) assets and (3) tracing the disposed asset to a new, qualifying use. Additional language added to 1.141-12 allows issuers to take anticipatory remedial action if they anticipate a deliberate action (such as a sale of bond-financed property) will result in nonqualified use of the property. For certain remedial actions, it may be necessary to treat some or all of the bonds as reissued for tax purposes and, as a result, it may be necessary to undertake steps including, for example, a new TEFRA approval.

II. $150 MILLION LIMIT

A. The rule – Section 145(b)(1): A bond, other than a qualified hospital bond (Note – See Part E for a description of what constitutes a “hospital”), will not be treated as a qualified 501(c)(3) bond if the aggregate amount of the bond allocated to a Section 501(c)(3) organization during the test period, plus the aggregate amount of all other non-hospital bonds allocated to that organization, exceeds $150 million. This rule was imposed as part of the Tax Reform Act of 1986.

B. In 1997, Congress partially repealed the $150 million limitation. The Taxpayer Relief Act of 1997 added Section 145(b)(5), which provides that the $150 million limit does not apply to a qualified 501(c)(3) bond issued after August 5, 1997, if at least 95% of the net proceeds are used to finance capital expenditures incurred after August 5, 1997. Section 145(b)(5) does not explicitly refer to refundings of new money issues that were not subject to the $150 million limit by reason of Section 145(b)(5), but most practitioners take the position that the repeal also applies to such refundings.

C. Bonds to which the $150 million limit does not apply are not taken into account in applying the $150 million limit to other bonds.

D. The $150 million limit will continue to govern issuance of other non-hospital bonds (e.g., refunding bonds with respect to capital expenditures incurred before August 6, 1997, new money bonds for capital expenditures incurred before that date or new money bonds where less than 95% of net proceeds are spent on capital expenditures).

(1) For example, the $150 million limit may still apply to a new money financing where post-construction period interest and other working capital costs are financed with more than 5% of net proceeds.

(2) Qualified 501(c)(3) bonds are allocated to “test period beneficiaries.” A “test period beneficiary” is any organization that is an owner of the financed property, or a user of more than 10% of the financed property during the “test period.” Section 145(b)(4); Section 144(a)(10)(D).

(3) The test period ends three years after the later of the date the bonds were issued or the date the bond-financed property is placed in service.


(4) Once bonds are allocated to a test-period beneficiary, they remain so allocated until the bonds are actually retired.

E. Section 145(c): A qualified hospital bond is a bond at least 95% of the proceeds of which are used with respect to a “hospital”.

(1) The term “hospital” includes a facility that primarily provides to inpatients diagnostic and therapeutic services or treatments by or under the care of physicians.

(2) The facility must be accredited by the Joint Commission on Accreditation of Healthcare Organizations (JCAHO), the American Osteopathic Association, or a governmental program recognized by the Secretary of Health and Human Services.

(3) The facility must require that every patient be under the care and supervision of a physician, and must provide 24-hour nursing services.

(4) The term “hospital” does not include nursing homes, day care centers, medical school facilities, research laboratories, or most free-standing ambulatory care centers (unless they are totally integrated with and assist the in-patient hospital).

III. ADDITIONAL REQUIREMENTS FOR RESIDENTIAL RENTAL HOUSING

A. Section 145(d) (sometimes referred to as the “Donnelly Amendment”) denies qualified 501(c)(3) bond treatment to any issue if any portion is used to directly or indirectly provide “residential rental property for family units.” The basic policy of this provision is to minimize the likelihood that non-profits will enter into direct competition in the traditional rental housing market with for-profit housing developers. Section 145(d) provides exceptions to the foregoing rule if

(1) The bonds finance new residential rental property (first use of property is pursuant to such issue);

(2) The bonds finance qualified residential rental property as defined in Section 142(d) (requires meeting certain low income set aside minimums); or

(3) The bonds finance property that will be substantially rehabilitated (generally, rehabilitation expenditures at least equal adjusted basis of building) within a 2-year period beginning 1 year after the date of acquisition of such property.

B. What is residential rental property?

(1) Residential rental property for family units consists of housing units that are not used on a transient basis and provide complete facilities for living, sleeping, eating, cooking, and sanitation. This description might include certain assisted living facilities.

(2) In September 1998, the IRS issued Revenue Ruling 98-47 in which it analyzed whether three buildings in an integrated assisted living complex constituted


residential rental property for purposes of Sections 142(d) and 145(d). The Revenue Ruling seems to suggest a two tier test:

(a) Is all or any part of the facility comprised of complete living units? If no (e.g., a nursing home), then not residential rental property. If yes, then you must answer the next question to determine if the facility is residential rental property.

(b) If the facility is comprised of complete living units, does the facility make available continual or frequent nursing, medical, or psychiatric services. If yes, then it is not residential rental property.

IV. OTHER TAX REQUIREMENTS

A. As with all tax-exempt bonds, qualified 501(c)(3) bonds must:

(1) Comply with the Section 148 arbitrage and rebate requirements. Two issues that arise frequently for qualified 501(c)(3) bonds are:

(a) Reimbursement generally

(i) “Official intent” requirement

(ii) Time periods

a) expenditures paid no earlier than 60 days prior to date of official intent

b) bonds issued (reimbursement allocation made) no later than 18 months after later of date expenditure is paid or date project is placed in service and no later than three years after date expenditure is paid.

(iii) exception for “preliminary expenditures” (i.e., soft costs such as architectural, engineering, feasibility and legal expenses relating to the project to be financed regardless of when incurred).

(b) Replacement proceeds – if funds have a sufficiently direct nexus to the bond issue or to the governmental purpose of the issue to conclude that the amounts would have been used for the governmental purpose if the proceeds of the issue were not used or to be used.

(i) Endowment funds

(ii) Fundraising campaigns

(iii) Pledged funds

(iv) Negative pledges – potential issues when reviewing financial covenants requested by bond insurers or banks, e.g.. calculation of days cash on hand or other liquidity measures more frequently than semi-annually.


Note: For a discussion of the application of the replacement proceeds rules to nonprofit hospitals and to colleges and universities, see the reports of the Congressional Budget Office dated December 2006, entitled “Nonprofit Hospitals and Tax Arbitrage” and dated April 2010 entitled “Tax Arbitrage by Colleges and Universities,” respectively.

(2) Be issued in registered form. Section 149(a).

(3) Not be federally guaranteed. Section 149(b).

(4) Not be hedge bonds. A bond is not a hedge bond if the issuer reasonably expects that at least 85% of the net sale proceeds will be used to carry out the governmental purposes of the bond (including the use of proceeds by the 501(c)(3) borrower) within 3 years of the issue date, and not more than 50% of the proceeds of the bond, if any, are invested in investments having a substantially guaranteed yield for 4 or more years. Section 149(e).

(5) Reported by timely filing of IRS Form 8038. Section 149(g).

B. As a type of private activity bond, qualified 501(c)(3) bonds must comply with:

(1) Section 147(b) maturity limits (120% of average remaining useful life of facilities financed).

(2) Section 147(e) prohibitions against financing airplanes, skyboxes, gambling facilities, and liquor stores. Section 147(e) also generally prohibits the financing of health club facilities with private activity bonds, but Section 147(h)(2) excludes qualified 501(c)(3) bonds from this prohibition.

(3) Section 147(f) notice and public approval requirements (a/k/a “TEFRA” requirements).

(4) Section 147(g) limit on costs of issuance (“2% rule”).

C. Qualified 501(c)(3) bonds may be advance refunded one time (unless the bond being refunded is a pre-1986 bond, or is a refunding bond that refunded a pre-1986 bond). Section 149(d).

D. Interest on qualified 501(c)(3) bonds is not subject to the alternative minimum tax on individuals.

E. “Acquisition financing” vs. “refunding”

(1) Certain transactions involving both the repayment of a prior issue and a transfer of interests in the assets securing such issue will be treated as a sale of the assets rather than as a refunding for federal tax purposes, although not necessarily for state law purposes.


(2) Characterization of a financing as one or the other may be critical. See definitions of “refunding issue” and “controlled group” in Section 1.150-1(d) and (e) of the regulations.

(3) Important distinction for various purposes, including (i) determination of permitted escrow yield, (ii) number of permitted advance refundings, and (iii) carryover of favorable treatment for refunding bonds.

V. “BANK QUALIFIED” STATUS

A. Bonds issued to provide financing for a 501(c)(3) entity may be eligible for “bank qualified” status under Section 265 of the IRC, but the status is based on the eligibility of the governmental issuer of the bonds. The governmental issuer must not anticipate selling more than $10,000,000 in tax-exempt bonds during the calendar year and must designate the bonds as “bank qualified.”

B. Under the American Recovery and Reinvestment Act of 2009 (the “Stimulus Act”), 501(c)(3) entities were allowed special treatment under the “bank qualified” status rules of Section 265 of the IRC. Basically, each 501(c)(3) entity was allowed its own $30 million per year exemption. This raised difficult questions about the treatment of related 501(c)(3) entities.

The Stimulus Act provisions expired December 31, 2010. Special treatment under Section 265 is no longer available, and a refunding or reissuance of any 501(c)(3) debt that received special treatment may result in a loss of Section 265 bank qualified status.

VI. FINANCING STRUCTURES FOR 501(c)(3) BONDS

A. Master Indenture financing structures – Used by many healthcare systems. It attempts to “pool” the credit of multiple nonprofit operating and other entities (e.g., a related foundation) known as an “obligated group” that are under common control.

(1) Master Indenture can consolidate all financial covenants into a single document that is then used for each bond issue.

(a) Financial and other covenants may provide the security necessary to market the bonds to potential buyers. Examples of common covenants are restrictions on incurring additional debt unless minimum debt service coverage ratios are met, restrictions on transferring property outside of the obligated group, restrictions on placing liens on certain property, restrictions on mergers and acquisitions, etc.

(b) Benefits:

(i) Provides single set of financial covenants; no need to renegotiate for each succeeding bond issue. (Not always the result as bond insurers or bank purchasers may require additional covenants or what the “market” will require from a particular credit may change.)


(ii) By “pooling” the entities into a single credit, there is the potential for increasing the credit worthiness of the group as a whole and decreasing borrowing costs for those entities with lesser credit attributes.

(2) The Master Indenture also operates as an intercreditor agreement, allowing various creditors secured by the Master Indenture to share on a pro rata basis in collateral subject to the Master Indenture (e.g., revenues or mortgaged facilities). This avoids relegating future creditors to subordinate or junior lien status, although additional security may be given in specific transactions outside of the Master Indenture and limited to the specific creditor(s).

(3) Obligated Groups vs. Restricted Groups.

(a) Each member of the Obligated Group is jointly and severally liable for debt issued under the Master Indenture and a party to the Master Indenture.

(b) Restricted Group usually has a single party to the Master Indenture. Other members of the Restricted Group are brought in through provisions of the corporate formation documents and/or contribution agreements by which they agree to provide funds to pay debt service on indebtedness secured by the Master Indenture.

(4) Issues raised by Master Indenture structure.

(a) Fraudulent conveyance/bankruptcy issues – if one group member must pay debt service on indebtedness from which it received no benefit, transfer may be voidable under bankruptcy law or treated as a fraudulent conveyance.

(b) Violation of “public charity” doctrines – Possibility of reluctance of court to enforce joint and several obligation if the corporation is not able to carry out its charitable purposes or if it is insolvent because it was forced to pay debt service for another member’s debt.

B. “Corporate Style” Master Indentures. Limited financial covenants and remaining covenants are tested based on the financials of the “System” (i.e. all of the entities that are controlled directly or indirectly by the primary borrower).

C. Financing of facilities with capital fundraising pledges. A 501(c)(3) organization may wish to finance a facility (for example, a museum) that will be paid for in part by pledges to be realized over time from a related capital fundraising campaign and in part through the issuance of tax-exempt bonds. The proceeds of those pledges may constitute replacement proceeds. The actual amount of pledges to be received, and the timing of those receipts, may make it difficult to size a tax-exempt bond issue for the facility. If bonds are issued in anticipation of the pledges to be received, overissuance concerns and sinking fund concerns may be avoided by having bonds redeemed periodically (for example, annually) with pledges in excess of the amount necessary to pay the required annual maturity of bonds. Alternatively, one or more additional series of bonds may be short-term in nature, reflecting the expected fund raising. Note that fundraising that is for a 501(c)(3)’s general purposes, as opposed to


being dedicated to the specific project(s), will not constitute replacement proceeds, even if used by the 501(c)(3) for the specific project(s).

VII. FINANCING SCHOOLS SPONSORED BY OR AFFILIATED WITH RELIGIOUS ORGANIZATIONS

A. The issuance of municipal bonds for the benefit of a school sponsored by or affiliated with a religious organization raises interesting issues under the federal Establishment Clause and similar provisions in state constitutions. Fundamentally, these are not federal tax law issues but are matters of constitutional law that implicate the validity of the bonds to be issued. The primary question is whether the conduit issuer is acting “ultra vires” by purporting to issue indebtedness that does not withstand Establishment Clause scrutiny. In recent years, these issues have become more acute because an increasing number of colleges, universities, secondary and primary schools with religious affiliations have looked to the potential use of tax-exempt bonds to obtain a lower cost-of-borrowing for their capital expenditures. The primary question with which practitioners must grapple is whether the entity in question provides a curriculum which is secular in nature. Even where that is the case, certain facilities (e.g., a sectarian chapel or an on-campus monastery) will not qualify for financing through the use of tax-exempt bonds). In addition, certain ancillary uses by a sectarian education institution, such as allowing a parking lot to be used by a neighboring church, can raise issues about financing that ancillary facility with tax-exempt bonds.

The following are citations for the leading United States Supreme Court cases dealing with, or having a bearing on, the issues related to the use of tax-exempt bonds and other governmental support by sectarian institutions of learning:

Lemon v. Kurtzman, 403 U.S. 602 (1971)

Tilton v. Richardson, 403 U.S. 672 (1971)

Hunt v. McNair, 413 U.S. 734 (1973)

Committee for Public Education v. Nyquist, 413 U.S. 756 (1973)

Roemer v. Board of Public Works of Maryland, 426 U.S. 736 (1976)

Zobrest v. Catalina Foothills School District, 509 U.S. 1 (1993)

Agostini v. Felton, 521 U.S. 203 (1997)

Mitchell v. Helms, 530 U.S. 793 (2000)



04. QUALIFIED 501(C)(3) BONDS


What are Qualified 501(c)(3) Bonds?

• Qualified 501(c)(3) Bonds are issued by a state or local government and the proceeds are used by a Section 501(c)(3) organization in furtherance of its exempt purpose.

• Qualified 501(c)(3) bonds are a special category of tax-exempt qualified private activity bonds issued under Section 145 of the Code.


Determining 501(c)(3) Status• What are the requirements to be a Section 501(c)(3) organization?

• General Rule:• - Organized and operated exclusively for exempt purposes (“No private benefit”)• - No part of the organization’s net earnings may inure to or for the benefit of any

private shareholders or individuals (“No private inurement”)• - Not engaged in substantial lobbying activity• - Not engaged in political campaign activity

• Evidence of 501(c)(3) status• - IRS Determination Letter• - Group Ruling Letter

• Typical 501(c)(3) organizations -- hospitals, colleges and universities, independent schools, museums, social service organizations, nursing homes and senior living facilities



Private Benefit vs. Private Inurement

• Who receives benefits?• Private inurement involves “insiders” (e.g., officers, directors, founders of

the 501(c)(3) organization)• Example – excessive compensation to CEO or loans for the personal benefit of a

board member and his/her family• Note, however, that transactions between a Section 501(c)(3) organization and those

who are “insiders” are allowed if transaction passes certain standards of reasonableness

• Private benefit involves benefits to anyone other than the target group (the “charitable class”) of the 501(c)(3) exempt purpose

• A de minimus amount of private benefit is allowed so long as it is purely “incidental” to the 501(c)(3) organization’s exempt purpose


Due Diligence and 501(c)(3) Opinions• Items to review to diligence 501(c)(3) status

• 1023 application (if available)• Determination letter• IRS Form 990 and 990-T

• Schedule K re tax-exempt bonds• Organizational documents (e.g., articles of agreement)• Corporate minutes• Agreements with employees, directors, etc.


Due Diligence and 501(c)(3) Opinions

• 501(c)(3) Counsel Opinion • Reliance on IRS Determination Letter• Borrower’s counsel should perform a “due inquiry”-- has there been anything since the 1023 application

that might jeopardize the 501(c)(3) status?• What are you willing to give as 501(c)(3) counsel and what must you see as bond counsel or underwriter’s counsel?



Private Benefit vs. Private Inurement

• Who receives benefits?• Private inurement involves “insiders” (e.g., officers, directors, founders of

the 501(c)(3) organization)• Example – excessive compensation to CEO or loans for the personal benefit of a

board member and his/her family• Note, however, that transactions between a Section 501(c)(3) organization and those

who are “insiders” are allowed if transaction passes certain standards of reasonableness

• Private benefit involves benefits to anyone other than the target group (the “charitable class”) of the 501(c)(3) exempt purpose

• A de minimus amount of private benefit is allowed so long as it is purely “incidental” to the 501(c)(3) organization’s exempt purpose


Due Diligence and 501(c)(3) Opinions• Items to review to diligence 501(c)(3) status

• 1023 application (if available)• Determination letter• IRS Form 990 and 990-T

• Schedule K re tax-exempt bonds• Organizational documents (e.g., articles of agreement)• Corporate minutes• Agreements with employees, directors, etc.


Due Diligence and 501(c)(3) Opinions

• 501(c)(3) Counsel Opinion • Reliance on IRS Determination Letter• Borrower’s counsel should perform a “due inquiry”-- has there been anything since the 1023 application

that might jeopardize the 501(c)(3) status?• What are you willing to give as 501(c)(3) counsel and what must you see as bond counsel or underwriter’s counsel?


Hybrid Status

• Before 1986 Tax Act, 501(c)(3) organizations were treated as exempt entities, like governmental entities

• Now a special category for tax-exempt status, with some features like governmental bonds and some features like private activity bonds


Basic Requirements of Section 145

• Section 145(a)(1) - Ownership Requirement• All property financed by the net proceeds of a qualified 501(c)(3) bond

issue must be owned by a 501(c)(3) organization or a state or local government throughout the term of the bonds.

• Section 145(a)(2) - Use Requirement• At least 95% of net proceeds of bonds must be used by (i) a 501(c)(3)

organization engaged in exempt activities or (ii) a state or local governmental unit.


Ownership Requirement

• What entity owns the property?• Non-profit corporation• Limited liability company • Joint venture • Partnership

• Legal title vs. ownership for tax purposes



Use Requirement

• 95% of net proceeds of the bonds must be used for “good” use

• Use of property = use of proceeds• Net proceeds

• Net of DSRF• Include investment earnings

• “Soft costs” included in financing• Costs of issuance - not treated as a “good” use; 501(c)(3) bonds are

treated differently than other tax-exempt bonds• Qualified guarantee fees (bond insurance, LOC fees) and qualified

hedge fees - allocated based on other uses of the proceeds


Use Requirement

• Use by a 501(c)(3) organization in an “unrelated trade or business” is not “good” use.

• Unrelated trade or business (Section 513(a) of the Code) is:• - any trade or business • - regularly carried on• - no substantial causal relationship • to furthering the exempt purpose


Use Requirement

• Types of use• Ownership• Leases - both lessor and lessee are users• Management contracts• Research contracts• Other actual or beneficial use



Use Requirement

• 95% of net proceeds of the bonds must be used for “good” use

• Use of property = use of proceeds• Net proceeds

• Net of DSRF• Include investment earnings

• “Soft costs” included in financing• Costs of issuance - not treated as a “good” use; 501(c)(3) bonds are

treated differently than other tax-exempt bonds• Qualified guarantee fees (bond insurance, LOC fees) and qualified

hedge fees - allocated based on other uses of the proceeds


Use Requirement

• Use by a 501(c)(3) organization in an “unrelated trade or business” is not “good” use.

• Unrelated trade or business (Section 513(a) of the Code) is:• - any trade or business • - regularly carried on• - no substantial causal relationship • to furthering the exempt purpose


Use Requirement

• Types of use• Ownership• Leases - both lessor and lessee are users• Management contracts• Research contracts• Other actual or beneficial use


$150 Million Limit on Non-hospital Bonds

• 501(c)(3) organization cannot have more that $150 million of “non-hospital” bonds allocated to it

• Examples of “non-hospital” facilities include educational, cultural and social service facilities, as well as nursing homes, day care centers, medical school facilities, research labs, and urgent care facilities.

• Amended on 8/5/97 • Most new money bonds will not be subject to limitation• Still may need to address limitation for refunding bonds and some new

money deals with non-capital expenditures exceeding 5%


Residential Rental Housing• 501(c)(3) bonds may not finance “residential rental property for

family units” unless:• Bonds finance new residential rental property (first use rule)• Bonds finance “qualified” residential rental property (Sect. 142(d))

• Requires meeting certain low-income set –aside minimums• Bonds finance property that will be

substantially rehabilitated within a 2 year period beginning 1 year afterthe date of acquisition of such property


Residential Rental Housing

• What is “residential rental property”?• Housing units not used on transient basis and provide complete facilities

for living, sleeping, eating, cooking and sanitation• Rev. Rul. 98-47 - How do you treat facilities providing different levels of

service?• Is all or any part of the facility comprised of complete living units?

• Yes – go to step 2• No – the facilities are NOT residential rental property

• If so, does the facility make available continual or frequent nursing, medical or psychiatric services?

• Yes – the facilities are NOT residential rental property• No – the facility is residential rental property



Other Tax Requirements

• Section 147(b) – average maturity of qualified 501(c)(3) bonds cannot exceed 120% of the average reasonably expected economic life of the property financed or refinanced with the proceeds of the bond issue

• Section 147(e) – no skyboxes, airplanes, gambling facilities and liquor stores (but health club facilities are allowed for qualified 501(c)(3) bonds)

• Section 147(f) - TEFRA hearing and approval• Section 147(g) - 2% limit on cost of issuance • Section 148 - arbitrage/rebate/refunding restrictions • Section 149(a) - registered form• Section 149(b) - no federal guarantee• Section 149(e) - no hedge bonds • Section 149(g) – timely file form 8038


Other Tax Requirements• A 501(c)(3) organization may spend money on a project in

anticipation of a qualified 501(c)(3) bond issuance and then wish to reimburse itself from bond proceeds for these expenditures when the bonds are issued

• Reimbursement issues (Treasury Regulations Section 1.150-2; see also Section 148) –

• Declaration of “official intent” within 60 days after the payment of the original expenditures to be reimbursed

• Can be by 501(c)(3) entity, rather than issuer of bonds• Time periods covered:

• Reimbursement must be made not later than 18 months after the later of:• The date the original expenditure is paid OR• The date that the financed project is placed in service or abandoned

• BUT in no event later than 3 years after the date of the original expenditure• “Preliminary expenditures” exception to official intent• “De minimus” exception to official intent



• Section 148 arbitrage and rebate requirements• Arbitrage restrictions on earnings above the bond yield apply to

gross proceeds, which include replacement proceeds• Replacement proceeds

• Endowment funds • Fundraising campaigns • Pledged funds• Negative pledges




• Section 147(b) – average maturity of qualified 501(c)(3) bonds cannot exceed 120% of the average reasonably expected economic life of the property financed or refinanced with the proceeds of the bond issue

• Section 147(e) – no skyboxes, airplanes, gambling facilities and liquor stores (but health club facilities are allowed for qualified 501(c)(3) bonds)

• Section 147(f) - TEFRA hearing and approval• Section 147(g) - 2% limit on cost of issuance • Section 148 - arbitrage/rebate/refunding restrictions • Section 149(a) - registered form• Section 149(b) - no federal guarantee• Section 149(e) - no hedge bonds • Section 149(g) – timely file form 8038


Other Tax Requirements• A 501(c)(3) organization may spend money on a project in

anticipation of a qualified 501(c)(3) bond issuance and then wish to reimburse itself from bond proceeds for these expenditures when the bonds are issued

• Reimbursement issues (Treasury Regulations Section 1.150-2; see also Section 148) –

• Declaration of “official intent” within 60 days after the payment of the original expenditures to be reimbursed

• Can be by 501(c)(3) entity, rather than issuer of bonds• Time periods covered:

• Reimbursement must be made not later than 18 months after the later of:• The date the original expenditure is paid OR• The date that the financed project is placed in service or abandoned

• BUT in no event later than 3 years after the date of the original expenditure• “Preliminary expenditures” exception to official intent• “De minimus” exception to official intent



• Section 148 arbitrage and rebate requirements• Arbitrage restrictions on earnings above the bond yield apply to

gross proceeds, which include replacement proceeds• Replacement proceeds

• Endowment funds • Fundraising campaigns • Pledged funds• Negative pledges



• Refunding restrictions of Section 148 apply• “Acquisition financing” vs. “refunding” characterization may be

critical, e.g.:• Limitation of advance refundings• Escrow yield• Carryover treatment of favorable tax laws

• Section 1.150-1(d) & (e) define “refunding issue” and “controlled group”


Common Financing Structures

• Master Trust Indenture• Designed to pool credit of multiple 501(c)(3) organizations• Consolidates financial covenants • Obligated Group vs. Restricted Group

• “Corporate” style Master Indenture• Financing of facilities with capital fundraising pledges.

• Replacement proceed issues arise


Financing Religiously Affiliated Facilities

• Establishment Clause – part of 1st Amendment• prohibits the government from making any law “respecting an

establishment of religion”• Potential violation of Establishment Clause of US

Constitution and similar provisions in state constitutions• Tax-exempt bonds bestow benefit on entity sponsored by or

affiliated with religious organization• Primarily a “validity” issue, not a tax issue



Financing Religiously Affiliated Facilities

• Lemon v. Kurtzman, 403 U.S. 602 (1971)• U.S. Supreme Court identified three main evils –

• (i) sponsorship, • (ii) financial support and • (iii) active involvement of the government • in religious activity

• To pass the “Lemon Test”:• the statute must have a secular purpose;• its principal/primary effect must be one that neither advances nor inhibits religion; and• the statute must not foster an excessive government entanglement with religion

• Additional cases are in the materials




05. Qualified Small Issue & Exempt Facility Bonds

Faculty:Christopher B. Langhart McManimon, Scotland & Baumann, LLC – Roseland, NJ Ryan K. Callender Squire Patton Boggs (US), LLP- Cleveland, OH

I. SMALL ISSUE BONDS - SECTION 144

A. Qualified Projects.

1. Manufacturing Facilities.

a. A manufacturing facility includes any facility used in the core manufacturing or production of tangible personal property (including processing resulting in a change in the condition of such property). There are several private letter rulings which provide insight into the type of processing necessary for a facility to constitute a manufacturing facility. For example, an ocean-going vessel that harvests and transforms scallops into a processed product ready for commercial consumption and use is a manufacturing facility, but a project that breeds, grows, harvests and packages fish is not a manufacturing facility.

b. A manufacturing facility includes facilities which are directly related and ancillary to the core manufacturing facility if (i) such facilities are located on the same site as the core manufacturing facility; and (ii) not more than 25% of the net proceeds are used for such directly related and ancillary facilities.

2. Refunding of Commercial Facilities.

Prior to the 1986 Act, small issue bonds could be issued for a much broader array of activities, including non-manufacturing commercial endeavors (e.g. K-Mart and McDonalds). The 1986 Act restricted the use of proceeds to the above described manufacturing facilities. However, small issue refunding bonds may be issued pursuant to transition rules in the 1986 Act, the 1954 Code and the 1986 Code to refund bonds issued before December 31, 1986, to finance non-manufacturing facilities if the bonds are current refunding bonds in an amount not greater than the amount of the bonds to be refunded and with an average maturity date not greater than the average maturity date of the refunded bonds.

3. Refunding of Manufacturing Facilities.

Small issue manufacturing bonds may be refunded under a variety of provisions depending upon the date of issue of the refunded bonds.


a. If the refunded bonds were issued after August 15, 1986, then section 144(a)(1)(B) will apply to the refunding bonds.

b. If the refunded bonds were issued before August 15, 1986, then section 1313 of the Tax Reform Act of 1986 provides transitional relief from certain changes made by the Act for refundings of pre-August 16, 1986 issues if the following requirements are met: (a) it is a current refunding; (b) the amount of the refunding bonds not to exceed the amount of refunded bonds; and (c) the weighted average maturity of the refunding bonds does not exceed 120% of weighted average economic life of the facilities financed.

B. Prohibited or Restricted Uses.

1. Prohibited Uses.

a. Sections 144(a)(8)(B) and 147(e) prohibit the use of any proceeds of a small issue bond to finance any private or commercial golf course, country club, massage parlor, tennis club, skating facility, racquet sports facility, hot tub facility, suntan facility, racetrack, airplanes, skyboxes, health club facilities, gambling facilities and liquor stores. Note: Cannot use 5% bad costs to finance these.

b. Section 144(a)(10) prohibits the use of more than $250,000 of bond proceeds for property used in a trade or business of farming.

2. Restricted Uses.

Section 144(a)(8)(A) prohibits the expenditure of more than 25% of bond proceeds for facilities the primary purpose of which is to provide retail food and beverage services, automobile sales or services, or the provision of recreation or entertainment.

C. Size Limitation of Bond Issue.

1. Amount of Bonds.

a. $1 Million Issue.

Small Issue bonds may be issued with an aggregate face amount of $1 million or less. $1,000,000 applies to face amount of bonds being issued plus outstanding amount of prior small issues with respect to facilities in the same incorporated municipality or county with the same principal user or related person. Capital expenditures are not taken into account.

b. $10 Million Issue.

An issuer can elect to change the limit from $1,000,000 to $10,000,000. In determining size, prior small issue bonds and capital expenditures are included if they are paid or incurred during the six-year period beginning three years before the issue date for the bonds with respect to facilities in the same incorporated municipality or county used by a principal user of the financed facility or by any related person. For bonds issued after December 31, 2006, the capital expenditures limit is modified by allowing the issuer to disregard $10,000,000 of capital


expenditures. Capital expenditures include any expenditure chargeable to the capital account of any person. Capital expenditures include movable equipment that is acquired within the six-year measurement period and certain governmental expenditures that solely benefit the principal user or related person. Leased equipment can be excluded if leased from the manufacturer or leasing company. Under Proposed Regulation §1.103-10(b)(2), a person may become a principal user or a related person after a bond issue closes. If the $10,000,000 bond size limit is exceeded due to a capital expenditure, the bonds will become taxable on the date of such expenditure and not retroactively to the date of issue.

2. Simultaneous or Composite Issues.

Multiple lots of bonds are considered a single issue if:

a. the obligations are sold at substantially the same time,

b. the obligations are sold pursuant to the same plan of financing,

c. the obligations are payable from the same source of funds, and

d. for purposes of Section 144(a) only, the obligations finance facilities located in 1 state and which have the same principal user (counting related persons as the same person).

3. Aggregation of Bonds for a Single Project.

Section 144(a)(9) requires the aggregation of two or more small issues, part or all of which are used to finance “a single building, an enclosed shopping mall, or a strip of offices, stores or warehouses using substantial common facilities.” In addition, any principal user of any such issue will be treated as a principal user of all the aggregated issues. Consequently, capital expenditures and outstanding obligations for all principal users will be taken into account in determining the aggregate size of the issue.

D. $40,000,000 Limit.

Section 144(a)(1) provides that the “aggregate authorized face amount” of the small issue being issued and the “aggregate face amount of tax exempt facility-related bonds” outstanding at the time of the small issue allocable to a “test-period beneficiary” must not exceed $40,000,000.

1. Outstanding “tax-exempt facility-related bonds” include exempt facility bonds, qualified small issue bonds and qualified redevelopment bonds.

2. “Test-period beneficiary” is defined to mean any person who was an owner or a principal user of the small-issue financed facilities at any time during the three-year period commencing on the later of the date the facilities were placed in service or the bonds were issued.Accordingly, at bond closing it is impossible to determine the identity of the “test-period beneficiaries.”

3. Section 144(a)(10)(C) contains allocation rules for owners and principal users to determine what portion of the small issue in question and any allocable tax-exempt facility-


related bonds outstanding at the time of the small issue in question are allocable to any “test-period beneficiary.” Depending on the nature of the facility, allocations are generally based on percentage of ownership, percentage of use based on fair rental value, or percentage of output purchased.

E. Residential Facilities. A small issue bond may not be issued for the purpose of financing residential facilities for family units. Such facilities must be financed as an exempt facility residential rental bond under Section 142 of the Code.

F. IRS Audit Program. Small issue bonds have been targeted under the IRS bond audit program, and the IRS has reportedly found numerous instances of noncompliance (e.g., with the capital expenditure limit).

II. EXEMPT FACILITY BONDS

A. In General.

Section 142 of the Code permits tax-exempt financing with respect to 15 categories of “exempt facilities.” The types of facilities eligible are:

(1) airports,

(2) docks and wharves,

(3) mass commuting facilities,

(4) facilities for the furnishing of water,

(5) sewage facilities,

(6) solid waste disposal facilities,

(7) qualified residential rental projects,

(8) facilities for the local furnishing of electrical energy or gas,

(9) local district heating or cooling facilities,

(10) qualified hazardous waste facilities,

(11) high-speed intercity rail facilities,

(12) environmental enhancements of hydro-electric generating facilities,

(13) qualified public educational facilities,

(14) qualified green building and sustainable design projects, and

(15) qualified highway or surface freight transfer facilities.


1. General Provisions Applicable to all Exempt Facility Bonds.

a. Functionally Related Facilities.

An exempt facility includes land, buildings or other property “functionally related and subordinate to such facility.” Property is functionally related and subordinate to a facility only if it is of “a character and size commensurate with the character and size of the exempt facility.” Whether the use of proceeds test is satisfied is determined by reference to the “ultimate use of proceeds,” ignoring the use of proceeds by intermediate parties in the transaction (such as lenders).

b. Public Use Requirement.

The regulations provide that an exempt facility must satisfy a “public use” test to “serve the public or be available on a regular basis for general public use, or be part of a facility so used.”For example, a private dock owned by or leased to and serving only a single manufacturing plant would not qualify (unless it is part of a public port); however, a hanger or repair facility at a municipal airport even if owned by or leased exclusively to a nonexempt person would qualify if such nonexempt person directly serves the general public (i.e. common passenger carrier or freight carrier). Sewage or solid waste disposal facilities are deemed to meet the public use test in all events under the regulations.

c. Special Rule Regarding Office Space.

Section 142(b)(2) provides that an office will not be treated as part of an exempt facility unless it is located on the premises of such facility and the functions to be performed at such office (except for a de minimis amount) are directly related to the day-to-day operations of such facility.

B. Specific Requirements for Qualified Exempt Facilities.

1. Airports, Docks and Wharves, and Mass Commuting Facilities.

a. Governmental Ownership Requirement.

(1) With respect to airports, docks and wharves, and mass commuting facilities, Section 142(b)(l) provides that such facilities will be treated as exempt facilities only if all of the property to be financed by the net proceeds of the issue are to be owned by a governmental unit.

(2) Section 142(b)(1)(B) provides a “safe harbor” rule for ownership by a governmental unit where such facilities are leased or subject to management contracts or similar operating agreements with nongovernmental units. The safe harbor rule permits the governmental unit to lease property, enter into management contracts or other similar types of operating agreements and still be treated as the owner of the facility if:


(a) the lessee or contractor makes an irrevocable election (binding also on successors in interest under the lease) to not claim depreciation or investment tax credit with respect to the property;

(b) the lease or contract term is not more than 80% of the reasonably expected economic life of the property; and

(c) the lessee or contractor has no option to purchase the property other than at fair market value as of the time the option is exercised.

b. Prohibition of Certain Uses.

Section 142(c)(2) prohibits the use of bond proceeds to finance certain facilities to be used for a private business use in connection with the financing of airports, docks and wharves, mass commuting facilities and high-speed intercity rail facilities. Private business use is prohibited under Section 142(c) (2) with respect to the following facilities:

(1) any lodging facilities (including airport hotels);

(2) any retail facility (including food and beverage facilities) in excess of a size necessary to serve passengers and employees at the exempt facilities;

(3) any retail facility (other than parking) for passengers or the general public located outside the exempt facility terminal;

(4) any office building for individuals who are not employees of a governmental unit or of the operating authority for the exempt facility; and

(5) any industrial park or manufacturing facility.

c. Storage and Training Facility.

Section 142(c)(1) permits tax-exempt financing of storage or training facilities directly related to airports, docks and wharves, mass commuting facilities and high-speed intercity rail facilities.

2. Airports.

Reg. 1.103-8(e)(2)(ii) defines the term “airport” to include facilities which are

a. directly related and essential to (a) servicing aircraft, enabling it to take off and land (such as a maintenance or overhaul facility), or (b) transferring passengers or cargo to or from aircraft, and

b. which need to be located at or in close proximity to the runway area in order to perform their function.


Reg. 1.103-8(a)(2) provides that a hangar or repair facility at a municipal airport will meet the public use requirement, even if leased to a nonexempt person, if the nonexempt person directly serves the general public as a common carrier or if it is part of a facility available for public use.

3. Docks and Wharves.

Reg. 1.103-8(e)(2)(iii) provides that a “dock or wharf” includes property functionally related or subordinate to exempt docks and wharves such as the structure alongside which a vessel docks, equipment used to on and off load cargo and passengers (e.g., cranes, conveyors), and related storage, handling, office and passenger areas.

4. Qualified Residential Rental Projects.

a. Residential Rental Project.

A “residential rental project” is a building or structure containing one or more similarly constructed units that are not used on a transient basis.

(1) A unit must contain separate and complete facilities for living, sleeping, eating, cooking and sanitation, but may, however, be served by centrally located equipment such as air conditioning or heating.

(2) Hotels, motels, dormitories, fraternity and sorority houses, rooming houses, hospitals, nursing homes, sanitariums, and rest homes are not residential rental projects.

(3) Revenue Ruling 98-48, released in September 1998, distinguishes various housing components of a continuing care facility that constitute “residential rental facilities.” Generally, a facility providing continuous or frequent nursing, medical or psychological services will not qualify as a residential rental facility.

(4) Note that regulations governing residential rental facilities are generally found in Reg. §1.103-8 and proposed Reg. § 103-8.

b. Low Income Tenants.

A “qualified residential rental project” must meet either one of the following low income tenant qualification requirements under section 142(d)(1)(A) or (B):

(1) 20% or more of the units are occupied by individuals having incomes of 50% or less of the area median gross income; or

(2) 40% or more of the units are occupied by individuals having incomes of 60% or less of the area median gross income.

The issuer is required to elect compliance with (1) or (2) at the time the bonds are issued. This election, once made, is irrevocable.


c. Continuing Income Restrictions.

Section 142(d)(3) requires that the income qualification determinations with respect to the current tenants of a project be made at least annually based on the tenant’s current income rather than its income at initial occupancy. A resident whose income upon initial occupancy did not exceed the applicable limit will continue to be a qualified resident for purposes of the low income unit targeting requirements unless the resident’s income as of the most recent determination exceeds 140% of the applicable income limit, and prior to the next income determination, a unit of comparable or smaller size is occupied by a new resident whose income exceeds the applicable limit.

Section 142(d) (2) (B) requires that the median gross income level for tenants be determined by the Treasury Department in a manner consistent with Section 8 program which shall include adjustments for family size.

d. Qualified Project Period.

The income targeting requirements referred to above must be met at all times during the “qualified project period.” “Qualified Project Period” is defined in Section 142(d)(2) to mean the period beginning on the first day on which 10% of the units are occupied (as opposed to prior law, which contained a 10-year requirement), and ending on the latest of:

(1) the date 15 years after the first date that 50% of the units are occupied;

(2) the date on which no bond is outstanding; or

(3) the date on which any Section 8 assistance terminates.

e. Annual Certification of Compliance.

Section 142(d) (7) requires the operator of the project to certify annually to the Treasury that the project currently is in compliance with the targeting requirements. Failure to meet this requirement will not cause interest on the bonds to become taxable, but will cause a $100 penalty under Code Section 6652(j) to be assessed against the operator.

f. Low Income Housing Credits.

The rules of Section 142(d) interrelate with the low income housing tax credit rules of Section 42 of the Code. If at least 50% of a project is financed with tax-exempt bonds subject to the volume cap (Section 146 of the Code), the project may receive tax credits without obtaining an allocation of a state’s low income tax credit ceiling.

5. Facilities for the Furnishing of Water.

Section 142(e) provides that a facility for the furnishing of water (e.g., water treatment and distribution facilities) for any purpose will quality as an exempt facility if:


a. the water is or will be made available to members of the general public (including electric utility, industrial, agricultural, or commercial users with an additional requirement that at least 25% be residential users); and

b. either the facilities are operated by a governmental unit or the rates for the furnishing or sale of the water have been established or approved by a State or political subdivision thereof, by an agency or instrumentality of the United States, or by a public service or public utility commission or other similar body of any State or political subdivision thereof.

6. Local furnishing of Electrical Energy or Gas.

a. Section 142(f) permits the tax-exempt financing for the local furnishing of electrical energy or gas. “Local furnishing” includes two contiguous counties as well as a city and a contiguous county. Either the owner or operator of the facilities must be obligated by law, ordinance or regulation to furnish gas or electric energy to all persons within the service area who request it and it must be reasonably expected that the facility will serve or be available to serve a large segment of the general public in the service area.

b. The Small Business Job Protection Act of 1996 generally restricts new financings for “local furnishing” facilities to facilities used by a person who was engaged in the local furnishing of that energy source on January 1, 1997 and such facilities will be used to provide service within the area served by the person on January 1, 1997. Certain relief provisions were also enacted relating to the expansion of service areas for existing facilities.

7. Local District Heating or Cooling Facility.

A local district heating or cooling facility for two contiguous counties or one city and a contiguous county qualifies as an exempt facility under section 142(g). Such facilities must be part of a system consisting of a pipeline or network providing hot or chilled water or steam to 2 or more users for (a) residential, commercial or industrial heating or cooling or (b) process steam.

8. Sewage Facilities

Reg. 1.103-8(f), dating from the early 1970’s, defines “sewage disposal facility” to mean any property used for the collection, storage, treatment, utilization, processing or final disposal of sewage. Reg. 1.142(a)(5)-1, promulgated in December of 1994, provides a more detailed definition. The new definition indirectly defines sewage as wastewater requiring traditional secondary (biological) treatment and having a biochemical oxygen demand (BOD) of 350 mg/liter. The new definition specifically excludes “pretreatment facilities” designed to deal with contaminants other than BOD, pH, oil and grease, fecal coliform and TSS total suspended solids. Costs of dual function (i.e., qualifying and nonqualifying) facilities must be allocated on reasonable basis.


9. Solid Waste Disposal Facilities Under Existing Regulations (Amending 1972-1975 Regulations).

a. On August 18, 2011, the IRS released final regulations setting forth guidance as to the definition of a solid waste disposal facility. The regulations eliminate the “no value test” from the definition of solid waste, provide that the solid waste disposal process, in effect, ends at the production of the first marketable product, eliminates the proposed rule that “residual’ material is solid waste only if it is less than five percent of the material introduced into the related process, and retains the rule that an entire facility qualifies for tax-exempt financing if at least 65 percent of the material processed is solid waste but with a new requirement that the 65 percent rule is generally tested annually (subject to limited exceptions).

b. A “solid waste disposal facility” is defined to mean any facility to the extent that the facility processes “solid waste” in a “qualified solid waste disposal process”, performs a “preliminary function”, or is functionally related and subordinate to a facility that performs either a qualified solid waste disposal process or a preliminary function.

c. “Solid waste” is defined in the final regulations as garbage, refuse, and other solid materials (determined at ambient temperature and pressure) derived from any agricultural, commercial, consumer, or industrial operation or activity if the person generating or acquiring such waste reasonably expects the waste to be introduced into a qualified solid waste disposal process within a reasonable time. Solid waste must be either (i) “Used material”, which is any material that has been previously used as a commercial, consumer, governmental, or industrial product, or a component of such product (including animal waste produced from a biological process); or (ii) “Residual material”, which is any residual byproduct or excess unused raw material that remains after or results from the production of any agricultural, commercial, consumer, governmental, or industrial production process or activity or from the provision of any service. The final regulations eliminate the proposed rule that residual material does not qualify unless it constitutes less than five percent of the total material introduced into the original production but retains the requirement that such material have a fair market value that is expected to be lower than any product resulting from such production process.

d. The term “qualified solid waste disposal process” includes the following (i) a “final disposal process” which is any process that provides for the incineration or permanent containment of solid waste or the placement of solid waste in a landfill, (ii) an “energy conversion process” which is any thermal, chemical, or other process that is applied to solid waste to create and capture synthesis gas, heat, hot water, steam, or other useful energy; the energy conservation process ends at the point at which the useful energy is created, captured, or incorporated into synthesis gas, heat, hot water, or other useful energy (collectively “Useful Energy”) or before any transfer of such Useful Energy and whether or not such Useful Energy is a “first useful product” (as described herein), and (iii) a “recycling process” which is any process that reconstitutes, transforms, or otherwise processes solid waste into a useful product but does not include refurbishment, repairs, or similar activities; the recycling process begins at the first application of such process to transform the solid waste into a useful product (for example, melting, re-pulping, or shredding) and the solid waste disposal process generally ends at the point the first useful product is produced from solid waste.


The determination of whether a useful product is produced must take into account whether a product could be sold, not whether the product is actually sold. However, operational constraints that affect the point when a useful product can be extracted or insolated and sold may be taken into account in any analysis. The cost of extracting, isolating, storing, and transporting the product to market may be taken into account only if the product is to be used at a different location from where it is produced.

e. A facility that performs a “preliminary function” also qualifies as a solid waste disposal facility. A preliminary function is a function to collect, separate, sort, store, treat, disassemble, or handle solid waste that is preliminary to and directly related to one of the qualified solid waste disposal processes described above. The final regulations eliminate the proposed rule that a function will be treated only as preliminary if more than 50 percent of the materials that result from the function are solid waste.

f. Regulations regarding solid waste facilities are found at Reg. §1.142(a)(6)-1.

10. Qualified Hazardous Waste Facilities.

a. Qualified hazardous waste facilities under Section 142(a)(1) are facilities which provide for the disposal of hazardous waste by incineration or entombment only if the facility is subject to final permit requirements under subtitle C of title II of the Solid Waste Disposal Act (RCRA) as in effect on October 22, 1986.

b. Cannot finance portion of the facility allocable to the processing of hazardous waste generated by the owner or operator of the facility or related person to such owner or operator (i.e., the facility is required to be available for use by the “public”).

c. “Hazardous waste” does not include radioactive waste and must be material having no market or other value at the place it is located.

11. High-Speed Intercity Rail Facilities.

a. A facility qualifies as a high-speed intercity rail facility if it is a facility (other than rolling stock) for fixed guideway rail transportation of passengers and their baggage between metropolitan statistical areas (as such areas are defined by the Secretary of Commerce). The facilities must use vehicles that are reasonably expected to operate at speeds in excess of 150 miles per hour between scheduled stops and the facilities must be made available to members of the general public as passengers.

b. The facility does not have to be owned by a governmental unit; however, any non-governmental owner must elect irrevocably not to claim any deduction for depreciation under Section 167 or 168 of the Code or claim any income tax credit with respect to the property to be financed with the issue’s net proceeds.

c. Section 147(c) of the Code, which limits the use of bond proceeds to acquire land to 25%, does not apply to land acquired for noise abatement, wetland preservation or future use as a high-speed rail facility if there is no other significant use of such land. With regard to the public approval requirement, if the issuer of the bonds is also the owner or operator of the facilities it is


deemed to be the only governmental unit having jurisdiction over such facility for purposes of the requirement.

12. Environmental Enhancements of Hydroelectric Generating Facilities (Fishladders).

Section 142((j) applies to facilities where at least 80% of the proceeds of the bonds are used to finance property for a federally licensed hydroelectric generating facility and which either protects or promotes fisheries or other wildlife resources or is a recreational facility or other improvement required by the federal licensing permit for the operation of the generating facility.The category is seldom if ever used.

13. Public Educational Facilities.

Section 142(k) applies to bonds at least 95 percent of the net proceeds of which are used to provide school facilities owned by for-profit entities pursuant to public-private partnership agreements with a State or local educational agency. The school facilities must be operated as part of a system of public schools. School facilities include school buildings and functionally related and subordinate land and can include stadiums or other athletic facilities used primarily for school events. These bonds are not subject to the general volume limitation under Code Section 146 but are subject to a separate volume limitation set forth in Code Section 142(k).

14. Green Building and Sustainable Design Projects.

An exempt facility bond for qualified green building and sustainable design projects was added in 2004. It applies to bonds at least 95 percent of the net proceeds of which are used to provide facilities that are designated by the Secretary of the Treasury Department as a qualified green building and sustainable design project upon application. A project cannot include a stadium or arena for professional sports exhibition or games. The application must show that the project meets the following requirements: (1) at least 75 percent of the square footage of the commercial building is registered under the United States Green Building Council’s Leadership in Energy and Environmental Design certification; (2) includes a brownfield as defined under the Comprehensive Environmental Response, Compensation and Liability Act of 1980; (3) receive specific state or local government contributions of at least $5,000,000 (can be tax abatements, grants, or in kind gifts); (4) include at least 1,000,000 square feet of building or 20 acres; and (5) employ at least 1,500 full time equivalents (or 150 FTE in rural areas). Also, required under the application are descriptions of (a) electric consumption reduced compared to conventional construction, (b) amount of sulfur dioxide daily emissions reduced compared to coal generation, (c) amount of the gross installed capacity of the project’s solar photovoltaic capacity measured in megawatts, and (d) amount in megawatts of project’s fuel cell energy generation. No part of the project can have any facility with the principal business of selling food or alcoholic beverages for consumption on the premises. These bonds are subject to the national limit of $2 billion and must be issued prior to October 1, 2009.

15. Highway or Surface Freight Transfer Facilities.

Section 142(a)(15) was added in 2006 and authorizes up to $15 billion dollars of bonds for qualified highway or surface freight transfer facilities. It applies to bonds at least 95 percent of the net proceeds of which are spent to provide qualified highway or surface freight transfer


facilities within 5 years. The Secretary of the Treasury may extend the 5 years upon request. Qualified highway or surface freight transfer facilities are (1) any surface transportation project that received federal highway funds, (2) any project for an international bridge or tunnel for which an international entity is responsible and received federal funds, or (3) any facility for the transfer of freight from truck to rail or rail to truck.

III. MISCELLANEOUS PROVISIONS APPLICABLE TO SMALL ISSUE AND EXEMPT FACILITY BONDS

A. Qualified Costs.

1. 95% of Net Proceeds.

95% or more of net proceeds be used to provide the qualifying facility (Section 142 (a)). “Net proceeds” is defined in Section 150(a) (3) to be the proceeds of an issue less amounts used to fund a reserve fund.

2. Qualified Costs.

Qualified costs, for purposes of 95% test, include expenditures attributable to capital costs of qualifying facilities (Reg. 1.103-8(a)(1)(i)) and, for qualified small issue bonds, for “the acquisition, construction, reconstruction or improvement of land or property of a character subject to allowance for depreciation (Section 144(a) (1)(A)). Must meet timing requirements described below.

3. NonQualified Costs.

“Nonqualified Costs” are any costs that are not qualified costs. This includes costs of issuance (Conference Report for Tax Reform Act of 1986, H.R. Conf, Rep. No. 99-841, at 697, 729).Total of nonqualified costs must not exceed 5% of the amount of net bond proceeds (which for this purpose includes earnings from investments of bond proceeds). Costs of issuance are also subject to a separate limit equal to 2% of the “proceeds of the issue” (for bonds sold at par, the face amount) (Section 147(g)).

4. Timing Requirements: Reimbursements (Reg. 1.150-2).

For bonds issued after date of expenditure, costs to be reimbursed:

a. must have been paid no earlier than 60 days before the adoption by the issuer of a “declaration of official intent” describing project and providing maximum anticipated amount to be issued (Reg. 1.150-2(d)(1)), and

b. must be reimbursed not more than 18 months after the facility is placed in service or 3 years after the expenditure is made, whichever is earlier (Reg. 1.150-2(d)(2)).


5. Excess Bond Proceeds: Remedial Action.

Reg. 1.142-2 provides that failure to meet the 95% test generally will not cause bonds to be taxable if (i) it was reasonably expected that the test would be met, and (ii) the non-qualified bonds are redeemed or defeased. This regulation replaces the rules previously provided in Rev. Procs. 79-5 and 81-22.

6. Acquisition of Existing Properties.

Proceeds may not be used for the acquisition of existing facilities, except for:

a. the acquisition of buildings if the owner incurs rehabilitation expenses in an amount equal to at least 15% of the proceeds used to acquire such building; or

b. the acquisition of structures if the owner incurs rehabilitation expenditures equal to at least 100% of the proceeds used for the acquisition of such facilities (Section 147(d)(2)).

7. Restrictions on the Acquisition of Land.

a. Not more than 25% of the proceeds may be used for the acquisition of land and none of the proceeds may be used for the acquisition of land for agricultural purposes (Section 147(c)(1)).

b. This restriction does not apply to land acquired by a governmental unit or issuing authority in connection with an airport, mass commuting facility, high-speed intercity rail facility, dock, or wharf, if such land is acquired for noise abatement or wetland preservation, or for future use as one of the aforementioned facilities (Section 147(c)(3)).

8. Limitation on Average Maturity.

The weighted average maturity of the bonds must not exceed 120% of the weighted averaged expected life of the assets financed with the proceeds of the bonds (Section 147(b)). For this purpose, the ADR midpoint life of the asset may be used as a safe harbor (Conference Report for Tax Equity and Fiscal Responsibility Act of 1982, H.R. Conf, Rep. No. 97-760, 519-20). Land is not taken into account in determining economic life unless more than 25% of proceeds are used for land, in which case 30 years is used as the economic life for land (Section 147(b)(3)(B)).

9. Public Approval.

There must be appropriate public approval of the bonds (Section 147(f)). Public approval is normally obtained by approval by an appropriate legislative or executive officer or body (Section 147(f)(2)), after a public hearing has been conducted for which there has been reasonable public notice (normally 14 days) (Reg. 5f.103-2(g)(3). Insubstantial deviations from the public notice will not cause the bonds to fail this requirement (Reg. 5f.103-2(f)(2).


10. Substantial User Limitation.

Although a bond may be tax-exempt, the interest on such bond will be taxable in the hands of a “substantial user” of the facilities financed with the bond issue or a “related person” thereto (Section 147(a)). When the bonds are transferred to a third person which is not a substantial user or related person, interest will once again to be tax-exempt.

Note: Bond counsel opinion and disclosure language for exempt facility bonds generally reflects the substantial user limitation.

11. Volume Cap.

All small issue and exempt facility bonds are subject to the volume cap requirement, except as noted below (Section 146 (a)). No volume cap is required for exempt facilities that must be governmentally owned (i.e., airports, dock and wharf facilities, ), having a specific exemption (i.e. environmental enhancements of hydro-electric generating facilities, qualified public educational facilities, qualified green building and sustainable design projects, and qualified highway or surface freight transfer facilities), and certain other facilities that are governmentally owned (i.e., high speed intercity rail and solid waste disposal facilities) (Section 146 (g)-(h).

Section 146 requires that volume cap be obtained for all small issue bonds, unless some specific exception applies, e.g. certain refundings (Section 146 (i)).

12. Change in Use.

Under Section 150(c), change in use of manufacturing facility or exempt facility will result in loss of interest deduction to borrower under tax-exempt financing. Under Reg. 1.142-2, change in use and other violations can generally be addressed through defeasance or redemption of bonds unless violation is of capital expenditure cap or $40,000,000 limit.

13. Issuance Costs Limit.

No more than 2% of the proceeds of an issue may be used for costs of issuance (Section 147(g)).For this purpose, costs of issuance include underwriter’s discount, legal fees, financial advisory fees, rating agency fees, trustees fees, paying agent fees, accounting fees, prinng costs, costs incurred in connection with public approvals, and costs of engineering and feasibility studies necessary to the issuance of the bonds (Reg. 1.150-1(b)). Costs of issuance do not include fees for any bond insurance or letter of credit that constitutes a “qualified guarantee” for arbitrage purposes. Proceeds (to determine the 2% limit) are generally sale proceeds of the issue (rather than face amount) but exclude pre-issuance accrued interest (Reg. 1.148-1(b)).


IV. GULF OPPORTUNITY ZONE BONDS

1. Background.

Gulf Opportunity Zone Bonds (“GO Zone Bonds”) were created in response to Hurricane Katrina in 2005 and are deemed to be exempt facility bonds provided they meet certain requirements.

2. Specific GO Zone Bond Requirements.

95% or more of net proceeds must be used to provide qualified project costs located in Gulf Opportunity Zone (portions of Alabama, Louisiana and Mississippi). The maximum aggregate face amount of GO Zone Bonds that may be issued are approximately $7.9 billion for Louisiana, $4.9 billion for Mississippi and $2.1 billion for Alabama. GO Zone Bonds must be issued before January 1, 2011.

Qualified project costs include acquisition, construction, reconstruction and renovation of nonresidential real property (including buildings and their structural components and fixed improvements), qualified residential rental projects and public utility property. GO Zone Bonds cannot finance movable fixtures and equipment.

For qualified residential rental projects, GO Zone Bonds use a different income test. Instead of the 20-50 or 40-60 tests, a project with 20% or more of units occupied by individuals whose income is 60% or less of the area median income (“20-60”) or 40% or more of units occupied by individuals whose income is 70% or less of area median income (“40-70”), will qualify.

3. Restrictions Applicable to Exempt Facility Bonds Apply to GO Zone Bonds.

a. GO Zone Bonds cannot be bank-qualified.

b. The issuer of GO Zone Bonds must adopt a “declaration of official intent” to issue bonds before the business user of the facilities begins spending amount to be reimbursed out of bond proceeds (or within 60 days after the expenditures are paid).

c. Public approval requirements under Section 147(f) are applicable to GO Zone Bonds.

d. The maturity limitations of Section 147(b) apply to GO Zone Bonds. The average maturity of the bonds cannot exceed 120% of the average economic life of the financed facilities.

4. Additional Modifications for GO Zone Bonds.

a. Issuance of GO Zone Bonds is not subject to the aggregate annual State private activity bond volume limits.

b. The restriction on acquisition of existing property is applied using a minimum requirement of 50% of the cost of acquiring the building being devoted to rehabilitation.


c. Special arbitrage expenditure rules for certain construction bond proceeds apply for treatment as a construction issue.

d. Interest on the bonds is not a preference item for purposes of the alternative minimum tax.

e. Additional advance refunding permitted for certain governmental and 501(c)(3) bonds.

f. Special bonus depreciation available for GO Zone property. Section 1400N(d) allows an additional first year depreciation deduction equal to 50% of the adjusted basis of the qualified GO Zone property. The original use of the property in the GO Zone must commence with the taxpayer on or after August 28, 2005. If property is bond financed, no bonus depreciation deduction is permitted.

4. Refunding of GO Zone Bonds

Pursuant to IRB Notice 2012-3, dated January 17, 2012, GO Zone Bonds may be currently refunded on a tax-exempt basis so long as the following requirements are met:

a. The original GO Zone Bonds were issued before the deadline for the issuance of GO Zone Bonds (i.e. December 31, 2011);

b. The issue price of the current refunding issue is not greater than the outstanding stated principal amount of the refunded bonds: and

c. The current refunding issue otherwise meets the applicable requirements for the issuance of GO Zone Bonds, including the requirement that the average maturity of the issue is not longer than 120% of the remaining economic life of the facilities refinanced with the proceeds of such issue.

V. RECOVERY ZONE FACILITY BONDS

1. Background.

Recovery Zone Facility Bonds (“RZFBs”) were created in The American Recovery and Reinvestment Act of 2009 and are deemed to be exempt facility bonds provided they meet certain requirements.

2. Specific GO Zone Bond Requirements.

a. RZFBs are exempt facility bonds if at least 95% of the proceeds are used for “Recovery Zone Property” in a “Recovery Zone.”

b. Issuer must designate the bonds as a Recovery Facility Bond at issuance.

c. Authorized cap for these bonds is limited to $15 billion.

d. Must be issued prior to January 1, 2011.


3. Definitions.

a. “Recovery Zone” is an area designated as having significant poverty, unemployment, rate of home foreclosures or general distress, any area designated as economically distressed by reason of the closure or realignment of military installation pursuant to the Defense Base Closure and Realignment Act of 1990, and any area designated as an empowerment zone or renewal community.

b. “Recovery Zone Property” is property to which Section 168 of the Code applies, was constructed, reconstructed or acquired by purchase by the taxpayer after the zone designation took effect, had an original use in the zone commenced by the taxpayer, and is substantially all used in the recovery zone and is used in the active conduct of a “qualified business” by the taxpayer in such zone.

c. “Qualified Business” is any trade or business except rental of residential property or a business involving a prohibited facility under Section 144(c)(6)(B) of the Code (gambling, country clubs, etc).

4. Restrictions Applicable to Exempt Facility Bonds Apply to RZFBs.

a. RZFBs cannot be bank-qualified.

b. The issuer of RZFBs must adopt a “declaration of official intent” to issue bonds before the business user of the facilities begins spending amount to be reimbursed out of bond proceeds (or within 60 days after the expenditures are paid).

c. Public approval requirements under Section 147(f) are applicable to RZFBs.

d. The maturity limitations of Section 147(b) apply to RZFBs. The average maturity of the bonds cannot exceed 120% of the average economic life of the financed facilities.

e. Issuance of RZFBs is not subject to the aggregate annual State private activity bond volume limits; however, RZFB cap is required.

f. The restriction on acquisition of existing property is applied using a minimum requirement of 50% of the cost of acquiring the building being devoted to rehabilitation.

g. Special arbitrage expenditure rules for certain construction bond proceeds apply for treatment as a construction issue.

h. Interest on the bonds is not a preference item for purposes of the alternative minimum tax.



05. Qualified Small Issue & Exempt Facility


Qualified Projects – Manufacturing Facilities

Small Issue Bonds may finance manufacturing facilities that satisfy the following:

a. Facilities used in the manufacturing or production of tangible personal property, including processing resulting in a change in the condition of such property (“Core Manufacturing”)

b. Facilities “directly related and ancillary” to the Core Manufacturing facilities and are (i) located on the same site; and (ii) not more than 25% of the net proceeds


a. Facilities may not be used for retail food and beverage services, automobile sales or services, provision of recreation or entertainment

b. No more than 2% of proceeds may be spent on costs of issuance (applies also to exempt facility bonds)

c. No residential facilitiesd. $250,000 limit on trade or business of farming

Additional Requirements for Small Issue Bonds



Acquisition of Existing PropertiesProceeds may not be used for the acquisition of existing facilities, except for:

- buildings meeting15% rehabilitation requirement; or

- other structures meeting 100% rehabilitation requirement

Applies also to exempt facility bonds


Restrictions on the Acquisition of Landa. 25% of proceeds may be used for acquisition of land, but none for acquisition of land for agricultural purposes

b. Applies also to exempt facility bonds except land acquired by a governmental entity in connection with an airport, mass commuting facility, high-speed intercity rail facility, dock, or wharf, if such land is acquired for noise abatement or wetland preservation, or for future use as one of such exempt facilities


Limitation on Average Maturitya. The weighted average term to maturity of bonds may not exceed 120% of the economic useful life of financed assets

b. To determine the economic useful life of an asset, the IRS’s “Asset Depreciation Range” system provides guidance for tangible assets that may be used as a safe harbor; land is not taken into account (unless more than 25% of proceeds used for land, in which case 30 years is used as its economic useful life)

c. Applies also to exempt facility bonds



Public Approval (TEFRA)a. Public approval required; normally obtained by approval by appropriate legislative or executive officer or body after public hearing following at least 14 days public notice

b. Insubstantial deviations from the public notice will not cause the bonds to fail this requirement

c. Applies also to exempt facility bonds, with special rules for multi-jurisdiction airports


Substantial User Limitationa. Interest on otherwise tax-exempt bond is taxable in the hands of a "substantial user" of the financed assets or a "related person" thereto

b. Applies also to exempt facility bonds


Size Limitation of “Small” Issuea. $1 Million Issue

$1,000,000 limit on aggregate amount of outstanding small issue including prior bonds and bonds being issued with respect to facilities (i) in same incorporated municipality or county with (ii) the same principal user or related person (capital expenditures are not taken into account)



b. $10 Million Issue

Issuer can elect to change the limit to $10,000,000. This limit applies to total of

(i) bonds being issued, (ii) prior small issues, and (iii) capital expenditures during six-year period beginning three years

before bond issuance -all with respect to facilities in the same incorporated municipality or county with the same principal user or any related person


Capital Expenditures

For bonds issued after December 31, 2006 issuer can disregard capital expenditures of $10,000,000

Capital expenditures include expenditures during the six-year period chargeable to capital account of any principal user of financed facility or related person

Leased equipment can be excluded if leased from manufacturer or leasing company

A person may become a principal user or a related person after a bond issue closes


$40,000,000 Limit

Section 144(a)(1) provides that (i) the face amount of the small issue bonds being issued plus (ii) the aggregate face amount of all other tax-exempt bonds outstanding at the time of the small issue and allocable to a "test-period beneficiary" must not exceed $40,000,000



b. $10 Million Issue

Issuer can elect to change the limit to $10,000,000. This limit applies to total of

(i) bonds being issued, (ii) prior small issues, and (iii) capital expenditures during six-year period beginning three years

before bond issuance -all with respect to facilities in the same incorporated municipality or county with the same principal user or any related person


Capital Expenditures

For bonds issued after December 31, 2006 issuer can disregard capital expenditures of $10,000,000

Capital expenditures include expenditures during the six-year period chargeable to capital account of any principal user of financed facility or related person

Leased equipment can be excluded if leased from manufacturer or leasing company

A person may become a principal user or a related person after a bond issue closes


$40,000,000 Limit

Section 144(a)(1) provides that (i) the face amount of the small issue bonds being issued plus (ii) the aggregate face amount of all other tax-exempt bonds outstanding at the time of the small issue and allocable to a "test-period beneficiary" must not exceed $40,000,000


EXEMPT FACILITY BONDS – I.R.C. SECTION 142The Code permits tax-exempt financing with respect to 15 categories of "exempt facilities,” set forth in Section 142(a)


Volume Cap RequirementExempt facility bonds generally subject to state PAB volume ceiling

Exceptions for: (i) airports, docks/wharves and government-owned solid waste disposal facilities; and(ii) categories subject to their own special ceiling


Governmental Ownership RequirementSince 1986 bond-financed airports, docks and wharves, and mass commuting facilities, must be owned by a governmental unit.

“Safe harbor" rule for governmental ownership of leased property: - No lessee bargain purchase option- No lessee claim of depreciation- Lease term less than 80% of economic life of the leased property



Qualified Exempt Facility Categories1. Airports

Qualifying facilities must:

(i) be directly related and essential to (a) servicing aircraft (e.g., maintenance or overhaul facility), or (b) transferring passengers or cargo to or from aircraft; (ii) need to be located at or in close proximity to the runway area in order to perform their function; and (iii) meet public use requirement


2. Docks and Wharves

Qualifying facilities include docks and wharves and property functionally related or subordinate to docks and wharves such as equipment used to on and off load cargo and passengers (e.g., cranes, conveyors), and related storage, handling, office and passenger areas


3. Mass Commuting Facilities

a. Qualifying facilities include land, buildings and equipment for serving the general public commuting on a day to day basis by bus, subway, rail, ferry, or other conveyance which moves over prescribed routes

b. Use of facilities by non-commuters in common with commuters is immaterial (e.g., a terminal leased to a common carrier bus line which serves both commuters and long distance travelers would qualify)



4. Facilities for the Furnishing of Water

a. Qualifying facilities include facilities used for treating and distributing water to members of the general public (including electric utility, industrial, agricultural, or commercial users with an additional requirement that at least 25% be residential users); and

b. Either the facilities are operated by a governmental unit or the rates are approved by a governmental unit


5. Sewage Facilities

a. Reg. 1.142(a)(5)-1 indirectly defines sewage as wastewater requiring traditional secondary (biological) treatment and having a biochemical oxygen demand (BOD) of 350 mg/liter

b. Definition excludes "pretreatment facilities" designed to deal with contaminants other than BOD, pH, oil and grease, fecal coliform and TSS (total suspended solids)

c. Costs of dual function (i.e., qualifying and nonqualifying) facilities must be allocated on reasonable basis


6. Solid Waste Disposal Facilities

a. Defined as property used to collect, store, treat, utilize, process or finally dispose of solid waste

a. "Solid waste" means garbage, refuse, and discarded solid waste materials from industrial, commercial, agricultural or community activities, excluding domestic sewage and significant common water pollutants

a. Costs of dual function (i.e., qualifying and nonqualifying) facilities must be allocated on reasonable basis. Entire facility qualifies if 65% of feedstock is solid waste

d. IRS released Proposed Regulations in September 2009, which set forth further guidance as to the definition of a solid waste disposal facility



7. Qualified Residential Rental Projects

a. A residential rental project is a building containing one or more similarly constructed units that are not used on a transient basis

b. Units must contain separate and complete facilities for living, sleeping, eating, cooking and sanitation, but may be served by centrally located equipment such as air conditioning or heating


c. Low Income Tenants

Qualified project must meet either of the following low income tenant qualification requirements, irrevocably elected by the issuer at the time bonds are issued:

(i) 20% or more of the units are occupied by individuals having incomes of 50% or less of the area median gross income; or

(ii) 40% or more of the units are occupied by individuals having incomes of 60% or less of the area median gross income


d. Low Income Housing Credits

The tax exempt finance rules interact with the low income housing tax credit rules. If at least 50% of a project is financed with tax-exempt bonds subject to the volume cap, the project may receive tax credits without obtaining an allocation of a state’s low income tax credit ceiling.



7. Qualified Residential Rental Projects

a. A residential rental project is a building containing one or more similarly constructed units that are not used on a transient basis

b. Units must contain separate and complete facilities for living, sleeping, eating, cooking and sanitation, but may be served by centrally located equipment such as air conditioning or heating


c. Low Income Tenants

Qualified project must meet either of the following low income tenant qualification requirements, irrevocably elected by the issuer at the time bonds are issued:

(i) 20% or more of the units are occupied by individuals having incomes of 50% or less of the area median gross income; or

(ii) 40% or more of the units are occupied by individuals having incomes of 60% or less of the area median gross income


d. Low Income Housing Credits

The tax exempt finance rules interact with the low income housing tax credit rules. If at least 50% of a project is financed with tax-exempt bonds subject to the volume cap, the project may receive tax credits without obtaining an allocation of a state’s low income tax credit ceiling.


8. Local furnishing of Electrical Energy or Gas

Section 142(f) permits the tax-exempt financing for the local furnishing of electrical energy or gas. "Local furnishing" includes two contiguous counties as well as a city and a contiguous county. Since legislation in 1996, this category is available only to a small number of grandfathered borrowers.


9. Local District Heating or Cooling Facility

Facilities must be part of a system consisting of a pipeline or network providing hot or chilled water or steam to two or more users for (a) residential, commercial or industrial heating or cooling or (b) process steam. System is local if it serves no more than two contiguous counties or one city and a contiguous county.


10. Qualified Hazardous Waste Facilities

a. Includes facilities which provide for the disposal of hazardous waste (as defined by RCRA) by incineration or entombment

b. Cannot finance any portion of the facility allocable to the processing of hazardous waste generated by the owner or operator of the hazardous waste disposal facility or a related person



11. High-Speed Intercity Rail Facilities

a. Includes facilities (other than rolling stock) for fixed guideway rail transportation of passengers and their baggage between metropolitan statistical areas. Category seldom if ever used

b. The facilities must use vehicles that are reasonably expected to operate at speeds in excess of 150 miles per hour between scheduled stops

c. Private owner cannot claim deprecation


12. Environmental Enhancements of Hydroelectric Generating Facilities

For fishladders at a federally licensed hydroelectric generating facility. Category seldom if ever used.


13. Qualified Public Educational Facilities

a. School facilities owned by for-profit entities pursuant to public-private partnership agreements with a State or local educational agency and operated as part of a public school system

b. These bonds are not subject to the general volume limitation under section 146 but are subject to a separate special state by state volume limitation



11. High-Speed Intercity Rail Facilities

a. Includes facilities (other than rolling stock) for fixed guideway rail transportation of passengers and their baggage between metropolitan statistical areas. Category seldom if ever used

b. The facilities must use vehicles that are reasonably expected to operate at speeds in excess of 150 miles per hour between scheduled stops

c. Private owner cannot claim deprecation


12. Environmental Enhancements of Hydroelectric Generating Facilities

For fishladders at a federally licensed hydroelectric generating facility. Category seldom if ever used.


13. Qualified Public Educational Facilities

a. School facilities owned by for-profit entities pursuant to public-private partnership agreements with a State or local educational agency and operated as part of a public school system

b. These bonds are not subject to the general volume limitation under section 146 but are subject to a separate special state by state volume limitation


14.Green Building and Sustainable Design Projects

a. Added in 2004.

b. Eligible facilities are those designated by the Secretary of Treasury as a qualified green building and sustainable design project. Only a few projects have been designated through a very specific application process

c. These bonds are not subject to the general volume limitation under I.R.C. Section 146 but are subject to a separate national limit of $2 billion. They must be issued before October 1, 2009


15. Highway or Surface Freight Transfer Facilities

a. Added in 2006.

b. Eligible facilities include (i) any surface transportation project receiving federal highway funds, (ii) an international bridge or tunnel receiving federal funds, or (3) any facility for the transfer of freight from truck to rail or rail to truck

c. Bonds are not subject to the general volume limitation under section 146 but are subject to a separate national limit of $15 billion





06. IRS Issues & Enforcement

Faculty:Aviva M. Roth Orrick, Herrington & Sutcliffe LLP – Washington, DC Carla A. Young Nixon Peabody LLP – Washington, DC

I. Introduction

When bond counsel renders its approving opinion, it does so based on existing law and the reasonable expectations of the issuer and any conduit borrower at the time the bonds are issued. Such existing law includes the Internal Revenue Code (Code) and published guidance interpreting the Code that is issued by the Internal Revenue Service (IRS) in conjunction with the the IRS Office of Chief Counsel (Chief Counsel) and the Department of Treasury (Treasury). Reference may also be made to IRS written determinations which are not precedent but provide insight into how the IRS may view a transaction involving tax exempt or tax credit bonds. The expectations of the issuer and/or borrower relate, among other things, to the planned use of the bond proceeds and the bond-financed facilities. In addition, bond counsel expects that the issuer and/or conduit borrower will take certain required actions post-closing, such as the calculation of arbitrage rebate or ensuring that management contracts with for-profit entities meet the safe harbor standards.

However, existing law is not always clear and issuers and bond counsel may need to seek additional guidance from the IRS or Treasury. In addition, what the parties reasonably expect at the time of issuance of the bonds – and what actually happens over the course of the life of the bond issue – may be different. In some cases, such as the change in use of all or part of the bond-financed facilities, there are steps that the issuer and/or conduit borrower can take to ensure that the bond issue remains in compliance with the requirements of the Code. In other cases, the issuer and/or conduit borrower may need to enter into an agreement with the IRS to resolve an issue that arises post-closing.

In recent years, the IRS has increased its post-closing surveillance of bond issues through a variety of techniques, making clear that it is determined to ensure that bond issues comply with governing law over the life of the bonds. These efforts are generally directed through the IRS’ Tax-Exempt Bond office (TEB). Enforcement generally takes place either in the context of an examination of a bond issue or an issuer’s participation in the IRS’ Voluntary Closing Agreement Program (VCAP).

This outline addresses the various interactions between issuers and the IRS, including the process by which the IRS and Treasury provide published guidance that may be relied upon by issuers, the process by which an issuer may request an IRS determination with respect to a


specific transaction, the process followed during an examination of a bond issue and the procedures for requesting an agreement with the IRS through VCAP. Readers of this outline may also want to refer to the discussions on these topics contained in the “Federal Tax Aspects of Municipal Bonds” chapter of NABL’s companion book entitled “Fundamentals of Municipal Bond Law.”

II. Published Guidance – the Players

IRS Commissioner. The Commissioner of the IRS is appointed by the President of the United States with the advice and consent of the U.S. Senate. The mission of the IRS is to provide America's taxpayers top quality service by helping them understand and meet their tax responsibilities and by applying the tax law with integrity and fairness to all. IRM 32.1.1.1(1).

Office of Chief Counsel. The Office of Chief Counsel of the IRS provides legal guidance and interpretive advice to the IRS, Treasury and taxpayers. The Chief Counsel is also appointed by the President with the advice and consent of the U.S. Senate and is the chief legal advisor to the IRS Commissioner on all legal matters including the interpretation, administration and enforcement of internal revenue laws. The mission of the Office of Chief Counsel is to serve America's taxpayers fairly and with integrity by providing correct and impartial interpretations of the internal revenue laws and the highest quality legal advice and representation for the IRS. IRM 32.1.1.1(3). Chief Counsel's primary means of providing correct and impartial interpretations of the internal revenue laws is through published guidance, which includes the issuance of regulations compiled in Chapter 26 of the Code of Federal Regulations (CFR), revenue rulings, revenue procedures and notices.

Treasury. The Department of Treasury’s Office of Tax Policy (OTP) establishes policy criteria reflected in regulations and rulings, and, together with the IRS and the Office of Chief Counsel, prepares regulations and rulings. IRM 32.1.1.3.1(1).

A. Regulatory Guidance

Regulatory Guidance includes Advanced Notices of Proposed Rulemaking (ANPRM) Notices of Proposed Rulemaking (NPRM), Temporary Regulations and Final Regulations.

1. ANPRM – Notice of Proposed Regulations

An ANPRM describes a problem or situation, announces that the IRS is considering regulatory action, describes the anticipated regulatory approach, and seeks input from the public about the issues, the need for regulation, and the adequacy of the proposed regulatory action. An ANPRM is typically issued early in the rulemaking process. IRM 32.1.1.2.1. ANPRMs are published in the Federal Register.

2. NPRM - Proposed Regulations

An NPRM announces to the public that the IRS is considering modifying the existing regulations contained in the CFR or issuing rules on matters not addressed in existing regulations. In either circumstance, an NPRM sets out the proposed regulatory text, contains a preamble explaining the rules and the reasons for providing the rules, and requests public


comments on the suggested changes. NPRMs may also contain a Notice of Hearing. Unless there is an express statement in an NPRM allowing issuers to rely on the rules within the NPRM, NPRMs do not have full force and legal effect and cannot be relied upon by issuers for planning purposes unless and until they are adopted as final regulations. Prior to adoption, NPRMs may be withdrawn or modified at any time. NPRMs are initially published in the Federal Register. See IRM 32.1.2.2.

3. Temporary Regulations

Temporary regulations are issued to provide immediate guidance prior to publishing final regulations and are effective and can be relied upon by issuers when published in the Federal Register. Pursuant to § 7805(e) of the Code, the IRS is required to publish a cross-referencing NPRM when it publishes a temporary regulation. Section 7805(e) also provides that a temporary regulation expires (sunsets) within three years of issuance. IRM 32.1.1.2.3.

4. Final Regulations

Final regulations are issued after considering the public comments on the proposed regulations. The preamble of a final regulation cites to the underlying NPRM and other rulemaking history (for example, an ANPRM), discusses and analyzes public comments received, and explains the agency's final decision. A final regulation is almost always preceded by an NPRM. IRM 32.1.1.2.4.

B. Other Published Guidance

In addition to regulations, the IRS, Chief Counsel and Treasury promulgate other forms of “published guidance” the most common of which are revenue rulings, revenue procedures and notices. The IRS also occasionally issues announcements. Revenue rulings, revenue procedures and notices can generally be relied upon when published in the Internal Revenue Bulletin (IRB). The IRB is issued weekly and subsequently compiled into two annual Cumulative Bulletins (CB). IRM 32.2.2.1(1).

1. Revenue Ruling

Revenue Rulings are used to set forth statements of the IRS’ position and are an official interpretation by the IRS of the Code, related statutes, and regulations. Revenue Rulings are seldom issued relating to substantive tax issues involving tax exempt bonds. See Rev. Rul. 2003-116 (helicopter not considered airplane under Section 147(e)).

2. Revenue Procedure

Although Revenue Procedures are generally used to announce statements of procedure or general instructional information, in relation to tax exempt bonds, a revenue procedure can provide a holding on substantive tax issues where it sets forth safe harbors, guidelines or conditions such as provided in Revenue Procedure 97-13 (private business use safe harbors for management contracts). IRM 32.2.2.4(4).


3. Notice

A Notice is a public pronouncement that may contain guidance involving substantive interpretations of the Code or other provisions of the tax law. Notices may be used in circumstances in which a revenue ruling or revenue procedure would not be appropriate. Notices may also be used to solicit public comments on issues under consideration, in connection with non-regulatory guidance, such as a proposed revenue procedure. A Notice also can be used to indicate what regulations will say in situations in which the regulations may not be published in the immediate future. IRM 32.2.2.3.3. Notices have been the most frequent form of published guidance issued regarding tax exempt bonds in recent years and generally have provisions allowing issuers to rely on the guidance set forth in such Notice. See, e.g., Notice 2014-67 (amplified Rev. Proc. 97-13 by adding new safe harbor).

4. Announcement

An Announcement is a public message that is used by the IRS to announce programs or other procedural matters. For example, Announcement 2015-02 announced the availability of a VCAP program for certain Section 501(c)(3) organizations that had lost their tax-exempt status.

C. Priority Guidance Plan

Each year the IRS and Treasury solicit recommendations from the public as to items that should be addressed in published guidance. Upon consideration of recommendations from the public and recommendations from within the government, the parties develop a Priority Guidance Plan or "business plan" identifying the issues that they intend to address in published guidance during the business plan year. Recommendations with respect to future guidance may be submitted at any time, although the IRS and Treasury formally solicit recommendations from the public annually in May. IRM 32.2.2.6.2.

III. Informal Guidance and Written Determinations

A. Informal Guidance

1. IRS Website

The IRS website has a section entitled “Information for the Tax Exempt Bond Community” which contains links to published guidance, the IRM and other areas of interest to issuers and borrowers of tax exempt bond proceeds. In addition, the IRS publishes informal articles which discuss the application of the law to specific areas, such as “Sale of Assets Financed with Tax-Exempt Bonds by State and Local Governments and 501(c)(3) Organizations” and “TEB Financial Restructuring Compliance”. The TEB website also contains Frequently Asked Questions on different matters relating to tax exempt and tax credit bonds.

2. Soft Contact

IRS employees within the Office of Chief Counsel, Financial Institutions and Products, Branch 5 (Branch 5), are available to respond informally to inquiries by issuers or their representatives as to the proper application of the tax law to specific situations involving tax


exempt bonds. Branch 5 employees ordinarily will discuss with issuers or their representatives whether the IRS will rule on particular issues and will answer questions relating to procedural matters about submitting requests for letter rulings. At the IRS’ discretion and as time permits, substantive issues may also be discussed. Such discussions are not binding on the IRS and cannot be relied upon as a basis for obtaining retroactive relief under the provisions of Section 7805(b). See IRM 32.3.1.9(2).

B. Written Determinations

Written determinations include chief counsel advice, technical advice memoranda and private letter rulings. Unless the IRS otherwise establishes by regulations, a written determination may not be used or cited as precedent.

Chief Counsel Advice. Chief Counsel advice is written advice or instruction under any name or designation prepared by any national office component of the Office of Chief Counsel which is issued to field or service center employees of the IRS or regional or district employees of the Office of Chief Counsel and conveys any legal interpretation of the tax law. See Section 6100 of the Code. See, e.g., AM 2014-009 (defeasance of Build America Bonds); PMTA 2014-4 (credit for qualified bonds).

Technical Advice Memorandum. A Technical Advice Memorandum (TAM) is guidance furnished by the Office of Chief Counsel in response to a request by an IRS official, regarding technical or procedural questions that develop during an audit or proceeding. See, e.g., TAM 201538013 (advance refunding did not result in excess gross proceeds or abusive arbitrage device); TAM 201334038 (community development district not a political subdivision) and related TAM 201537023 (7805(b) relief granted for application of TAM 201334038).

Private Letter Rulings. A private letter ruling (PLR), is a written determination issued to a taxpayer by a branch within an Associate Chief Counsel office that interprets and applies the tax laws to the taxpayer's specific set of facts. See IRM 32.3.1.1(2). Most written determinations affecting tax exempt bonds are issued by Branch 5 of the Associate Chief Counsel for Financial Institutions and Products. See, e.g., PLR 201507002 (private business use of certain water facilities).

C. More on Private Letter Rulings

1. Reliance of PLRs

Although a PLR is not precedent, an issuer that receives a PLR may generally rely on it for the transaction addressed in that PLR. However a PLR found to be in error or not in accord with the current views of the IRS may be revoked or modified and such revocation or modification will apply retroactively unless the IRS uses its discretionary authority under § 7805(b) of the Code to limit the retroactive effect. Generally, the revocation or modification of a PLR will not be applied retroactively to the issue or stakeholder for whom the PLR was issued if: (i) there has been no change in the applicable law, (ii) the letter ruling was originally issued for a proposed transaction, and (iii) the taxpayer directly involved in the letter ruling acted in good faith in relying on the letter ruling, and revoking or modifying the letter ruling retroactively would be to the taxpayer's detriment. The revocation or modification of a PLR will be applied


retroactively to the taxpayer to whom the PLR was issued if there was a misstatement or omission of controlling facts or the facts at the time of the transaction were materially different from the controlling facts on which the PLR was based. See IRM 32.3.1.6.

2. Areas where the IRS will not issue PLRs

There are certain substantive areas in which, the IRS will not issue letter rulings. Section 4.01 of Rev. Proc. 2016-3 provides that rulings or determination letters will not ordinarily be issued with respect to the following specific questions and problems relating to tax exempt bonds:

(5) Whether the interest on state or local bonds will be excludible from gross income under § 103(a), if the proceeds of issues of bonds (other than advance refunding issues) are placed in escrow or otherwise not expended for a governmental purpose for an extended period of time even though the proceeds are invested at a yield that will not exceed the yield on the state or local bonds prior to their expenditure.

(6) Whether a state or local governmental obligation that does not meet the criteria of section 5 of Rev. Proc. 89–5, 1989–1 C.B. 774, is an “arbitrage bond” within the meaning of former § 103(c)(2) solely by reason of the investment of the bond proceeds in acquired nonpurpose obligations at a materially higher yield more than 3 years after issuance of the bonds or 5 years after issuance of the bonds in the case of construction issues described in former § 1.103–13(a)(2)(ii)(E) or § 1.148–2(e)(2)(ii).

(7) Whether state or local bonds will meet the “private business use test” and the “private security or payment test” under § 141(b)(1) and (2) in situations in which the proceeds are used to finance certain output facilities and, pursuant to a contract to take, or take or pay for, a nongovernmental person purchases 30 percent or more of the actual output of the facility but 10 percent or less of the: (i) subparagraph (5) output of the facility as defined in § 1.103–7(b)(5)(ii)(b) (issued under former § 103(b)), or (ii) available output of the facility as defined in § 1.141–7(b)(1). In similar situations, the Service will not ordinarily issue rulings or determination letters concerning questions arising under paragraphs (3), (4), and (5) of § 141(b).

(8) Whether an issue of private activity bonds meets the requirements of § 142 or § 144(a), if the sum of—

(i) the portion of the proceeds used to finance a facility in which an owner (or related person) or a lessee (or a related person) is a user of the facility both after the bonds are issued and at any time before the bonds were issued, and

(ii) the portion used to pay issuance costs and nonqualified costs equals more than 5 percent of the net proceeds, as defined in § 150(a)(3).


(9) Whether amounts received as proceeds from the sale of municipal bond financed property and pledged to the payment of debt service or pledged as collateral for the municipal bond issue are sinking fund proceeds within the meaning of former § 1.103–13(g) (issued under former § 103(c)) or replaced proceeds described in § 148(a)(2) (or former § 103(c)(2)(B)).

The IRS will generally not issue a letter ruling addressing a substantive area that is the subject of an open regulatory or other published guidance project. See IRM 32.3.1.4.8. In addition, the IRS will not issue a ruling addressing whether a taxpayer has permission to use a single yield for two or more issues of qualified mortgage bonds or qualified student loan bonds under § 1.148–4(a) until the IRS resolves the issue through the publication of a revenue ruling, revenue procedure, regulation or otherwise. Section 5.01 of Rev Proc. 2016-3(3).

The IRS will not issue a letter ruling if at the time of the request the identical issue involving the taxpayer is being examined or is pending in litigation. IRM 32.3.1.4.2. The IRS will generally also not issue a letter ruling on only part of an integrated transaction. IRM 32.3.1.4.3. Similarly, the IRS will not issue a letter ruling on alternative plans of proposed transactions or on hypothetical situations.

3. Procedures for submitting a ruling request

The initial revenue procedure published by the IRS each year provides the procedures and filing fees associated with filing a ruling request. See Rev. Proc. 2016-1. In addition to following the procedures in the initial revenue procedure, any letter ruling request under Sections 103, 141 through 150, 1394 and 7871 of the Code must also comply with the requirements of Rev. Proc. 96-16.

4. Reviewable and Nonreviewable Rulings

As indicated in Rev. Proc. 96-16, two different types of rulings are available relating to tax exempt bonds – those that are reviewable by the United States Tax Court and those that are not.

Reviewable rulings. Under Section 7478 of the Code, the United States Tax Court has the jurisdiction to issue a declaratory judgment with respect to whether interest on bonds will be excludable from gross income under Section 103(a) of the Code. A prospective issuer of bonds can petition the United States Tax Court for such declaratory judgments only if the IRS determines that interest on bonds will not be excluded from gross income under Section 103 or if the IRS fails to make a determination with respect to the excludability of interest within 180 days from the time the request for a determination is made. Accordingly an issuer may choose to submit a request to the IRS for a “reviewable ruling” determining whether or not an issue of prospective bonds will be tax exempt under Section 103(a) of the Code. Because the IRS and the Court will ultimately determine the taxability of the bond issue, the request for a reviewable ruling must address all of the tax exempt bond requirements. Reviewable rulings are fairly uncommon. See, e.g., PLR 200026020 and City of Santa Rosa, California v. Commissioner, 120 T.C. 339 (2003).


Nonreviewable rulings. An issuer of tax exempt bonds may also request a “nonreviewable” ruling that is not subject to the declaratory judgment provisions of Section 7478 relating to one or more of the various requirements for excludability under Section 103. In addition a request for a nonreviewable ruling can relate to the effect of a proposed transaction on an outstanding issue of bonds. Nonreviewable rulings are significantly more common than reviewable rulings.

Both reviewable and nonreviewable rulings addressing whether an issue of bonds will be tax exempt, will only be issued if the request for such ruling is submitted after the issuer adopts a bond resolution in accordance with state or local law, although such resolution may provide that the issuance of bonds is contingent on achieving a favorable ruling by the IRS. Once bonds are issued and outstanding the IRS will only issue a nonreviewable ruling on whether the bond issue meets one or more conditions for tax exemption if the request is received by the IRS before any interest on the bond is required to be reported by a holder. The IRS may also issue a nonreviewable ruling on the effect of a proposed act or transaction on one or more conditions for the tax exemption of outstanding bonds, but the request must contain a statement by the issuer that the outstanding bonds have met the conditions for exemption from the date of issuance until the submission of the request. The IRS will not issue a nonreviewable ruling on the status or classification of an issuer of bonds unless the status or classification of the issuer affects the exclusion of interest under Section 103 on a specific prospective issue of obligations. Rev. Proc. 96-16, Section 5.05.

Both reviewable and nonreviewable ruling requests are required to comply with the requirements of Rev. Proc. 96-16. The requirements of Rev. Proc. 96-16 are designed to make clear to both the requesting party and the IRS whether a request is a reviewable under Section 7478 and to ensure that for a reviewable request all necessary information with respect to the proposed issue of bonds is provided in a timely manner that will allow the IRS to make its determination within 180 days from the date the request is filed.

5. Who can request a nonreviewable ruling

A request for a nonreviewable ruling can be made by an issuer or a holder of a bond. An issuer for this purpose also includes any “on-behalf-of” issuer described in Rev. Rul. 63-20 and any constituted authority described in Rev. Rul. 57-187 if such on-behalf-of issuer or constituted authority has been designated by a state or political subdivision to issue the bonds. The term does not include any conduit borrower of the proceeds of tax exempt bonds. Other parties may join an issuer or a holder in requesting a nonreviewable ruling. Rev. Proc. 96-16, Section 5.01.

6. Pre-submission Conference

It is generally advantageous to both the IRS and the issuer to hold a conference, in person or by telephone, before the PLR request is submitted to discuss substantive or procedural issues relating to a proposed transaction. These conferences are held at the discretion of the IRS and if time permits and only if the identity of the issuer is provided to the IRS. An issuer or issuer’s representative may request a pre-submission conference in writing or by telephone. If an issuer’s representative will attend the pre-submission conference, a Form 2848, Power of Attorney and Declaration of Representative must be executed and provided to the IRS. In addition, the issuer


will be asked to provide, at least three business days before the scheduled pre-submission conference, a statement of whether the legal issue is an issue on which a letter ruling is ordinarily issued and a detailed written statement of the proposed transaction, issue, and legal analysis. Any discussion of substantive issues at a pre-submission conference is advisory only, is not binding on the IRS and cannot be relied upon as a basis for obtaining retroactive relief under the provisions of Section 7805(b).

7. PLR Submission

To request a PLR, a completed submission must be filed with the IRS Office of Chief Counsel in accordance with the requirements contained in the annual revenue procedure (i.e., Rev. Proc. 2016-1) and Rev. Proc 96-16. Requests can be filed via US Mail, private delivery service or delivered directly via courier. Requests cannot be officially submitted using email or fax.

A PLR request may be submitted as signed by the issuer or the issuer’s authorized representative and should contain the following information if relevant to the request:

(1) the name, address, and taxpayer identification number of the issuer, each underwriter, each conduit borrower (except conduit borrowers of the proceeds of bonds such as qualified mortgage bonds, qualified veterans' mortgage bonds, and qualified student loan bonds);

(2) a description of all uses and users of proceeds of the obligations;

(3) a description of the accounting method or methods that have been or will be used to account for investments and expenditures of gross proceeds of the obligations, including refunding obligations;

(4) an accounting of all fees that will be paid in connection with the issuance of the obligations;

(5) for outstanding obligations, including refunded obligations, the actual principal amount, actual issue price, actual issue date, and actual yield of the obligations and investments;

(6) for prospective obligations, the expected principal amount, expected yield, expected issue price, and expected issue date of the prospective obligations and of the expected investments to be acquired with bond proceeds;

(7) descriptions of any obligations that have been or will be refunded and representations whether the interest on each obligation that has been or will be refunded has been treated by the issuer as excludable from gross income under Section 103;

(8) a statement whether the issuer has received an appropriate allocation of volume cap under Section 146; and


(9) a description of any elections made pursuant to the regulations under Section 148, including elections on the application of the various versions of those regulations. See Rev Proc 96-16, Section 5.06.

In addition, the request should also include the following documents if relevant:

(1) the resolution, official statement, and trust indenture;

(2) management and service contracts, leases, output contracts, and agreements that affect any facility financed with the proceeds from the obligations;

(3) the arbitrage certificate and other documents containing covenants about arbitrage rebate and about subsequent intentional acts to earn arbitrage; and

(4) copies of relevant provisions of local law. See Rev Proc 96-16, Section 5.07.

The request must also include the following statements required by Rev. Proc. 2016-1 relating to:

(1) Whether the same issue has already been considered by the IRS in an examination or in a ruling request or by the courts;

(2) Whether the law in connection with the issue is uncertain and whether the issue is adequately addressed by relevant authorities;

(3) Whether there are any contrary authorities as well as a discussion of such contrary authorities; and

(4) Whether there is any applicable pending legislation.

The request may also contain any and all of the following requests relating to the ruling:

(1) A request to have the ruling processed in an expedited manner. These requests are rarely granted for PLRs relating to tax exempt bonds.

(2) A request for the IRS to fax to the taxpayer or the taxpayer’s representative a copy of any document relating to the ruling request.

(3) A request to have a conference to discuss the issue relating to the request.

The request must also include a completed copy of the letter ruling request checklist included in Rev. Proc. 2016-1 as Appendix C, a check payable to the Internal Revenue Service for the applicable fee (currently $28,300) and an original executed Form 2848 Power of Attorney and Declaration of Representative if the request is being submitted by an attorney or if the issuer wishes the IRS to communicate with its attorney(s). The issuer may also indicate on the Form 2848 whether the representative should receive a copy of the PLR.

All requests must be accompanied by the following items which must be signed by the issuer, regardless of whether a representative signs the remainder of the request:


(1) A statement identifying information to be deleted from the public inspection copy of the letter ruling or determination letter. Rev. Proc. 2016-1.

(2) An original signed copy of the following statement signed by the taxpayer: Under penalties of perjury, I declare that I have examined this request, including accompanying documents, and, to the best of my knowledge and belief, the request contains all the relevant facts relating to the request, and such facts are true, correct, and complete. Rev. Proc. 2016-1.

(3) An original signed copy of the following statement: The undersigned acknowledges that the request for a ruling submitted by [insert name of holder or issuer] to the Internal Revenue Service on [insert date of the request for a ruling] is governed by section 5 of Rev. Proc. 96-16. Section 5 of Rev. Proc. 96-16 sets forth procedures that must be followed to obtain a non-reviewable ruling. Therefore, the request for a ruling does not comply with the requirements of section 4 of Rev. Proc. 96-16 which sets forth the procedures that must be satisfied to obtain a ruling that is reviewable by the United States Tax Court under § 7478 of the Internal Revenue Code. Rev. Proc. 96-16.

8. Processing of PLR Requests (Section 8 of Rev Proc. 2016-1)

Within 21 calendar days after a letter ruling request has been received, an IRS representative will contact the issuer or the issuer’s authorized representative to discuss any procedural issues in the letter ruling request. The issuer or the issuer’s authorized representative may obtain information regarding the status of a request for a letter ruling or determination letter by calling such IRS representative.

During its consideration of the PLR request, the IRS may request additional factual information or legal analysis which the taxpayer must submit within 21 calendar days unless an extension is obtained. To the extent the issuer provides additional factual information, such information must be accompanied by a penalty of perjury statement (similar to the statement submitted with the original PLR request) signed by the issuer.

If the IRS is considering issuing an adverse ruling, it will give the issuer an opportunity to schedule an adverse conference of right. This conference, which may be conducted in person or by telephone, is normally held at the branch level, and is attended by a person who has the authority to sign the letter ruling in his or her own name or for the branch chief. The IRS representative will explain the IRS’ tentative decision on the substantive issues and the reasons for that decision and the issuer will be allowed to present views in its favor. The issuer should furnish to the IRS any additional data, reasoning, precedents, etc. that were proposed by the issuer and discussed at the conference but not previously or adequately presented in writing within 21 calendar days from the date of the conference.

Generally, after the conference of right is held but before the letter ruling is issued, the IRS representative will orally notify the issuer or the issuer’s representative of the IRS’ conclusions. If the ruling will be adverse to the issuer, the issuer will be offered the opportunity to withdraw the letter ruling request. If, within ten calendar days of the notification by the branch representative, the issuer or the issuer’s representative does not notify the branch representative that the issuer wishes to withdraw the ruling request, the adverse letter ruling will


be issued unless an extension is granted. The user fee will not be refunded for a letter ruling request that is withdrawn.

An issuer may withdraw a request for a letter ruling at any time before the letter ruling is signed by the IRS. Correspondence and exhibits related to a request that is withdrawn or related to a letter ruling request for which the IRS declines to issue a letter ruling will not be returned to the issuer and the fee will generally not be refunded.

IV. IRS Enforcement

A. Goals of the Tax-Exempt Bond Program

The IRS’ Examination Procedures state that the tax-exempt bond program “combines compliance and enforcement initiatives with outreach and educational activities” to accomplish, in part, the following goals:

1. Achieve significant levels of pre-issuance and post-issuance compliance;

2. Respond promptly to abusive transactions;

3. Increase the effective use of information returns;

4. Encourage transaction participants to take an active role in ensuring that their bond issues comply with the Code and Regulations; and

5. Promote voluntary compliance with the requirements of the Code and Regulations.

IRM 4.81.1.2.

B. Who Is The Subject of An Examination

Although the potential consequence of non-compliance with the Code and the bond documents is the loss of the tax-exempt status of the bonds, bondholders are typically not involved in an examination or other enforcement action. The appropriate party is the issuer of the bonds, regardless of whether the issuer is a direct issuer, such as a governmental subdivision, or is serving as a conduit for a private borrower, despite the conduit borrower being the real party in interest. The IRS’ Examination Procedures state that the policy of the IRS is to attempt to resolve violations at the “transaction level” with issuers or participants, and not at the bondholder level and “to obtain resolution of such violations (including payment of any settlement amounts) from the appropriate party to the transaction to ensure that interest income received by the holders of tax-exempt bonds continues to be exempt for federal income tax purposes and that the holders of tax credit bonds continue to be allowed the tax credit against the taxpayer’s federal income tax.” See IRM 4.81.6.1-2. In fact, the IRS taxes bondholders only on rare occasions.


C. Methods In Which An Examination Is Initiated

Agents may conduct a preliminary review of a bond issue before opening an examination. Agents are directed to consider the following documents as part of their pre-examination research: issuer information returns; official statements and continuing disclosure filings; filings with Guidestar, EDGAR and EMMA databases; issuer and conduit borrower websites; pertinent state or federal agency reports or files; and any other information obtained through internet searches. See IRM 4.81.5.4-3.

The Examination Procedures direct an agent to inform the issuer of the examination at the beginning of an examination. Agents are directed to issue one of four opening letters: 1) the General Program Examination Letter; 2) the Project/Initiative Examination Letter; 3) the Referral Examination Letter; or 4) the Identified Noncompliance Exam Letter. IRM 4.81.5.6.1-2. The first letter is for cases selected randomly. The second letter is for cases selected as part of a project initiative, where the IRS is undertaking a focused review of a specific issue, e.g., transportation bond financings. The third letter is for situations where the IRS is examining specific bonds based on internally developed information or information received from external sources. The fourth letter indicates the IRS has information that raises specific concerns regarding the tax compliance of the specific bond issue. Agents are also required to provide Publication 1 “Your Rights As A Taxpayer” with all examination letters. IRM 4.81.5.6.1-3.

D. Compliance Check Questionnaires and Focused Examinations

A compliance check is not treated by the IRS as an examination. Instead, it is viewed as a “soft contact” to ascertain the levels of adherence to certain requirements. There is no legal requirement to respond to a compliance check questionnaire. Nevertheless, the IRS may use compliance checks to identify potential examination targets, although it is unclear whether TEB has actually taken this step with respect to issuers or borrowers who did not file a response. TEB has launched several separate compliance check questionnaire programs since 2007: (1) exempt organization borrowers of qualified 501(c)(3) bonds; (2) governmental issuers of tax-exempt governmental bonds; (3) governmental issuers of direct pay Build America Bonds; (4) governmental issuers of advance refunding bonds and exempt organization borrowers benefitting from advance refunding bonds; and (5) Qualified School Construction Bonds. A significant portion of the questions in each compliance check focused on the existence of procedures to ensure post-issuance compliance and the retention of records.

TEB is expanding the use of limited scope or “focused” examinations. These are often conducted solely as correspondence examinations. As an example, the issuer may receive correspondence from the Compliance and Program Management Group (CPM) questioning why the amount of issuance costs reflected on a Form 8038 exceeded the 2% limitation. These examinations may look similar to compliance checks, but are in fact examinations of the bonds.

E. Initial Steps In An Examination

Agents are directed to obtain and review the bond transcript and develop factual and legal questions. The Examination Procedures expressly contemplate that third-party investigative


inquiry may be necessary, including the issuance of a summons to obtain necessary information. See IRM 4.81.5.7.3.1.

An issuer that is the subject of an examination will typically hire counsel to represent it, which may be the firm that served as bond counsel for the bond issue(s) in question or another bond counsel firm. In order to communicate with the IRS in an examination, counsel is required to provide a Power of Attorney on Form 2848, signed by the issuer, even if counsel's principal client is a conduit borrower, in which case a joint representation waiver and agreement should be obtained. IRM 4.81.5.6.4.1. In some cases where there is a joint representation, an issuer or a conduit borrower may also wish to have its own counsel represent it.

IRM 4.81.5.6.4.1 provides that examiners should review all Forms 2848 received during the examination and determine whether a conflict of interest exists as defined under section 10.29(a) of Circular 230. If the examiner believes that a conflict exists, he or she must secure a conflict of interest waiver from each affected client. However, in 2014 TEB instructed agents that the guidance in IRM 4.81.5.6.4.1 is superseded by the provisions of proposed IRM 4.82.3.4.2. IRM 4.82.3.4.2 provides that if an agent has reason to believe, based on all pertinent facts and circumstances available, that a representative has a conflict of interest, the examiner should promptly raise the issue with the representative and request that the representative act to address the conflict of interest. If the examiner is persuaded that there is not a conflict of interest or that the conflict has been waived, then the examiner can treat the matter as concluded. A representative may also resolve a conflict of interest by, for example, withdrawing from the representation and rescinding the power of attorney. If the representative has or will obtain the represented person’s informed consent to the representation notwithstanding the conflict of interest, the examiner should require written assurance from the representative that the conflict has been resolved through informed consent. The examiner should specifically require a letter or other signed document from the representative stating that after being informed of the conflict of interest, each affected client has waived the conflict and given informed consent to the representation and such consent was confirmed by each client in writing. The examiner ordinarily should not request copies of the actual informed-consent documents that were signed by the affected clients (emphasis supplied). See Memorandum for Tax Exempt Bond Examiners and Group Managers from Rebecca L. Harrigal, Director, Tax Exempt Bonds, dated January 13, 2014.

Whether bond counsel that originally represented the issuer is the appropriate choice for the issuer in an audit may depend on the particular facts and circumstances of the examination. For example, if the examination is random, then there is no initial suggestion that the bond counsel opinion may be in issue. In other circumstances it may be best for the issuer to hire bond counsel that did not work on the original issue.

F. Contacts With Third Parties

As a general matter, agents are not permitted to contact third parties without providing the issuer reasonable notice in advance that such contacts will be made. Such contact is permitted when the agent is unable to obtain the relevant information from the issuer or its representative or to verify information provided by the issuer or its representative. The IRS is required to


provide the issuer with a record of persons contacted with respect to the determination whether the bonds are taxable. IRM 4.81.5.7.7.

G. Procedures For Making A Determination

In certain cases, an agent may conclude, with the concurrence of his or her manager, that there is no liability on the part of the issuer or conduit borrower. In those cases, the IRS will issue a “No Change” letter, which will terminate the examination. IRM 4.81.5.9.3.

If, however, an agent has identified a potential issue, the agent should discuss it with the issuer or its representative as soon as possible. If the issuer does not concur, the agent may provide the issuer with a written summary of potential issues on Form 5701-TEB, Notice of Proposed Adjustment (NOPA). The NOPA includes statements of the issues, facts, law, and the agent’s position. IRM 4.81.5.9.

In some cases an agent may seek a Technical Advice Memorandum (TAM), which is a memorandum prepared by the IRS’ Office of Chief Counsel addressing the application of governing law to the specific facts of the case before the agent. If a TAM is requested, whether before or after issuance of a NOPA, the issuer is afforded certain procedural rights, including the right to receive notification of the request and the agent’s arguments, the right to submit written materials in opposition to the agent’s positions, and the right to an adverse conference. See Rev. Proc. 2016-2.

In the event all issues are not resolved by agreement between the IRS and the issuer, the agent may prepare a proposed adverse determination for review and approval by the agent’s group manager and the Manager, Field Operations. A proposed adverse determination, if issued, triggers the issuer’s right to appeal to the IRS Office of Appeals. The IRS cannot issue a final adverse determination until either an appeal has been concluded or the issuer has failed to request an appeal in a timely manner. IRM 4.81.5.9.1 and 4.81.5.9.2.

If it is determined that interest on the bonds is not yet taxable, but might become taxable if certain corrective actions are not taken (for example, cessation of private use or reductions in arbitrage), an agent, with the group manager’s concurrence, should issue a closing letter identifying such issues. IRM 4.81.5.9.4.

H. Closing Agreements

Because the Tax-Exempt Bond program contemplates that almost all disputes with issuers will be resolved by closing agreements, the provisions in the Examination Procedures setting forth the procedures and terms of closing agreements are, as a practical matter, particularly significant.

The Examination Procedures expressly require that a closing agreement must be signed by the governmental issuer. An agent is instructed to permit participation by others (such as the conduit borrower) in negotiations only if the issuer provides a disclosure waiver. See IRM 4.81.6.4.


The Examination Procedures impose significant requirements for examination closing agreements. See IRM 4.81.6.4. For instance, the Examination Procedures require an agent to obtain approval from the “TEB Senior Management Team” of any proposed settlement terms prior to drafting a closing agreement. To obtain this approval, the agent must prepare a written summary of the proposed settlement terms for the Senior Management Team. Only after that summary is prepared, presented and approved, will the field agent begin to draft the closing agreement.

1. Terms of Closing Agreements

The Examination Procedures state that a closing agreement should be narrowly drafted to cover only those issues raised during the examination process. See 4.81.6.4-7. Payment of any closing agreement amount is to be made after execution of the closing agreement by the issuer and through the Electronic Federal Tax Payment System (EFTPS). IRM 4.81.6.6.

The Examination Procedures state that, when negotiating a closing agreement, it is important that all potential adjustments, such as adjustments to the conduit borrower’s depreciation allowance, adjustments pursuant to Section 150(b) of the Code (relating to change in use of the bond-financed facilities), and the deductibility of any closing agreement payment, be included in the terms of the closing agreement where appropriate. See IRM 4.81.6.4-8. It should be noted that adjustments for depreciation allowance and Section 150(b) adjustments involve a different party – the conduit borrower rather than the issuer that will be the primary party executing the closing agreement.

The Examination Procedures provide that closing agreement terms “will generally include a requirement that the issuer redeem the bonds of the issue at the earliest possible date.” IRM 4.81.6.5.1. If the closing agreement requires early redemption, but the redemption will not occur until after the closing agreement is finalized, the Examination Procedures require the issuer to provide a call notice to bond holders prior to execution of the closing agreement and provide evidence of such notification to the IRS. See IRM 4.81.6.5.1.

The Examination Procedures generally state that an irrevocable defeasance escrow to redeem the bonds on the first no penalty call date will typically be established if the bonds are not redeemed prior to the date of execution of the closing agreement. The issuer will provide written notice to TEB of the establishment of the irrevocable defeasance escrow prior to the execution date of the closing agreement. Id.

Section 7121 of the Code provides that the closing agreement will be “final and conclusive” and can only be set aside by the IRS upon a showing of fraud or malfeasance, or misrepresentation of material fact.

2. Basis for Determining the Closing Agreement Amount

The Examination Procedures state that “[g]enerally, a closing agreement amount is based on the present value of the taxpayer exposure of the bond issue.” IRM 4.81.6.5.3. The closing agreement amount could, however, also be based upon the present value of an AMT adjustment amount, Section 150(b) adjustment amounts, Section 168(g) adjustment amounts, excessive arbitrage profits, or Section 6700 penalties. Certain provisions of the IRM speak to the amount


to be paid with respect to tax credit and direct pay bonds. For such bonds, payment may be based upon the present value of credits to be received in future periods. IRM 4.81.6.5.3.2.

The IRM indicates that TEB will take into account actions of the issuer or conduit borrower to implement written post issuance compliance procedures and to exercise post issuance reasonable due diligence and compliance monitoring when determining the closing agreement amount. IRM 4.81.6.5.3.

The total taxpayer exposure is defined as the amount of tax the IRS could collect if the bondholders paid tax on the interest they have earned and will earn as interest on the bonds. Taxpayer exposure for any year is equal to the interest both accrued and scheduled to accrue in that year on the outstanding bonds multiplied by the relevant tax percentage plus interest at the underpayment rate on that amount. Interest on variable rate bonds for future periods may be determined using the average of the interest rate paid to date, the last interest rate paid on the bonds, or the applicable fixed swap rate less up to 50 basis points, as appropriate under the facts and circumstances of each case. The “relevant percentage” is based on the IRS’s estimate of the average investor’s highest tax bracket, and will generally equal 29%, unless a more accurate assessment of the investors’ actual tax rate is known. Historically, the IRS has used 29% as the “relevant percentage.” IRM 4.81.6.5.3.1

The Examination Procedures provide that the total taxpayer exposure for prior years is calculated by adding together the taxpayer exposure for all open years, after adding interest at the underpayment rate for each open year. IRM 4.81.6.5.3.1 provides that the number of open years will include all three years from “the date the compliance failure was identified by TEB,” and that this date occurs when the IRS “provides written notification to the issuer.” As a result, tax years that would normally expire during the examination or appeals process due to the three year statute of limitations will no longer be dropped from the settlement calculation, which raises a significant question as to whether delays in the examination or appeals process are detrimental to settlement.

IRM 4.81.6.5.3.1 also states that the general three year open statute period may be increased to six years when TEB determines that the issuer or its representative has not acted in good faith in resolving the compliance failure. The Examination Procedures provide that taxpayer exposure for future years should be computed on a present value basis, using the taxable applicable federal rate as the discount rate. IRM 4.81.6.5.3.9.

Excessive arbitrage profits for this purpose are generally defined as the estimated amount of the “economic benefit” realized by the issuer or other parties to the transaction in excess of the amount permitted to be realized pursuant to the arbitrage restrictions. IRM 4.81.6.5.3.8.

I. Administrative Appeal Procedures For Issuers of Tax-Exempt Bonds

Special procedures for an administrative appeal from a proposed adverse determination by the IRS that a bond issue is not tax-exempt (or from the denial of a claim for recovery of excess arbitrage rebate payments) are set forth in Rev. Proc. 2006-40. Rev. Proc. 2006-40 indicates that, except as otherwise provided, the administrative appeals procedures that are generally applicable to taxpayers also apply to tax-exempt bond issuers.


Rev. Proc. 2006-40 implements the direction in Section 3105 of the Internal Revenue Service Restructuring and Reform Act of 1998 that the IRS modify its administrative procedures to allow tax-exempt bond issuers an expeditious appeal from a proposed adverse determination before the IRS proceeds to tax bondholders.

1. The Issuer as “Taxpayer”

Rev. Proc. 2006-40 follows the historical approach of the IRS of treating tax-exempt bond issuers as deemed taxpayers. Bondholders do not, however, lose their status as taxpayers, and they retain separate appeal rights. Conduit borrowers and other interested persons may inspect or receive confidential information during the Appeals process, if authorized by the issuer, by submitting a duly executed Form 8821, Taxpayer Information Authorization, to the Appeals officer.

2. Procedure for Requesting an Appeal

Rev. Proc. 2006-40 states that established appeals procedures that apply to taxpayers generally, including those governing submissions and taxpayer conferences, typically apply to a tax-exempt bond issuer pursuing an appeal. An issuer’s appeal request must be submitted in writing within 30 days of the date of the proposed adverse determination, subject to possible extension by the IRS following an issuer’s written request justifying such an extension. Failure to submit an appeal within the permitted period will result in the proposed adverse determination becoming final.

The appeal request must contain a written response to the proposed adverse determination, and include a full and complete discussion of the issuer’s position on the issue(s) contained in the proposed adverse determination. Upon receipt of the request, TEB reviews it for compliance with the requirements of Rev. Proc. 2006-40. If it does not comply, TEB will notify the issuer of the deficiencies. If it does comply, but raises new issues, TEB will notify the issuer that the new information may change the case’s outcome and will require further discussion before a transfer to Appeals. If the request complies and does not raise new issues, TEB will transfer the case file to Appeals.

Before appeal requests are transferred to Appeals, they are first “expeditiously” reviewed by CPM to ensure that the requirements of Rev. Proc. 2006-40 have been satisfied and that the factual and legal matters in the file support the issues raised by TEB Field Operations in the proposed adverse determination. After a case file is sent to Appeals, Appeals has jurisdiction over the issues raised in the proposed adverse determination.

3. The Administrative Appeal Process

An appeal is assigned to a senior Appeals officer specializing in tax-exempt bonds. Appeals will consider the case a priority assignment and will resolve the case as expeditiously as possible. An issuer may request that an issue be referred for technical advice under section 5.02 of Rev. Proc. 2016-2.

If Appeals and the issuer agree that no action is necessary with respect to the issues raised in a proposed adverse determination, Appeals will provide written notification to the issuer that


the proposed adverse determination has been withdrawn. If Appeals and the issuer reach an agreement with respect to the bond issue, Appeals will generally prepare a closing agreement.

If Appeals and the issuer cannot reach an agreement, Appeals will provide written notification to the issuer that TEB's Proposed Adverse Determination has become final. Appeals then returns the case to TEB, which may initiate procedures to impose tax on the bondholders.

4. Special Appeals Procedures for Conduit Borrowers

Rev. Proc. 2006-40 provides that, in appropriate circumstances, such as the determination of issues under Sections 150(b) or 168(g), Appeals may consider issues that relate to the tax liability of a conduit borrower at the same time as the issuer’s appeal. Appeals will consider using this procedure only if the conduit borrower is under examination with respect to the issue, the resolution of the issue is affected by the determination of whether the interest on the bond issue is tax-exempt, and the conduit borrower agrees to resolve the issue at the same time as the issuer’s appeal.

J. Examination Procedures for Direct Pay Bonds

The IRS issued a Memorandum for Tax Exempt Bond Employees dated July 20, 2015, which contains interim procedures for conducting examinations of direct pay bonds that are to be incorporated into IRM 4.82.6. The interim guidance provides that the examination procedures for tax-exempt bonds generally apply to direct pay tax credit bonds unless otherwise indicated. It further provides that the credit payment is treated as a refund of an overpayment of tax. The applicable period of assessment is three years from the date a particular IRS Form 8038-CP is filed, and a separate statute of limitations applies to each Form 8038-CP. Because issuers of direct pay bonds are the “taxpayer” for federal tax purposes, the Memorandum provides guidance to agents for requesting extensions of the statute of limitations. This is in contrast to the procedures applicable to tax-exempt bonds where only bondholders can agree to an extension of the applicable statute of limitations.

K. The Voluntary Closing Agreement Program

On September 25, 2001, the IRS issued News Release 2001-85, announcing the establishment of a voluntary closing agreement program known as the TEB VCAP. TEB VCAP is administered by CPM. Since 2001, the IRS and issuers have resolved a substantial number of compliance issues through VCAP closing agreements.

The IRS states that TEB VCAP is intended to encourage issuers and conduit borrowers to exercise due diligence in complying with the Code and applicable regulations by providing a vehicle to correct violations thereof in furtherance of the IRS’ policy of taxing bondholders as a last resort.

Generally, in consideration of the issuer’s voluntary action in making the TEB VCAP request, its statements of good faith, its description of a violation, and its description of the procedures it has adopted that are intended to promote compliance and prevent violations, the issuer submitting a TEB VCAP request can expect to settle the case on terms that are no less favorable, and generally on terms that are more favorable, to the issuer than the settlement terms


that would be expected had the violation been discovered as a result of an examination. The benefit the issuer received as a result of the violation is one factor, among others, that may be considered in resolving TEB VCAP requests. IRM 7.2.3.1.1.

VCAP procedures have been continuously refined since 2001, including those made in Notice 2008-31 and IRM provisions released in subsequent years. The notice and new guidelines (1) added tax credit bonds to VCAP, (2) provide for electronic submission of VCAP requests, (3) establish roles for a TEB VCAP Inventory Coordinator, a CPM team leader, and the TEB Closing Agreement Committee, (4) provide details regarding the internal briefing requirements necessary to resolve a VCAP, (5) establish the requirement to pay the closing agreement amount through the official electronic payment system, and (6) create a streamlined closing agreement process for certain identified violations.

The IRM has also expanded and clarified the prior VCAP procedures to encompass certain tax credit bonds and direct pay bonds, identify specific violations for these categories of tax-advantaged bonds, and provide specific resolution standards for the enumerated violations. These provisions eliminate much uncertainty as to the resolution of problems relating to Build American Bonds and Recovery Zone Economic Development Bonds.

TEB VCAP has a limited mandate. It is rarely appropriate unless the violation is clear and undisputed. Therefore, the program has had limited applicability as a tool to settle disputes of fact and law related to initial or ongoing compliance. In some cases, it may be prudent for an issuer to participate in TEB VCAP because it might be determined that the cost of settlement could be significantly higher upon an involuntary examination. If an issuer fails to participate in TEB VCAP and subsequently receives an audit letter, participation in VCAP is foreclosed. IRM 7.2.3.1.2-6 states that TEB VCAP is not available to any bond issue under examination.

1. Scope of TEB VCAP

TEB VCAP is not available if the exempt status of any bonds is under examination or is an issue in a court proceeding, is being considered in the IRS Office of Appeals, or the IRS determines that a violation was due to willful neglect. Presumably, an issuer may be found to have done a transaction with “willful neglect” if it did a transaction that TEB has previously identified as abusive through formal announcement or public statements.

2. Anonymous VCAP

In some cases an issuer may request participation in VCAP anonymously. Unlike ordinary VCAP requests, however, a bond issue is still at risk of examination and of becoming ineligible for TEB VCAP until the names of the issuer and bond issue are disclosed to the IRS. IRM 7.2.3.1.5

3. TEB VCAP Closing Agreement Request Procedures

IRM 7.2.3.2.1 sets forth the information that must be provided in a request for a closing agreement by the issuer or its authorized representative. The request must provide all relevant information, under penalty of perjury, including the following specifically required items:


A. IRS Form 14429. A VCAP request must be submitted with IRS Form 14429.

B. Information identifying the issuer of the bond issue including: (1) the name; (2) employer identification number; (3) street address, city, state, and zip code; and (4) name, title, and telephone number of an official of the issuer who may be contacted for additional information. With respect to a violation that affects multiple issuers or issues of bonds, such as a composite issue, each issuer of an affected issue must join in the request and provide the information required in connection with a TEB VCAP request.

C. Information identifying the bond issue including: (1) the name of the bond issue and issue date; (2) the issue price; (3) a full debt service schedule for the issue showing principal maturities and interest rates (for variable rate issues include a description of how the rate is set and the interest payments to the date of the request); and (4) CUSIP number(s), if any.

D. Information including: (1) a clear statement of the specific federal tax requirement which provides a basis for finding a violation; (2) a description of the identified violation(s), and the facts and circumstances pertaining to the nature of the identified violation and its occurrence; and (3) a statement as to when and how the facts surrounding the identified violation were discovered. In the event that the issuer identifies a violation but requests CPM to consider as a factor in determining an appropriate resolution that certain legal questions apply, the issuer must also include the following information in its request: (1) a description of established law supporting a determination that there is a credible basis for finding that a violation occurred; and (2) as well as a description of such legal questions, and their application to the facts of the submission, supporting why CPM should consider such legal questions as a factor in the appropriate resolution of the violation.

E. Description of the issuer’s proposed settlement terms for resolving the identified violation. If the proposal includes the payment of a closing agreement amount, the issuer must include: (1) an identification of the computation methodology described in IRM section 4.81.6 used to determine the amount or a description of an alternative computation methodology including a discussion of why such an alternative is appropriate under the facts and circumstances; and (2) an identification of the source of funds to be used to pay the closing agreement amount. If the proposal includes the redemption, defeasance, tender, or purchase of any amount of the bonds comprising the bond issue, the issuer must identify the source of funds to be used to effectuate such action and the maturities of the bonds subject to such action.

F. Representations including: (1) a statement that the TEB VCAP request is permitted under IRM section 7.2.3.1 (i.e., that the bond issue is not under examination or under consideration by the IRS Office of Appeals); (2) a statement that the tax-advantaged status of the bonds is not at issue in any federal court; (3) a statement as to whether the bonds are under review in any court (other than a federal court), administrative agency, commission, or other proceeding (identify the proceeding); (4) a statement as to whether the issuer knew or reasonably expected on the issue date that the violation might occur; (5) a description of the policies or procedures which have been or


will be implemented to prevent this type of violation from recurring with this or any other bond issues; and (6) a statement regarding the date(s) of the violation, the date and circumstances surrounding the discovery of the violation, and the date and nature of any actions taken in response to the discovery of violation (e.g., redemption, defeasance).

G. Identification of any previous and contemporaneous VCAP requests (including anonymous requests) submitted by the issuer (or the conduit borrower in a conduit financing) either: (1) with respect to the bond issue that is the subject of the request; or (2) pertaining to a violation that is the same as the subject of the request provided that such request was submitted within the past five years. With respect to identified requests include the name(s) of the related bond issue(s) and brief summaries of the violation(s) identified in, and resolution(s) of, all previous requests. If no previous or contemporaneous VCAP requests have been submitted, then a statement to that effect.

H. Identification of all previous or contemporaneous private letter ruling requests submitted by the issuer with respect to the bonds and relating to the violation which is the subject of the TEB VCAP request. With respect to identified ruling requests include a brief summary of the matters addressed therein. If no previous or contemporaneous ruling requests have been submitted, then a statement to that effect.

I. Whether the identified violation has been disclosed on EMMA (the Municipal Securities Rulemaking Board’s Electronic Municipal Market Access System) or to any state or local taxing jurisdiction that grants tax-advantaged treatment to the issuer’s bonds, a statement describing the disclosure and how it was made. If no such disclosure has been made, a statement to that effect.

J. If the issuer wishes to assert that the violation was caused by another partyand requests CPM to consider this as a factor in determining an appropriate resolution, a statement that the violation was due to the acts or omissions of a person or persons other than the issuer, together with a description of the circumstances surrounding the violation thereof, and any information that the issuer has regarding such acts or omissions (including an identification of the person or persons) whose acts or omissions caused the violation).

K. Statement regarding post-issuance procedures. The issuer must include with the request a statement about whether it has post-issuance procedures in place to monitor compliance with the Federal tax laws and whether the issuer mandates that others that have control over actions that might cause a violation of the Federal tax laws have compliance procedures in place with respect to those relevant actions. IRM 7.2.3.2.1-3. The extent to which an issuer has appropriate written compliance procedures may be an equitable factor that will receive consideration in determining appropriate resolution terms with respect to VCAP requests.

L. IRS Form 8038 Series. A copy of the Form 8038 Series information return filed in connection with the bonds must be provided. If the violation relates to Section 148 of the Code, include any Forms 8038-T or 8038-R that were filed. If the issuance is a direct pay bond, include a copy of all 8038-CP forms filed in connection with the issue.


M. Model Closing Agreement. TEB has created but not yet released a VCAP model closing agreement that will be available on the TEB website (VCAP Model Agreement) and discussed in IRM 7.2.3.3.2. Once the VCAP Model Agreement is available on the TEB website, the request must include a draft of the VCAP Model Agreement, filled in as appropriate for the TEB VCAP request. Generally TEB will not deviate from the terms specified in the VCAP Model Agreement that are applicable to the TEB VCAP request, however, if the issuer believes a deviation is necessary, it should notate the proposed change on the VCAP Model Agreement it submits and the reason it believes that the deviation is necessary. If the TEB VCAP request is for a violation for which the IRS has provided a specialized closing agreement template (as contrasted with the VCAP Model Agreement) in an Announcement or other form of guidance (Specialty Agreement Template), the issuer should follow the instructions provided in that announcement or other guidance when submitting the proposed agreement. IRM 7.2.3.2.1-5.

4. VCAP Case Development Process

IRM 7.2.3.3.2 describes the manner in which CPM processes a typical closing agreement request. If the violation is covered by the streamlined process and the language of the proposed closing agreement does not substantively differ from the VCAP Model Agreement language, the CPM specialist will prepare a briefing memorandum following the applicable resolution standards and forward the briefing memo and proposed closing agreement to the specialist’s CPM group manager for review, concurrence and ultimately for the signature of the CPM Manager. These agreements do not require the approval of the VCAP Committee. IRM 7.2.3.2-3(A). Similarly, if the violation is covered by a template set forth in an announcement or other form of guidance and the agreement, including the required template language, complies with the instructions in the guidance, the agreement is submitted to the specialist’s CPM group manager for approval and submission to the CPM Manager for signature. Committee approval is not required. IRM 7.2.3.2-3(B).

If (a) the violation is covered by a template and the guidance permits changes to the template or settlement terms or, (b) the violation is not covered by a template and either the request is not covered by the streamlined process or the proposed closing agreement language substantively differs from the VCAP Model Agreement language, the specialist will prepare a briefing memorandum which will include a discussion of the key facts, applicable law, issuer’s proposed resolution offer, the changes made from the template or Model Agreement and the reason for those changes, and the specialist’s recommendation for case resolution. The specialist will send the briefing memorandum and the proposed closing agreement to the specialist’s CPM group manager for review and concurrence. Upon concurrence by the CPM group manager, the proposed resolution will be discussed with the issuer, emphasizing that the resolution terms have not been approved by the Committee or CPM Manager. These cases require Committee approval.

Throughout the case development process, the specialist will provide the issuer or its authorized representative with status updates via telephone. These updates will include a reminder of any outstanding requests for information. The specialist will record such updates and reminders on the case chronology record. The specialist will also clearly document in the case file any delays by the issuer or its authorized representative in providing requested information


because such documentation may be necessary to determine that an issuer’s failure to respond to requests for additional information indicates an absence of good faith by the issuer in proceeding toward resolution with due diligence for purposes of establishing eligibility for TEB VCAP. IRM 7.2.3.3.2-4 and 5.

If at any time during the case development process, the specialist determines that an issuer or its authorized representative is not proceeding toward resolution in good faith and with due diligence, the specialist will discuss the appropriateness of issuing a final demand letter with the CPM group manager. IRM 7.2.3.3.2-5.

5. Effect of a TEB VCAP Closing Agreement

IRM 7.2.3.1.3 provides that VCAP closing agreements are final and conclusive and may not, in the absence of fraud, malfeasance or misrepresentation of material fact, be reopened.

6. VCAP Resolution Standards For “Identified Violations”

IRM 7.2.3.4.2 contains a list of certain Identified Violations relating to tax-exempt bonds as to which the IRS has specified the terms on which it will enter into closing agreements. The categories are:

Excessive Nonqualified Use;

Ownership of Qualified 501(c)(3) Bond-Financed Property;

Failure to Provide Notice of Defeasance;

Failure to Call Defeased Bonds Within 10.5 Years Of Issuance;

Alternative Minimum Tax Adjustment;

Capital Expenditure Limitation Failure;

Maturity Exceeding 120% of Economic Life;

Impermissible Advance Refunding;

Failure to Timely Reinvest Proceeds Into 0% SLGS;

Failure to Satisfy TEFRA Public Approval for 501(c)(3) Advance Refundings;

Failure to Satisfy TEFRA Public Approval in Connection with Status of Applicable Elected Representative;

Certain Small Issue Bonds Issued as Draw Down Bonds in an Amount that Exceeds Volume Cap;

Extinguishment/Merger; and


Failure to Satisfy Information Reporting Requirements After Remedial Action.

The IRS has indicated its intention to expand the list of Identified Violations relating to tax-exempt bonds over time. The IRS also occasionally announces targeted settlement programs through the issuance of a notice or announcement. See e.g., Announcement 2015-02 (certain violations relating to student loan bonds).

With respect to certain direct pay bonds, IRM 7.2.3.4.3 identifies the following as Identified Violations:

Private Activity Violation;

Impermissible Use of Proceeds;

De Minimis Premium Violations; and

Extinguishment/Merger.

Current procedures do not invite negotiation beyond the current standards for these specified violations. However, the failure to meet the criteria for a specified or identified violation does not foreclose an issuer’s ability to request a review of the specific facts and circumstances justifying possible deviation from these standards.

7. Failure to Resolve Issues in VCAP Proceeding

In certain situations, it is appropriate to close a TEB VCAP case without a final resolution. For example, an issuer may withdraw the request or the issuer and CPM may fail to reach an agreement in a reasonable period of time after an offer is made by CPM to enter into a closing agreement. CPM may also determine that an issuer’s failure to respond to requests for additional information indicate an absence of good faith by the issuer in proceeding toward resolution with due diligence for purposes of establishing eligibility for TEB VCAP. IRM 7.2.3.3.6.


Exhibit A Hypo – Qualified Management Contract

Hospital would like to enter into a contract with a physicians’ group (LLC) for services relating to the Hospital’s radiology department. The physicians’ group is organized as a limited liability corporation, and the physicians are not employees of the Hospital. The LLC requests a 7-year contract that is terminable only for cause. The compensation paid to the LLC would be a per-unit fee based on the type of medical procedure that is performed. Will this contract result in private business use of the Hospital by the LLC?

Code: Section 141(b)(6) – “private business use” means use (directly or indirectly) in a trade or business carried on by a nongovernmental person.

Legislative History of Tax Reform Act of 1986: Senate Report: directs Treasury to liberalize existing management contract safe harbors Conference Report: Senate provision adopted with modifications Bluebook: Further discussion

Regulations: Section 1.141-3(b) – A management contract with respect to financed property may result in private business use of that property based on all of the facts and circumstances.

Proposed Treasury Regulations and Final Regulations – compare proposed version of regulation to final version; review preamble for rationale behind original proposal and changes made in final version.

Rev. Proc. 97-13 (as modified by Rev. Proc. 2001-39): Safe harbor provided for a management contract in which (i) half of the compensation is based on a fixed fee and the other half is based on a per-unit fee capped at the amount of the fixed fee, (ii) term of contract is 5 years, and (iii) contract must be terminable by the qualified user (the Hospital) without penalty or cause after three years.

Notice 2014-67: Amplifies safe harbor in Rev. Proc. 97-13. Safe harbor provided for a management contract in which (i) all compensation is based on a per-unit fee, and (ii) term of contract is 5 years. Contract does not have to be terminable by the qualified user (the Hospital) after three years.

PLRs: Numerous (see e.g., PLRs 201412011, 201338026, 201338031, 201228029, 201145005, 200813016)

Ruling Request? Ask for formal determination that under the facts and circumstances, the contract does not result in private business use.

VCAP? Possible if the contract is already in place and you conclude that contract results in private business use that violates the limits.



06. IRS Issues & Enforcement


• Congress• Department of Treasury

• Office of Tax Legislative Counsel• Office of State and Local Finance

• IRS—Office of Chief Counsel • Financial Institutions and Products, Branch 5

• IRS—Office of Tax Exempt Bonds• Enforcement, Compliance and Outreach


IRS Office of the Chief Counsel

• Works closely with Treasury on published guidance related to tax exempt bonds Regulations Revenue Rulings Revenue Procedures Notices

• Provides input on legality • Provides determinations to issuers of tax exempt bonds

Private Letter Rulings



IRS Office of the Chief Counsel -- Mission

Serve America's taxpayers fairly and with integrity by providing correct and impartial interpretation of the internal revenue laws and the highest quality legal advice and representation for the Internal Revenue Service


• Chief Counsel Code and Subject Matter Directory Available at: http://www.taxanalysts.com/www/irsdirpdfs.nsf/Files/Chart+5425.pdf/$file/Chart+5425.pdf

• Tax Exempt Bonds, Branch 5, (202) 317-6980, CC:FIP:B05


IRS Office of Tax Exempt Bonds

• TEB - Under the IRS Commissioner’s Office• Works with Treasury and Chief Counsel on published

guidance• Provides input on administrability• Audits outstanding issues of tax exempt bonds• Administers VCAP Program• Engages in education and outreach in the area of tax exempt

bonds



IRS Office of the Chief Counsel -- Mission

Serve America's taxpayers fairly and with integrity by providing correct and impartial interpretation of the internal revenue laws and the highest quality legal advice and representation for the Internal Revenue Service


• Chief Counsel Code and Subject Matter Directory Available at: http://www.taxanalysts.com/www/irsdirpdfs.nsf/Files/Chart+5425.pdf/$file/Chart+5425.pdf

• Tax Exempt Bonds, Branch 5, (202) 317-6980, CC:FIP:B05


IRS Office of Tax Exempt Bonds

• TEB - Under the IRS Commissioner’s Office• Works with Treasury and Chief Counsel on published

guidance• Provides input on administrability• Audits outstanding issues of tax exempt bonds• Administers VCAP Program• Engages in education and outreach in the area of tax exempt

bonds


• Internal Revenue Code• Regulations• Court cases• Revenue Rulings• Revenue Procedures• Notices & Announcements• IRS website postings• Private Letter Rulings & Technical Advice Memoranda


• Legislative History Versions of bills House and Senate Reports Conference Reports Bluebook – Joint Committee on Taxation Explanation Floor statements


• Advance Notice of Proposed Rulemaking (ANPRM)• Proposed Regulations• Final Regulations• Temporary Regulations• Annual Guidance Plan



• Bond cases rarely get to court – party with standing is bondholder

• Declaratory judgments relating to reviewable rulings


• Revenue Ruling—an official IRS interpretation of the tax law which does not have the force and effect of a regulation but may generally be relied upon by taxpayers in substantially similar circumstances.

• Revenue Procedure—an official statement of IRS procedure that either affects the rights or duties of taxpayers or other members of the public under the tax law or, although not necessarily affecting the rights and duties of the public, should be a matter of public knowledge


• Notices - public pronouncement that may contain guidance. May be used when revenue rulings or revenue procedures are inappropriate or regulations will not be issued in near future

• Announcements - public message used to announce programs or procedural matters

• IRS Website – www.irs.gov (e.g., sale of bond-financed assets, compliance procedures)



• Guidance to IRS Office of TEB• Addresses broader topics (fact-pattern specific instead of deal

specific)• More broadly reliable because directed at IRS


• Issuer that receives ruling may rely on it• May not be relied upon by other issuers• Indicative of current interpretations of tax issues


Working with the IRS to resolve questions or issues when there is no published guidance or answer is unclear in published guidance



Telephone Questions

• IRS Chief Counsel Attorneys Can get sense of where Branch 5 is on issue Feedback of whether Branch 5 would be open to private letter ruling on

issue• IRS Enforcement Sense of whether VCAP is available for particular issue

• Treasury Can meet with groups to hear issues and suggestions on legislative or

regulatory matters


PLR Requests – Rev. Proc. 2016-1

• Provides general procedures for all private letter ruling requests• Fees (currently $28,300)• Pre-submission Conferences encouraged• Questionnaire• Form 2848 Power of Attorney


PLR Requests –Rev. Proc. 96-16

• Tax Exempt Bond Specific Guidance• Non-Reviewable Ruling Ruling on specific aspect of tax law Must be for prospective issue (Bond Resolution Required) or prospective

action Certification of Request for Non-Reviewable Ruling Signed by Issuer



Telephone Questions

• IRS Chief Counsel Attorneys Can get sense of where Branch 5 is on issue Feedback of whether Branch 5 would be open to private letter ruling on

issue• IRS Enforcement Sense of whether VCAP is available for particular issue

• Treasury Can meet with groups to hear issues and suggestions on legislative or

regulatory matters


PLR Requests – Rev. Proc. 2016-1

• Provides general procedures for all private letter ruling requests• Fees (currently $28,300)• Pre-submission Conferences encouraged• Questionnaire• Form 2848 Power of Attorney


PLR Requests –Rev. Proc. 96-16

• Tax Exempt Bond Specific Guidance• Non-Reviewable Ruling Ruling on specific aspect of tax law Must be for prospective issue (Bond Resolution Required) or prospective

action Certification of Request for Non-Reviewable Ruling Signed by Issuer


• Reviewable Ruling Extremely Rare Ruling on tax exempt status of entire issue Addresses all tax law requirements Determination appealable to U.S. Tax Court under Section 7478 of the

Code


VCAP

• Addresses violations that already occurred• Not available if bonds are under audit• Achieve settlement on better terms than available on audit• Agreement final and conclusive absent fraud, malfeasance or

material misrepresentation• Involves payment of settlement amount and/or redemption of

bonds


Initiating a VCAP

• Phone call to IRS to discuss question• Anonymous: initial approach permitting issuer representative to

approach IRS without identifying issuer or bond issue. Upon receipt of proposed IRS terms, issuer must submit formal VCAPsubmission

• Written Submission



• Notice 2008-31• VCAP Checklist Form 14429• Format of VCAP Requests IRM 7.2.3.2• Identified Violations IRM 7.2.3.4• Form 2848 Power of Attorney• Specific procedures (e.g., Announcement 2015-02)


• Excessive Nonqualified Use• Ownership of Qualified 501(c)(3) Bond-Financed Property• Failure to Provide Notice of Defeasance• Failure to Call Defeased Bonds with 10.5 Years of Issuance• Alternative Minimum Tax Adjustment• Capital Expenditures Limitation Failure• Maturity Exceeding 120% of Economic Life


• Maturity Exceeding 120% of Economic Life• Impermissible Advance Refunding• Failure to Timely Reinvest Proceeds into 0% SLGS• Failure to Satisfy TEFRA Requirements• Volume Cap for Small Issue Draw Down Bonds• Extinguishment/Merger• Failure to File 8038 after Remedial Action Taken • Build America Bonds



• Notice 2008-31• VCAP Checklist Form 14429• Format of VCAP Requests IRM 7.2.3.2• Identified Violations IRM 7.2.3.4• Form 2848 Power of Attorney• Specific procedures (e.g., Announcement 2015-02)


• Excessive Nonqualified Use• Ownership of Qualified 501(c)(3) Bond-Financed Property• Failure to Provide Notice of Defeasance• Failure to Call Defeased Bonds with 10.5 Years of Issuance• Alternative Minimum Tax Adjustment• Capital Expenditures Limitation Failure• Maturity Exceeding 120% of Economic Life


• Maturity Exceeding 120% of Economic Life• Impermissible Advance Refunding• Failure to Timely Reinvest Proceeds into 0% SLGS• Failure to Satisfy TEFRA Requirements• Volume Cap for Small Issue Draw Down Bonds• Extinguishment/Merger• Failure to File 8038 after Remedial Action Taken • Build America Bonds


VCAP Process

• File Application with Form• Follow-up and Recommendation by Specialist & Reviewer• Concurrence by Group Manager• Review by VCAP Committee• Taxpayer Payment and Signature• IRS Signature


IRS Favors VCAP

• Most favorable settlement terms reserved for VCAP and not offered in audit settlements

• Settlement terms favor more prompt requests• IRS “Settlement Programs” and Audits of bonds that do not settle

through program


• How Bond Issues are Selected for AuditRandomMarket Segment ProgramWhistleblower ReferralsOther ReferralsNews sources (including EMMA)



• Advance refunding bonds• 8038-T• Governmental bonds – environmental and transportation bonds• Private activity bonds – 501(c)(3) nonhospital, solid waste, multi-

and single-family housing• Build America Bonds


Who is Subject to Examination?

• Audited Party is Issuer Even where the conduit borrower is the true party in interest, the conduit

issuer will be the party with whom the IRS deals Counsel for various parties need to discuss representation, powers of

attorney Form 8821 – Issuer gives IRS permission to speak to third parties like

trustee or underwriter



• Mismatch between party who can cause tax compliance problems (issuer and/or conduit borrower) and party harmed if bonds become taxable (bondholders)

• In practice, bondholders are rarely involved in an examination or other enforcement action

• Policy of the IRS is to resolve examinations at the transaction (issuer) level



• Advance refunding bonds• 8038-T• Governmental bonds – environmental and transportation bonds• Private activity bonds – 501(c)(3) nonhospital, solid waste, multi-

and single-family housing• Build America Bonds



• Audited Party is Issuer Even where the conduit borrower is the true party in interest, the conduit

issuer will be the party with whom the IRS deals Counsel for various parties need to discuss representation, powers of

attorney Form 8821 – Issuer gives IRS permission to speak to third parties like

trustee or underwriter



• Mismatch between party who can cause tax compliance problems (issuer and/or conduit borrower) and party harmed if bonds become taxable (bondholders)

• In practice, bondholders are rarely involved in an examination or other enforcement action

• Policy of the IRS is to resolve examinations at the transaction (issuer) level


Compliance Checks

• Compliance check questionnaires are used to obtain information on certain areas to gauge level of compliance

• No legal obligation to respond; however, the IRS may use compliance checks to identify potential examination targets

• Six compliance check programs since 2007• Looks like a regular audit with multiple choice questions but not an audit

unless it says so


Audits - Opening Letters

• Agents inform issuers of audits through one of four opening letters: General Program Examination Letter (for cases selected randomly) Project/Initiative Examination Letter (for focused initiatives, e.g.,

transportation bonds) Referral Examination Letter (examination of a specific bond issue based

on information from internal/external source) Identified Noncompliance Exam Letter (based on specific noncompliance

information)


Responding to Audit

• Issuer hires counsel• Possible use of bond counsel

• Potential conflict• Advance waiver of conflict issues—No longer required

• Conduit borrower role• Formulation of response to IDR

• Typically IDR#1 requests transcript



Responding to Audit

• Develop strategy of responsiveness with client• May be numerous IDRs• Site visits

• Other relevant considerations:• Who is the “client” within a governmental issuer?• Public meetings and “sunshine” laws• Approach with auditors• If applicable, approach on Form 990, Schedule K


Determination Procedures

• No liability -> “No Change” letter• If issue identified -> discussions with issuer/issuer representative• If issuer does not concur -> Notice of Proposed Adjustment• Possible use of Technical Advice Memorandum (TAM)• Agent can issue proposed adverse determination, which gives rise to issuer’s

right of appeal


Closing Agreements

• IRS presumes most controversies will be resolved in a closing agreement

• Agreement should be narrowly drafted in light of the specific facts of the case

• All potential adjustments should be included• Closing agreements will generally require that the issuer redeem

the bonds at the earliest possible date



Responding to Audit

• Develop strategy of responsiveness with client• May be numerous IDRs• Site visits

• Other relevant considerations:• Who is the “client” within a governmental issuer?• Public meetings and “sunshine” laws• Approach with auditors• If applicable, approach on Form 990, Schedule K


Determination Procedures

• No liability -> “No Change” letter• If issue identified -> discussions with issuer/issuer representative• If issuer does not concur -> Notice of Proposed Adjustment• Possible use of Technical Advice Memorandum (TAM)• Agent can issue proposed adverse determination, which gives rise to issuer’s

right of appeal


Closing Agreements

• IRS presumes most controversies will be resolved in a closing agreement

• Agreement should be narrowly drafted in light of the specific facts of the case

• All potential adjustments should be included• Closing agreements will generally require that the issuer redeem

the bonds at the earliest possible date


Closing Agreement Amount

• Based upon “taxpayer exposure”• Open years at issue commence on date issuer receives written

notification• Tolling agreements• Bond redemptions


• Issuers entitled to appeal proposed adverse determinations• Time limits for appeal – 30 days of date of proposed adverse

determination



Securities Law Training Session Materials





07. Underwriting: Behind the Scenes

Faculty:Kathleen Miles Chief Counsel, Public Finance, The PNC Financial Services Group,

Inc. - Washington, DC Eric Rockhold Managing Director, Bank of America Merrill Lynch - Chicago, IL Don E. Wilbon Managing Director, J.P. Morgan - Chicago, IL

I. Overview of a Bond Transaction

A. Financing Participants

1. Bond Counsel – Attorneys retained by the issuer/borrower to give an expert and objective legal opinion with respect to the validity of bonds and other subjects, particularly the federal tax income treatment of interest on the bonds

2. Credit Enhancer – Bond insurer, commercial bank, or other financial institution issuing an insurance policy or a supporting letter of credit in order to improve an issue’s credit rating; distinguish from a liquidity facility which is a letter of credit, standby purchase agreement or other arrangement used to provide liquidity to purchase securities, commonly in the case of variable rate demand obligations that have been tendered to the issuer or remarking agent but cannot be immediately remarketed

3. Disclosure Counsel – Attorneys serving as the principal drafters of an issuer’s disclosure document; may provide 10b5 opinion to issuer and underwriters

4. Financial Advisor – Person who advises an issuer/borrower on financial matters pertinent to an issue, such as structure, timing, marketing, fairness of pricing, terms, and bond ratings

5. Independent Registered Municipal Advisor (IRMA) – A designation of a financial advisor as an IRMA permits an underwriter to provide advice to an issuer or obligated person with respect to municipal financial products or the issuance of municipal securities without being deemed to be a municipal advisor

6. Issuer – A state, political subdivision, agency, or authority that borrows money through the sale of bonds or notes

7. Issuer’s Counsel – Attorneys representing the issuer


8. Obligated Person - A person (including the issuer) legally committed to support payment of all or a part of an issue of municipal securities, other than certain unrelated providers of credit enhancement

9. Paying Agent/Registrar – Entity responsible for transmitting payments to bondholders and maintaining records of the registered owners of the bonds

10. Rating Agency – Organization which provides publicly available ratings of the credit qualities of securities

11. Trustee – Financial institution which acts in a fiduciary capacity for the benefit of bondholders in enforcing the terms of the bonds

12. Underwriter – Broker or dealer which purchases a new issue of municipal securities for resale

13. Underwriter’s Counsel – Attorneys representing the underwriter in connection with the purchase of a new issue of municipal securities

B. Investors. Investors have specific preferences for maturity length, credit rating, and bond structure, and varying levels of price sensitivity. Typical municipal bond purchasers include:

1. Retail Investors

a. Individuals

b. Bank Trust Departments (On behalf of customers) -- see below

c. Investment Advisers (Professional Retail) – see below

2. Institutional Investors

a. Bond Funds

b. Insurance Companies

c. Arbitrage Accounts

d. Bank Trust Departments

e. Investment Advisers

f. Bank Portfolios

C. Typical Steps in a Transaction

1. Assemble team

a. MSRB Rule G-23


i. Municipal Securities Rulemaking Board (MSRB) is a non-governmental, self-regulatory organization (SRO) that is charged with primary rulemaking authority over municipal securities dealers and municipal advisors in connection with their municipal securities and municipal advisory activities.

ii. Rule G-23

A. Purpose - Establishes ethical and disclosure requirements for broker-dealers who act as Financial Advisors (“F.A.”).

B. Financial Advisory Relationship - Covers F.A. or consultant services with respect to the issuance of municipal securities, including advice re: structure, timing, terms or similar matters.

Excludes Underwriters - F.A. relationship shall not exist when underwriter renders advice in connection with a transaction in which the underwriter is performing underwriting services. A broker-dealer that clearly identifies itself in writing as an underwriter and not as a F.A. from the earliest stages of its relationship with the issuer with respect to that issue will be considered to be acting as an underwriter. Other disclosures must be given.

C. Writing Requirement - F.A. must have written agreement.

D. Prohibition on Underwriting Services - No broker-dealer that has a financial advisory relationship “with respect to the issuance of municipal securities” may acquire all or part of such issue, or act as placement agent.

E. Prohibition on Remarketing Activities - No broker-dealer with a financial advisory relationship, may act as a remarketing agent with respect to the issue; except, if it resigns, then after one-year it may act as successor remarketing agent.

b. MSRB Rule – G-17 –Interpretive Notice

A. Rule G-17 General Purpose: Precludes dealers and municipal advisors, in the conduct of municipal securities or municipal advisory activities, from engaging in any deceptive, dishonest, or unfair practice with any person. Also establishes a general duty to deal


fairly with all persons (including, among others, issuers of municipal securities).

B. 2012 Interpretive Notice: Primary change is the requirement of additional disclosures, consisting generally of: (i) disclosures concerning the underwriter’s role, (ii) disclosures concerning the underwriter’s compensation, (iii) disclosures concerning material conflicts of interests, and (iv) disclosures concerning complex municipal securities financings.

C. Specific Disclosures:

1. The underwriter’s primary role is to purchase securities with a view to distribute in an arm’s-length commercial transaction with the issuer, and it has financial and other interests that differ from those of the issuer;

2. Unlike a municipal advisor, the underwriter does not have a fiduciary duty to the issuer under the federal securities laws and is, therefore, not required by federal law to act in the best interests of the issuer without regard to its own financial or other interests;

3. The underwriter has a duty to purchase securities from the issuer at a fair and reasonable price, but must balance that duty with its duty to sell municipal securities to investors at prices that are fair and reasonable;

4. The underwriter will review the official statement for the issuer’s securities in accordance with and as part of its responsibilities to investors under the federal securities laws, as applied to the facts and circumstances of the transaction;

5. The underwriter must disclose whether underwriting compensation will be contingent on the closing of a transaction, and that compensation that is contingent on the closing of a transaction or the size of a transaction presents a conflict of interest because it may encourage the underwriter to


recommend a transaction that it is unnecessary, or to recommend that the size of the transaction be larger than is necessary; and

6. Must disclose other potential conflicts of interest.

D. Complex Transactions: Underwriter must provide additional disclosures for "complex municipal securities financings."

E. Timing. Disclosure concerning the arm’s-length nature of the underwriter-issuer relationship must be made in the earliest stages of the underwriter’s relationship with the issuer with respect to an issue (e.g., in a response to a request for proposals or in promotional materials provided to an issuer).

2. Evaluate capital needs and cash flow capacity

3. Develop a financing plan and schedule

a. Type of sale

i. Negotiated, Competitive, Private Placement (distinguish from a Direct Purchase by a bank)

b. Structure

i. Source of repayment (limited or unlimited taxes, revenues, fees, lease payments, etc.)

ii. Amortization schedule

iii. Serial vs. term bonds (current interest, zero coupon or capital appreciation bonds, etc.)

iv. Bond covenants (additional bonds tests, limitations on future taxes, non-impairment provisions, etc.)

c. Credit Enhancements

i. Credit ratings

ii. Bond insurance

iii. Letter of credit (LOC)


d. Due Diligence (including checking on past Rule 15c2-12 continuing disclosure compliance)

e. Draft documents

i. Authorizing resolutions/ordinances

ii. Feasibility studies/ Engineering reports

iii. Trust Indentures/Agreements

iv. Notices to bondholders/insurance companies/trustee

v. Preliminary Official Statement

vi. Preliminary Blue Sky/Final Blue Sky Memorandum

vii. Bond Purchase Agreement/Contract of Purchase

viii. Agreement Among Underwriters

ix. Selling Group Agreement

x. Accountants (inclusion/agreed-upon procedures may be required)

f. Marketing

II. Bond Structuring and Sizing

A. Types of Sale

1. Competitive Sale

a. Bonds are advertised for sale (notice of sale)

b. Any broker-dealer or bank may bid at the designated date and time

c. Bonds are awarded to the bidder offering the lowest True Interest Cost (“TIC”) or Net Interest Cost ("NIC"). NIC does not take into account the time value of money (as would be done in other calculation methods, such as TIC).

d. Selling syndicate

2. Negotiated Sale

a. Terms of the bonds and of the sale are negotiated with the issuer


b. Issuer and underwriter agree upon a yield level at which the underwriter will offer bonds to potential investors for each specific bond that is offered across the yield curve

c. Initial interest scale may be adjusted depending on investor demand

3. Private Placement

a. Bonds are sold to one or a few investors at negotiated terms

B. Elements of a Pricing

1. Coupon - Annual interest rate payable to the bondholder

2. Discount Bonds – Coupon is less than yield

3. Maturity - Date on which principal payments are due

4. Par Bonds – Coupon equals yield

5. Premium Bonds – Coupon is greater than yield

6. Price - Total amount paid by the issuer for the bonds

7. Principal/par amount - Face value of a bond to be paid back to the bondholder on the maturity date

8. Yield - Net annual interest cost to the issuer, taking into account the discount or premium on the purchase price, the interest rate and the length of time the bond is held

C. Serial vs. Term Bonds

1. Serial Bonds: Specific annual principal maturities scheduled annually over a period of years

2. Term Bonds: Mature on a specified date and commonly use sinking fund payments (payments of principal prior to final maturity)

3. Current Interest: (interest paid semi-annually over time) vs. Capital Appreciation or Zero Coupon Bonds (interest compounded and paid at maturity)

III. Marketing a Negotiated Bond Issue

A. Underwriting Process

1. Create Investor Target Plan

2. Develop Syndicate


3. Create Allocation Policy

4. Establish Priority of Orders

5. Pre-Pricing

6. Order Period

7. Bond Pricing

8. Award Bonds

9. Closing

B. Underwriting Terms

1. Sole Managed Underwriting

2. Syndicate – Group formed to purchase new issue. Agreement Among Underwriters – Determines liability and allocable share of liability for each underwriter.

3. Selling Group – Distinct municipal securities brokers and dealers that assist in the distribution of a new issue of securities that are NOT members of the underwriting syndicate, nor do they have liability as underwriters; selling group members are able to acquire securities from the underwriting syndicate at syndicate terms (i.e., less the total takedown), but do not share in syndicate profits nor share any liability for unsold balances.

4. Spread – Syndicate’s compensation. With respect to a new issue of municipal securities, the differential between the price paid to the issuer for the new issue and the prices at which the securities are initially offered to the investing public; this is also termed the “gross spread,” “gross underwriting spread” or “production.”

a. To the extent that the initial offering prices are subsequently lowered by the syndicate, the full amount of the spread may not be realized by the syndicate.

b. The spread is usually expressed in dollars or points per bond.

c. Historically, the spread has consisted of four components, although one or more components may not be present in any particular offering:

i. Expenses – The costs of operating the syndicate for which the senior manager may be reimbursed.

ii. Management Fee – The amount paid, if any, to the senior manager and/or co-manager for structuring the transaction and/or handling the affairs of the syndicate.


iii. Takedown – Normally the largest component of the spread, similar to a commission, which represents the income derived from the sale of the securities. If bonds are sold by a member of the syndicate, the seller is entitled to the full takedown (also called the “total takedown”). If bonds are sold by a broker-dealer that is not a member of the syndicate, such seller receives only that portion of the takedown known as the concession or dealer’s allowance, with the balance (often termed the “additional takedown”) retained by the syndicate.

iv. Risk or Residual – The amount of profit or spread left in a syndicate account after meeting all other expenses or deductions. A portion of the residual is paid to each underwriter within a syndicate on a pro rata basis according to the number of bonds each broker-dealer has committed to sell without regard to the actual sales by each member.

5. Order Period

a. In a competitive sale, the order period is the period of time following the sale of a new issue during which non-priority orders submitted by syndicate members are allocated without consideration of time of submission. The length of the order period is usually determined by the manager.

b. In a negotiated sale, the order period is the period of time established by the manager during which orders are accepted. The order period in a negotiated sale generally precedes the purchase of the issue by the underwriter from the issuer. At times, order periods are established at subsequent points in the life of a syndicate. Such subsequent order periods may occur when securities are repriced or market conditions change.

c. In some offerings, a “retail order period” may be designated during which orders will be accepted solely for retail customers (or, in some cases, small orders for any type of customers). MSRB Rule G-11 amended to address certain retail order period requirements.

6. Priority of Orders - The rules adopted by an underwriting syndicate specifying the priority to be given different types of orders received by the syndicate.MSRB rules require syndicates to adopt priority provisions in writing and to make them available to all interested parties. For competitive underwritings, orders received prior to the sale (“pre-sale orders”) generally are given top priority. In some negotiated offerings, retail orders or other restrictions designated by the issuer are given priority. Once the order period begins for either negotiated or competitive underwritings, the most common priority provision gives group net orders top priority, followed by designated orders and member orders.


a. Retail Order: Any order by customers other than institutional customers; “retail” is not defined by the MSRB.

b. Institutional Order: Any order by banks, financial institutions, bond funds, insurance companies or other business organizations that possess or control considerable assets for large scale investing.

c. Group Net Order: Any order that, if allocated, is allocated at the public offering price without deducting the concession or takedown. A group net order benefits all syndicate members according to their percentage participation in the account and consequently is normally accorded the highest priority of all orders received during the order period.

d. Designated (Member) Order: Any order submitted by a syndicate member on behalf of a buyer on which all or a portion of the takedown is to be credited to certain members of the syndicate. The buyer directs the percentage of the total designation each member will receive. Generally two or more syndicate members will be designated to receive a portion of the takedown.

e. (Non-Designated) Member Order: Any order submitted by a syndicate member where the securities would be confirmed to that member at syndicate terms (e.g., less the total takedown).

C. Potential Pricing Considerations

1. Yield Curve

2. Bond Structure

3. Supply

4. Economic Indicators

5. Market Psychology

6. Market Technicalities

7. Credit

8. Tax Status

D. Day of Sale

1. Pre-pricing call

a. Issuer, Financial Advisor and Underwriter discuss

i. Market conditions

ii. Comparable transactions


iii. Proposed interest rates (coupons, yields)

b. Issuer approves release of the bonds at proposed interest rates

c. Order period begins – investor feedback

d. Repricing: Adjustment of interest rates, if necessary

e. Bond counsel and underwriter check that sales fit within legal parameters

f. Confirmation of insurer premium and verification (if refunding)

g. Bond Counsel/ Underwriter’s Counsel finalize BPA

h. Issuer and underwriter sign BPA

i. Underwriter tickets the transaction

E. Pre-Closing and Closing

1. Pre-closing Considerations

a. Form G-32

b. Final OS

i. Dated to coincide with BPA execution

ii. Distributed to investors within 7 business days of BPA execution

c. Closing Memo

2. Closing Considerations

a. Closing Certificates

i. Issue price certificate

ii. Tax Certificate

iii. Provided by issuer or other transaction participants

b. Insurance Certificate (certifying bond insurance made economic sense)

c. Opinions



07. Underwriting: Behind the Scenes


Presentation Overview


II. Underwriting/Marketing Process –

Negotiated Deal

III. Pricing, Pre-Closing and Closing Elements

IV. Questions





Financing Participants• Bond Counsel• Credit Enhancer • Disclosure Counsel • Financial Advisor • Independent Registered Municipal Advisor (IRMA)• Issuer• Issuer’s Counsel • Obligated Person • Paying Agent/Registrar • Rating Agency • Trustee• Underwriter• Underwriter’s Counsel


Key Financing DocumentsMaster Trust

Indenture

Bond Indenture

Loan Agreement

Prelim/Final Official Statement

Bond Purchase

Agreement

Reimb. Agreement

Mortgage(if required)

Various Legal

Opinions

Legal details of how a particular series of

bonds operate

Outlines terms of loan between Issuer and

Borrower

Required disclosure that helps investors make

informed purchase decisions

Underwriter’s commitment to buy bonds from the Issuer on

behalf of Borrower

Security for bondholders

Tax-exemption, valid issuance, etc.

Borrower’s obligation to repay LOC bank

(variable only)

“Chassis” outlining how, when, why bonds can be issued, and what security can be granted

Parties to a Deal• Issuer• Issuer’s counsel• Borrower• Borrower’s counsel• Bond counsel• Underwriter• Remarketing Agent (VR only)• Underwriter’s counsel• Bond/Master Trustee• Trustee’s counsel• Auditor• Financial advisor• Bond insurer• LOC bank (VR only)• Rating agencies


Type of Sales• Competitive Sale

– Bonds are advertised for sale (notice of sale)– Any broker-dealer or bank may bid at the designated date and time– Bonds are awarded to the bidder offering the lowest True Interest Cost (“TIC”) or Net

Interest Cost (“NIC”) – Selling syndicate

• Negotiated Sale– Terms of the bonds and of the sale are negotiated with the issuer– Issuer and underwriter agree upon a yield level at which the underwriter will offer bonds

to potential investors – Initial interest scale may be adjusted depending on investor demand

• Private Placement– Bonds are sold to one or a few investors at negotiated terms



Preliminary Steps to a Transaction

1. Identify purpose of the borrowing2. Identify projects, borrower debt

capacity, savings3. Assemble team4. Develop a financing plan and schedule

−Type of sale−Structure−Timing and Scope of Due Diligence−Draft relevant transaction documents−Bond marketing, pricing, closing


Evaluation of Capital Needs and Cash Flow Capacity

Prior to structuring bond issues, it is important to analyze the capital and borrowing needs of the issuer AND the ability to repay the debt borrowed.

• Measures to repay General Obligation Bonds- Overall taxing base/per capita income levels/local and regional economy- Cash and levels of liquidity: fund balances- Amount of debt previously borrowed- Ability and willingness to raise taxes

• Measures to repay Revenue Bonds- Source of funding (dedicated taxes, user fees, tolls, excise taxes, etc.)- Levels of "coverage or cushion" above debt service- Economic base associated with revenues pledged for debt- Legal covenants (additional bonds test, non-impairment clauses, non-bankruptcy opinion)


II. Underwriting/Marketing Process – Negotiated Bond Issue



Preliminary Steps to a Transaction

1. Identify purpose of the borrowing2. Identify projects, borrower debt

capacity, savings3. Assemble team4. Develop a financing plan and schedule

−Type of sale−Structure−Timing and Scope of Due Diligence−Draft relevant transaction documents−Bond marketing, pricing, closing


Evaluation of Capital Needs and Cash Flow Capacity

Prior to structuring bond issues, it is important to analyze the capital and borrowing needs of the issuer AND the ability to repay the debt borrowed.

• Measures to repay General Obligation Bonds- Overall taxing base/per capita income levels/local and regional economy- Cash and levels of liquidity: fund balances- Amount of debt previously borrowed- Ability and willingness to raise taxes

• Measures to repay Revenue Bonds- Source of funding (dedicated taxes, user fees, tolls, excise taxes, etc.)- Levels of "coverage or cushion" above debt service- Economic base associated with revenues pledged for debt- Legal covenants (additional bonds test, non-impairment clauses, non-bankruptcy opinion)


II. Underwriting/Marketing Process – Negotiated Bond Issue


Underwriting/Marketing ProcessCreate Investor Target Plan

Define/Develop Syndicate- Create Allocation Policy- Establish Priority of Orders

Distribution Channels- Retail Order Period

Order Period

Role of Attorneys

- Institutional Only

Award Bonds- Verbal After Pricing- Written After Execute BPA- Identify Key MSRB Requirements

Pre-Pricing Evaluation

- Investor Call- ”Road Show”- Banking/Sales/Trading Coordination


Sample Investor Distribution: School District Bonds

Money Manager (38%)

Corporations (8%)

Trust Department (27%)

Fund Manager (24%)

Retail (0%)

Underwritten (3%)


III. Pricing, Pre-Closing, Closing



Pricing Considerations• Market “Tone” & Psychology

• Bond Structure – Term, Serials, Amortization

• Supply/Demand Dynamics

• Macroeconomic Factors

• Financial Performance/Credit Strength of Borrower

• Security/Covenants/Disclosure Policies

• Issuance state (“I Love New York!”)/Relative Trading Value/Tax Advantage


Elements of a Pricing• Principal/par amount - Face value of a bond to be paid back to the bondholder

on the maturity date

• Maturity - Date on which principal payments are due

• Coupon - Annual interest rate payable to the bondholder

• Yield - Net annual interest cost to the issuer, taking into account the discount or premium on the purchase price, the interest rate and the length of time the bond is held

• Price - Total amount paid by the issuer for the bonds

Premium Bondscoupon > yield

Par Bondscoupon = yield

Discount Bondscoupon < yield


Bond Pricing Process• Pre-pricing call: Issuer, Financial Advisor and Underwriter discuss

• Market conditions• Comparable transactions• Proposed interest rates (coupons, yields)

• Issuer approves release of the bonds at proposed interest rates• Order period begins – investor feedback• Repricing: Adjustment of interest rates, if necessary• Bond counsel and underwriter check that sales fit within legal

parameters• Confirmation of insurer premium and verification (if refunding)• Bond Counsel/ Underwriter’s Counsel revise BPA• Issuer and underwriter finalize BPA• Underwriter tickets the transaction



Bond Marketing & Pricing – Another Perspective•Analyze relevant market data•Pre-pricing call to discuss proposed rates and market tone•Entry into market / deal executionBond

pricing

•Develop deal momentum•Critical component•Coordinated effort with sales and banking

Pre-pricing investor dialogue

•Tier 1: major funds/broad coverage•Tier 2 & 3: less coverage/strong appetite•Goal is broadest distribution

Engage multiple tiers of investors

•Educate sales staff•Coordinate /communicate market intel•Generate early focus

Internal pre-marketing

•In-depth financial analyses•Understand organizational profileIntense pre-pricing credit work

•Bondholder communication strategy

•Periodic investor conference calls and/or meetings

Ongoing investor relations


Pre-Closing and Closing

• Pre-Closing Activities− Finalize documents with final “numbers”− Print/Mail final OS within required timeframe− Closing memo highlighting flow of funds

• Closing Activities− Relevant parties execute documents and certificates− Relevant attorneys deliver opinions

• Eat


Questions





08. Practical Due Diligence & Drafting the Disclosure Document

Faculty:Bradley D. Patterson Ballard Spahr LLP – Salt Lake City, UT Kris A. Moussette Hinckley, Allen & Snyder LLP – Boston, MA

1) Purpose of Due Diligence (depends on your role in the transaction and which party you are representing)

Background

The term “due diligence” is not defined in the federal securities laws but refers to the investigation into the business, legal and financial affairs of an entity involved in a securities offering or other corporate transaction. It is also used as an informal shorthand phrase to mean the process by which securities or common law liability can be avoided if the preparer of a disclosure document can show that any fraud that occurs in a bond transaction could not have been detected by a reasonable inquiry or “due diligence”.

Securities issued or guaranteed by states or their political subdivisions or public instrumentalities are “exempted securities” under the 1933 Securities Act and “municipal securities” under the 1934 Exchange Act. As such, they are exempt from the registration provisions of the 1933 Securities Act and from any requirement pursuant to the 1934 Exchange Act of filing a disclosure document with the SEC or the MSRB prior to issuance. However they are not exempt from the anti-fraud provisions of the 1933 Securities Act (Section 17(a)) or the 1934 Exchange Act (Section 10(b)).

Rule 10b-5 Standard: “It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange … (b) to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading...”

Underwriters

Section 11 of the 1933 Securities Act establishes the affirmative due diligence defenses available to an underwriter of securities subject to registration with the SEC in response to a liability claim made by a purchaser. Because municipal securities are not subject to registration, underwriters of municipal securities are not subject to liability under Section 11 of the 1933 Securities Act, but Section 11 provides by analogy useful guidance for establishing defenses to liability under Section 10(b) of the 1934 Exchange Act.


Distinctions between Due Diligence for Underwriters of Registered Securities and Municipal Securities – Who Bears Burden of Proof and the Standard of Liability.

a) Statutory Due Diligence Defenses for Registered Securities – Upon a showing of a material misleading statement or omission in a registration statement, the defendant underwriter must prove that it did not act in a negligent manner.

b) Due Diligence Defenses for Municipal Securities – The plaintiff, including the SEC, must prove, among other things, that the defendant underwriter acted with scienter in accordance with the requirements of Section 10(b) of the 1934 Exchange Act, or, with respect only to the SEC as plaintiff, negligence, under Section 17(a)(2) or (3) of the 1933 Securities Act.

Respective Roles of Underwriter and Underwriter’s Counsel.

“In conducting a due diligence investigation, there are (1) certain tasks that the underwriter must conduct itself; (2) certain matters as to which counsel is, in effect, rendering legal advice; and (3) certain tasks that may be delegated to underwriter’s counsel as agent of the underwriter, but that do not amount to legal advice.” Disclosure Rules of Counsel In State and Local Government Securities Offerings, 3d ed. ABA (2009), at 144.

“The underwriter is responsible for all due diligence, whether performed by itself or on its behalf by agents such as underwriter’s counsel, and can be held responsible not only for its own actions or inactions, but also for those of its attorneys and agents. Many bankers, even experienced ones, believe that it is the responsibility of underwriter’s counsel to lead and manage the due diligence process, and that the underwriter can confine its role to assessing the credit, coordinating with rating agencies and insurers, and marketing the bonds. That view is misplaced.” Disclosure Roles of Counsel at 145.

The purpose of an underwriter’s due diligence investigation is to “establish a reasonable basis for belief in the truthfulness and completeness of the key representations” made in the Official Statement.

Key Requirements for a Securities Claim under 10b-5:

A misrepresentation or omission of a material fact;

Reliance thereon from the plaintiff;

Damages; or

“Scienter” (Note: “scienter” is an intent to deceive, manipulate or defraud and includes recklessness) or fraudulent conduct.


Important Considerations:

a) Who’s your client and what level of investigation are they expecting you to make?

b) Obtain and verify information regarding issuer, authorization, use of proceeds and security for bonds.

Due diligence should be conducted sooner rather than later in the schedule of events to unearth potential problems with the financing or the project such as, for example, environmental contamination of the project site, pending litigation seeking to enjoin the project, limitations on the authority of the issuer or imposition of significant liabilities, or state or federal legislation that will be enacted during the term of the bonds that will negatively affect the revenue stream.

c) Comfort to deliver 10b-5 opinion (even though the letter generally states (1) no independent investigation has been made by Counsel and (2) nothing has come to the attention of such Counsel that would lead it to believe that there was a violation of the 10b-5 materiality standard) even if you are not serving as disclosure counsel.

d) Tax issues - The performance of due diligence permits the issuance of the tax opinion and will help show compliance with statutory/regulatory requirements of issuer.

i. Methods may include tax questionnaire, issuer application, conference interviews, due diligence sessions, closing certificates.

ii. Ira Weiss case.

e) Establish a defense to securities liability (as shown above), provided that the inquiry satisfies the general standard of professional performance expected of the underwriter and certain other professionals

Question – Will expanding of the SEC interpretive and enforcement law change the underlying basis of “due diligence” from that of establishing due diligence defenses to the affirmative undertaking of certain due diligence responsibilities (primarily related to disclosure)?

f) Past Compliance with Continuing Disclosure Undertakings. Rule 15c2-12 requires that final official statements contain “a description of the undertakings to be provided…and of any instances in the previous five years in which each [obligated] person failed to comply, in all material respects, with any previous undertakings in a written contract or agreement.”

i. In 1994, the SEC stated that, “Critical to the evaluation of a covenant is the likelihood that the issuer or obligated person will abide by the


undertakings. The definition of final official statement thus has been modified to require disclosure of all instances in the previous five years in which any person providing an undertaking failed to comply in all material respects with any previous informational undertakings called for by the amendments. This information is important to the market, and should, therefore, be disclosed in the final official statement. The requirement should provide an additional incentive for issuers and obligated persons to comply with their undertakings to provide secondary market disclosure, and will ensure that Participating Underwriters and others are able to assess the reliability of disclosure representations.” The 1994 Adopting Release at n. 52.

ii. In 2010, the SEC stated that, “The Commission has determined further to expound upon its prior interpretations regarding municipal underwriters’ responsibilities. As articulated in a prior interpretation [the 1994 Adopting Release], the Commission believes that it is doubtful that an underwriter could form a reasonable basis for relying on the accuracy or completeness of an issuer’s or obligated person’s ongoing disclosure representations, if such issuer or obligated person has a history of persistent and material breaches or has not remedied such past failures by the time the offering commences. The Commission believes that if the underwriter finds that the issuer or obligated person has on multiple occasions during the past five years failed to provide on a timely basis continuing disclosure documents, including event notices and failure to file notices, as required in a continuing disclosure agreement for a prior offering, it would be very difficult for the underwriter to make a reasonable determination that the issuer or obligated person would provide such information under a continuing disclosure agreement in connection with a subsequent offering. In the Commission’s view, it also is doubtful that an underwriter could meet the reasonable belief standard without the underwriter affirmatively inquiring as to that filing history. The underwriter’s reasonable belief should be based on its independent judgment, not solely on representations of the issuer or obligated person as to the materiality of any failure to comply with any prior undertaking. If the underwriter finds that the issuer or obligated person has failed to provide such information, the underwriter should take that failure into account in forming its reasonable belief in the accuracy and completeness of representations made by the issuer or obligated person.” The 2010 Adopting Release at n. 351.

Whether in a competitive or negotiated sale, it is critical that review of prior continuing disclosure compliance is undertaken and documented, and that past “failures to comply in all material respects,” are disclosed in the offering document. If there has been a history of noncompliance, the parties should consider hiring a third party dissemination agent to ensure future compliance, adopt internal procedures and controls, and undertake training.


Question - One of the parties involved in the current financing has been responsible for an issuer’s continuing disclosure filings, which have been filed either late, not at all, or incompletely. What do you do?

2) Purpose of the Disclosure Document

a) Providing information potential investors need to make an investment decision.

b) Drafts may be used to provide potential credit enhancers, rating agencies and others data about the use of the bond proceeds, the project and sources of security for payment.

c) Post closing, used by parties to the transaction for a quick reference that summarizes the terms of the deal.

d) Not a “contractual” document in the deal, so doesn’t establish restrictions on the issuer as would an indenture, loan agreement, etc.; but, if things ultimately turn out differently than described as anticipated, could face investor concerns about misrepresentations in the original disclosure document.

e) Note that the IRS has used disclosure documents to review deals for potential tax problems.

3) Names of the Disclosure Document

a) Official Statement or Limited Offering Memorandum or Private Placement Memorandum. What do you have and how do you choose? How does diligence differ in each case (including who performs it?)

b) The “preliminary” version of the disclosure document (Rule 15c2-12)

Note: The preliminary official statement (“POS”) is “deemed final”, which means that, but for the information that becomes available on the day of pricing—interest rates, what bonds are serials and what are term bonds and in what principal amounts, the amounts and timing of sinking fund installments, optional redemption provisions, sources and uses of funds—there should be no changes to the POS when it becomes the final OS.

4) Contract to Receive the Disclosure Document

a) An underwriter must contract with an issuer of municipal securities (or its designated agent) to receive within seven business days after any final agreement to purchase, offer, or sell the municipal securities, copies of a final official statement in sufficient time to accompany confirmations to customers and in sufficient quantities to meet requests and the requirements of MSRB Rule G-32.


5) Contents of the Disclosure Document

a) What information and how much detail?

i. Using a prior disclosure document as a precedent is common practice.

ii. Industry standards (see GFOA, NFMA, SIFMA) can be helpful, but avoid having an overly rigid “checklist mentality.”

iii. Type of transaction (variable vs. fixed rate) may dictate level of detail.

iv. Type of security (e.g. general credit of the issuer/borrower, project revenues, etc.) will dictate contents.

v. Resistance from others – group discussions and decisions – and what to do when parties don’t want to provide the information.

b) The importance of clarity.

c) Investor cautionary language – the “boilerplate.”

i. Description of responsibility for information; disclaimer of guaranty.

ii. Limitations on offer.

iii. Limitation on date of information.

iv. Possibility of “stabilizing” transactions.

d) Description of the bonds and relevant bond documents (Indenture or Bond Resolution, Ordinance, or Loan Agreement, if any, and other operative documents)

i. Interest rate provisions.

ii. Redemption provisions.

iii. Tender provisions, if any.

iv. Funds and accounts.

v. Flow of funds.

vi. Covenants.

vii. Events of default and remedies.

viii. Amendment of terms.


ix. Permitted and anticipated use of funds.

e) Description of security and matters affecting security.

i. Description of the issuer/borrower (as described under (f) below).

ii. Primary revenues: What are they? How and to whom are they paid? What is the legal authority pursuant to which they are required to be paid?

iii. Historical information concerning revenue receipts and primary revenue generators, data that sheds light on who or what is generating the revenues.

iv. Any documents necessary to generate revenues (sales tax sharing agreements, loan agreements).

v. Consider level of information required to be given regarding third parties which generate revenues.

vi. Any credit enhancement documents (guaranties, letters of credit, bond insurance) and information concerning the providers.

vii. Description of the project (if necessary to generate revenues), or description of area that will generate revenues (e.g., area encompassed within a school district).

A) Examples of the project described will be based on type of deal.

B) Description of who has been engaged for the undertaking, skill level, experience, etc.

viii. If project has not yet been built, description of any impediments to project completion.

A) Governmental approvals.

B) Environmental/geotechnical conditions.

C) Litigation.

D) Corporate authority.

E) Funding (to the extent there is a need in excess of bond proceeds).

ix. If existing project, statistics that describe status/health of specific project for the past X years.

x. Statistics describing economic status/health of region (economic/demographic section).


f) Information concerning the issuer/borrower (organization, operations and financial data, powers/authority, important decision makers).

g) Risk factors.

i. Sources/industry standards.

ii. Specific to your deal.

iii. Any differences when your deal is backed by a letter of credit or insured?

h) Limitations on potential purchasers – who can buy these? Must be clear

i) Tax information – Exempt? Taxable? Bank qualified? AMT? Tax Credit Bonds?

j) Tax credit stripping information.

k) Ratings (or non-rated).

l) Litigation.

m) Continuing disclosure undertaking (form or description if required; and disclosure of failure to comply, in all material respects, with prior undertakings for the past 5 years).

Note: Make sure that form or description of continuing disclosure reflects amendments to Rule 15c2-12 that went into effect on 12/1/10.

n) Bond numbers (preliminary vs. final) – prepared by Underwriter.

i. Principal amounts, maturities, interest rates.

ii. Price or yield.

iii. Sources and uses (including OID or OIP).

iv. Debt service tables.

o) Differences in the document when a competitive sale (including who prepares).

6) Gathering and Verifying the Information included in the Disclosure Document (and what ISN’T in the Disclosure Document) – a/k/a the Due Diligence process

a) Consider who is conducting the diligence and who is providing you with information? Before you begin: becoming informed about the subject matter (e.g. do you understand airport deals well enough to know what to ask?). Different credit structures entail different points of emphasis and review. Also consider which person at the issuer/obligor is providing you with the information you


request. Are your questions being forwarded to persons with expertise in the area of inquiry and direct access to the information requested?

b) Questionnaires/Lists NOTE: There is no official set of due diligence guidelines or lists. Consider each transaction (and its timing!) at the outset and what is appropriate to ask for both in terms of what is included in the disclosure document and with respect to the various factors in the deal.

i. Focus on items affecting the issuance and repayment of the bonds (see security above).

ii. Ask for (and review!) back-up documentation. Some examples of such documentation include (but are not limited to):

• Board minutes/articles of incorporation/by-laws (if applicable) - evidencing proper authorization of transaction as well as overall governance of the entity (most common in 501(c)(3) conduit financings).

• IRS Determination Letters – to verify 501(c)(3) status for not-for-profit borrowers (if applicable).

• Financial statements (3-5 years) and related auditor’s letters.

• Form 990s if it is a 501(c)(3) entity.

• Current enacted budget and proposed budget.

• Publicly available economic data (e.g. census data, labor statistics).

• Issuer’s (or borrower’s) strategic plan (if applicable), capital plan and annual report.

• Evidence of issuer/borrower indebtedness unrelated to financing and any material agreements that the issuer/borrower is a party thereto.

• Licensing and accreditation.

• Evidence of potential litigation, regulatory notices and conflicts of interests.

• Title report(s) regarding project realty and any other property to be pledged as security for the bonds.

• Environmental assessments.

• Investment policies.

• Swaps and other derivatives.


• Pension actuarial valuations.

iii. Explain expected use of information and any certificates that will be required at closing (establish that it is the underwriter’s duty to probe and to cross-check information).

iv. How formal does this really have to be? Meetings? Calls? Conferences?

v. To what extent do you have to independently verify information, e.g. confirming continuing disclosure filings on EMMA?

c) Updating a prior disclosure document (pros and cons).

d) Follow-up due-diligence/document review sessions (if necessary).

e) How far do you have to dig behind an answer?

f) Looking for trends in historical data.

g) Sources of information for learning about and understanding financial reports.

7) Consents to Include Information in Disclosure

a) Auditor’s (1) consent (or “inclusion”) letter and (2) agreed-upon-procedures letter.

b) Feasibility and other studies.

c) Rating agencies?

d) Other.

8) Certificates/Opinions Supporting the Information Provided

a) From (1) issuer and issuer’s counsel; (2) borrower and borrower’s counsel in conduit issues; and/or (3) a state/county/city in municipal-supported or appropriation backed bond issues.

b) From credit enhancement provider.

c) From bond counsel.

d) From dissemination agent/continuing disclosure compliance review service

e) To the Underwriter.

9) A few words on logistics

a) Getting sign-off/consent before “printing”; deeming the POS “final.”


b) What is “printing”? (hard copies versus posting – the latest trends).

c) Getting the pdf document to the printer and proofing the cover.

d) Dealing with attachments – coming from different parties (auditor, insurer, bond counsel, etc.).

e) “Stickering” a POS or OS for material updates during underwriting period or errors in the document.

f) When the final OS must be delivered.

10) Record Retention Issues

a) Drafts of official statements and other documents.

b) Email.

c) Attorney notes.

d) File memos, diligence lists and questionnaires – Law firms have different policies on documenting and retaining due diligence findings. Some maintain detailed findings – while others do not (and note that maintaining detailed records, while intending to demonstrate that a reasonable investigation was conducted, may in fact, reveal that it was not).



08. PRACTICAL DUE DILIGENCE & DRAFTING THE

DISCLOSURE DOCUMENT


What We Will Cover

• Purpose of Due Diligence• Purpose of Disclosure Document• Contents of the Disclosure Document• Gathering and Verifying the Information included in the Disclosure

Document• Other Due Diligence/Disclosure Document Topics


Purpose of Due Diligence• Due diligence refers to the investigation into the business, legal and financial affairs of an

entity involved in a securities offering or other corporate transaction• Reasonable investigation can provide a future defense in response to securities or common

law claims of fraud• Term “due diligence” is not defined in the federal securities laws but is often an informal

shorthand phrase by which securities law liability can be avoided if the preparer of a disclosure document can show that any fraud that occurs in a bond transaction could not have been detected by reasonable inquiry or “due diligence”



Underwriters – Due Diligence

The purpose of an underwriter’s due diligence investigation is to “establish a reasonable basis for belief in the truthfulness and completeness of the key representations” made in the Official Statement.

Registered Securities – Section 11 of the 1933 Securities Act establishes the affirmative due diligence defenses available to an underwriter of securities subject to SEC registration in response to a liability claim made by a purchaser. Although municipal securities are not subject to liability under Section 11 of the 1933 Securities Act, Section 11 provides by analogy useful guidance for establishing defenses to liability under Section 10(b) of the 1934 Exchange Act.


Due Diligence Defenses

Statutory Due Diligence Defenses for Registered Securities – Upon a showing of a material misleading statement or omission in a registration statement, the defendant underwriter must prove that it did not act in a negligent manner.

Due Diligence Defenses for Municipal Securities – The plaintiff, including the SEC, must prove, among other things, that the defendant underwriter acted with scienter inaccordance with the requirements of Section 10(b) of the 1934 Exchange Act, or, with respect only to the SEC as plaintiff, negligence, under Section 17(a)(2) or (3) of the 1933 Securities Act.


Roles of Underwriters and Counsel

“In conducting a due diligence investigation(1) certain tasks that the underwriter must conduct itself;(2) certain matters as to which counsel is, in effect, rendering legal advice;

and(3) certain tasks that may be delegated to underwriter’s counsel as agent of

the underwriter, but that do not amount to legal advice.”

Disclosure Rules of Counsel In State and Local Government Securities Offerings, 3d ed. ABA (2009), at 144.



Roles of Underwriters and Counsel (cont’d)

“The underwriter is responsible for all due diligence, whether performed by itself or on its behalf by agents such as underwriter’s counsel, and can be held responsible not only for its own actions or inactions, but also for those of its attorneys and agents.

Disclosure Roles of Counsel at 145.


Important Considerations

• Who’s your client and what level of investigation are they expecting you to make?• Obtain and verify information regarding issuer, authorization, use of proceeds and security for bonds.• Unearth potential problems with the financing or the project such as, for example, environmental

contamination of the project site, pending litigation seeking to enjoin the project, limit the authority of the issuer or impose significant liabilities, or state or federal legislation that will be enacted during the term of the bonds that will negatively affect the revenue stream.

• Comfort to deliver 10b-5 opinion (even though the letter generally states (1) no independent investigation has been made by Counsel and (2) nothing has come to the attention of such Counsel that would lead it to believe that there was a violation of the 10b-5 materiality standard) even if you are not serving as disclosure counsel.

• Tax issues - The performance of due diligence permits the issuance of the tax opinion and will help show compliance with statutory/regulatory requirements of issuer.

• Establish a defense to securities liability (as shown above), provided that the inquiry satisfies the general standard of professional performance expected of the underwriter and certain other professionals


Important Considerations (cont’d)

Past Compliance with Continuing Disclosure Undertakings

Rule 15c2-12 requires that final official statements contain “a description of the undertakings to be provided…and of any instances in the previous five years in which each [obligated] person failed to comply, in all material respects, with any previous undertakings in a written contract or agreement.”



Roles of Underwriters and Counsel (cont’d)

“The underwriter is responsible for all due diligence, whether performed by itself or on its behalf by agents such as underwriter’s counsel, and can be held responsible not only for its own actions or inactions, but also for those of its attorneys and agents.

Disclosure Roles of Counsel at 145.


Important Considerations

• Who’s your client and what level of investigation are they expecting you to make?• Obtain and verify information regarding issuer, authorization, use of proceeds and security for bonds.• Unearth potential problems with the financing or the project such as, for example, environmental

contamination of the project site, pending litigation seeking to enjoin the project, limit the authority of the issuer or impose significant liabilities, or state or federal legislation that will be enacted during the term of the bonds that will negatively affect the revenue stream.

• Comfort to deliver 10b-5 opinion (even though the letter generally states (1) no independent investigation has been made by Counsel and (2) nothing has come to the attention of such Counsel that would lead it to believe that there was a violation of the 10b-5 materiality standard) even if you are not serving as disclosure counsel.

• Tax issues - The performance of due diligence permits the issuance of the tax opinion and will help show compliance with statutory/regulatory requirements of issuer.

• Establish a defense to securities liability (as shown above), provided that the inquiry satisfies the general standard of professional performance expected of the underwriter and certain other professionals



Past Compliance with Continuing Disclosure Undertakings

Rule 15c2-12 requires that final official statements contain “a description of the undertakings to be provided…and of any instances in the previous five years in which each [obligated] person failed to comply, in all material respects, with any previous undertakings in a written contract or agreement.”



Whether in a competitive or negotiated sale, it is critical that review of prior continuing disclosure compliance is undertaken and documented, and that past “failures to comply in all material respects,” are disclosed in the offering document. If there has been a history of noncompliance, the parties should consider hiring a third party dissemination agent to ensure future compliance, adopt internal procedures and controls, and undertake training.


Purpose of Disclosure Document

• Providing information potential investors need to make an investment decision

• Drafts may be used to provide potential credit enhancers, rating agencies and others data about the use of the bond proceeds project and sources of security for payment

• After closing, used by parties to the transaction for a quick reference that summarizes the terms of the deal


Contents of the Disclosure Document

• Disclosure document may bear various names like official statement or limited offering memorandum or private placement memorandum, depending on how the bonds are being sold

• “Preliminary” version of the disclosure document may be distributed prior to sale



Contents of the Disclosure Document (cont’d)

• What information and how much detail?

Using a prior disclosure document

Industry standards (e.g., GFOA, NFMA, SIFMA)

Type of transaction (variable vs. fixed rate)

Type of security for payment (general credit of issuer/borrower; project revenues, etc.)

• Importance of clarity



• Description of the bonds and relevant bond documents• Description of security and matters affecting security• Information concerning the issuer/borrower (organization, operations and

financial data, powers/authority, important decision makers) • That “boilerplate” stuff on the inside cover



• Risk factors• Limitations on potential purchasers• Tax information

• Exempt? Taxable? Bank qualified? Alternate Minimum Tax? Tax Credit Bonds? • Ratings (or non-rated)• Litigation• Continuing disclosure




• What information and how much detail?

Using a prior disclosure document

Industry standards (e.g., GFOA, NFMA, SIFMA)

Type of transaction (variable vs. fixed rate)

Type of security for payment (general credit of issuer/borrower; project revenues, etc.)

• Importance of clarity



• Description of the bonds and relevant bond documents• Description of security and matters affecting security• Information concerning the issuer/borrower (organization, operations and

financial data, powers/authority, important decision makers) • That “boilerplate” stuff on the inside cover



• Risk factors• Limitations on potential purchasers• Tax information

• Exempt? Taxable? Bank qualified? Alternate Minimum Tax? Tax Credit Bonds? • Ratings (or non-rated)• Litigation• Continuing disclosure



• Bond sale numbers (preliminary vs. final) – prepared by underwriter• Content relating to some third parties (e.g. DTC, credit providers,

liquidity providers) prepared by those parties• Differences in the document when a competitive sale (including who

prepares)


Contents of the Disclosure Document(Boilerplate Language)

• Not Solicitation

• Information subject to change

• No guaranty of information by underwriter

• Official Statement considered in entirety

• Not recommended by any governmental body

• Forward looking statements

• Transactions to stabilize market price


Gathering and Verifying the Information Included in the Disclosure Document

• Consider who is conducting due diligence and who is providing information• Questionnaires/Lists • Focus on items affecting the issuance and repayment of the bonds • Ask for (and review!) back-up documentation



Gathering and Verifying the Information Included in the Disclosure Document (cont’d)

Examples:• Board minutes/articles of incorporation/by-laws (if applicable)• IRS determination letters• Form 990s (if applicable)• Financial statements (3-5 years) and related auditors letters• Current enacted budget and proposed budget• Publicly available economic data (e.g. census data, labor statistics)



• Issuer’s (or borrower’s) strategic plan (if applicable), capital plan and annual report

• Evidence of issuer/borrower indebtedness unrelated to financing and any material agreements involving the issuer/borrower

• Licensing and accreditation• Make sure to check for prior annual and material event filings on EMMA



• Evidence of potential litigation, regulatory notices and conflicts of interests

• Title report(s) regarding project realty and any other property to be pledged as security for the bonds

• Environmental assessments• Investment policies• Swaps and other derivatives• Pension actuarial valuations




Examples:• Board minutes/articles of incorporation/by-laws (if applicable)• IRS determination letters• Form 990s (if applicable)• Financial statements (3-5 years) and related auditors letters• Current enacted budget and proposed budget• Publicly available economic data (e.g. census data, labor statistics)



• Issuer’s (or borrower’s) strategic plan (if applicable), capital plan and annual report

• Evidence of issuer/borrower indebtedness unrelated to financing and any material agreements involving the issuer/borrower

• Licensing and accreditation• Make sure to check for prior annual and material event filings on EMMA



• Evidence of potential litigation, regulatory notices and conflicts of interests

• Title report(s) regarding project realty and any other property to be pledged as security for the bonds

• Environmental assessments• Investment policies• Swaps and other derivatives• Pension actuarial valuations



• Explain expected use of information and any certificates that will be required at closing (establish that it is the underwriter’s duty to probe and to cross-check information)

• How formal does this really have to be? Meetings? Calls? Conferences?



• Updating a prior disclosure document (pros and cons)• Follow-up due-diligence/document review sessions (if necessary)• How far do you have to dig behind an answer?• Looking for trends in historical data• Sources of information for learning about and understanding financial

reports


Consents to Include Information in Disclosure

• Auditor’s (1) consent (or inclusion) letter and (2) agreed-upon-procedures letter

• Feasibility and other studies• Rating Agencies?• Other consents



Certificates and Opinions Supporting the Information Provided

• Certificates and opinions from (1) issuer and issuer’s counsel; (2) borrower and borrower’s counsel in conduit issues; and/or (3) a state/county/city in municipal-supported or appropriation backed bond issues

• Certificates and opinions from credit enhancement provider• Certificates and opinions from bond counsel• Certificate from the dissemination agent/continuing disclosure review

service• Opinions to the underwriter


A Few Words on Logistics

• Getting sign-off/consent before “printing;” deeming the POS “final”• What is “printing”? (hard copies versus posting – the latest trends)• Getting the pdf document to the printer and proofing the cover• Dealing with attachments – coming from different parties (auditor, insurer, bond

counsel, etc.)• “Stickering” a POS or OS for material updates during underwriting period or errors in

the document• When the final OS must be delivered


Record Retention Issues

• Drafts of official statements and other documents• Email• Attorney notes• File memos, materials, diligence lists and

questionnaires



Certificates and Opinions Supporting the Information Provided

• Certificates and opinions from (1) issuer and issuer’s counsel; (2) borrower and borrower’s counsel in conduit issues; and/or (3) a state/county/city in municipal-supported or appropriation backed bond issues

• Certificates and opinions from credit enhancement provider• Certificates and opinions from bond counsel• Certificate from the dissemination agent/continuing disclosure review

service• Opinions to the underwriter


A Few Words on Logistics

• Getting sign-off/consent before “printing;” deeming the POS “final”• What is “printing”? (hard copies versus posting – the latest trends)• Getting the pdf document to the printer and proofing the cover• Dealing with attachments – coming from different parties (auditor, insurer, bond

counsel, etc.)• “Stickering” a POS or OS for material updates during underwriting period or errors in

the document• When the final OS must be delivered


Record Retention Issues

• Drafts of official statements and other documents• Email• Attorney notes• File memos, materials, diligence lists and

questionnaires



09. The Role of Underwriter’s Counsel

Faculty: Paul H. Billow Womble Carlyle Sandridge & Rice, LLP - Raleigh, NC Ryan K. Callender Squire Patton Boggs (US), LLP - Cleveland, OH Kathleen Miles PNC Financial Services Group, Inc. - Washington, DC

I. Introduction - Role of Underwriter’s Counsel

A. Assist in structuring the financing.

B. Review financing, authorization and tax documents (generally prepared by bond counsel).

C. Advise the Underwriter on disclosure and securities matters. The Issuer may have special disclosure counsel regarding disclosure and securities matters as they pertain to the Issuer.

D. Draft/assemble offering documents, sale/underwriting documents and, in some cases, continuing disclosure agreements.

E. Assist the Underwriter in meeting “due diligence” obligations imposed under securities laws. Prepare due diligence questionnaire, checklist and memorandum.

F. Advise the Underwriter on SEC Rule 15c2-12 compliance issues (continuing disclosure), including information to be included in the offering document.

G. Advise the Underwriter through a blue sky survey of actions required to sell bonds in certain states.

H. Review closing documents and opinions to ensure that all conditions of closing as specified in the Bond Purchase Agreement are met.

I. Deliver required Underwriter’s Counsel opinions at closing.

J. Provide any other advice requested by client.

II. Background - Role and Responsibilities of the Underwriter

A. Purchases bonds and redistributes to ultimate investors (underwrites the debt).

B. How and When Does the Underwriter get involved in the financing?


1. Who hires the Underwriter? The Issuer/Borrower (i.e., generally, the “Obligated Person” under SEC Rule 15c2-12).

a. Negotiated sale - The Issuer/Borrower selects an Underwriter or group of Underwriters based on their skills and negotiates the terms and conditions of the relationship with one or more of such Underwriters (“Managers” in a big syndicate). A “request for proposal” or “RFP” process is often used (and often with a financial advisor overseeing the process).

b. Competitive sale - The Issuer/Borrower sets the general terms and maturities for the bonds (often with a financial advisor assisting in the timing of the sale and the overall debt structure) and asks potential underwriting firms to submit the best “interest cost” they can offer for the bonds. This is typically done pursuant to a notice of sale and bid form disseminated (in writing or electronically through a bidding platform). The Issuer/Borrower selects the best offer submitted based on criteria set forth in the notice of sale.

C. What are the Underwriter’s responsibilities in a municipal bond financing?

2. In either a competitive or negotiated sale, the Underwriter:

a. Commits by contract (or bid in a competitive sale) to buy the bonds when issued;

b. Offers the bonds pursuant to a public offering to potential investors;

c. Complies with SEC Rule 15c2-12 (covered in General Securities session), MSRB rules and state blue sky statutes (as defined below); and

d. Is responsible for conducting “due diligence” sufficient to have a reasonable basis for recommending any municipal securities and to provide a basis for a future defense of securities law claims.

3. In a negotiated sale, the Underwriter:

a. Often serves many of the same functions as a financial advisor; i.e., distributes a financing schedule, develops the structure of the bonds, provides market information to the Issuer and the financial advisor, prepares financing numbers, assists with preparation of offering documents, coordinates meetings with rating agencies, credit enhancers and liquidity providers, markets the bonds and oversees pricing; but November 2011 amendments to MSRB Rule G-23 have made it clear that a securities dealer who serves as a


financial advisor to an Issuer cannot serve as an Underwriter of the bonds in the same transaction (see Section VII(C) below).

b. November 2011 Amendments to Rule G-23 prohibit dealer financial advisors from acting as remarketing agent for the bonds.

4. Underwriters and Municipal Advisors

a. The Dodd-Frank Act makes it unlawful for a person to provide advice to or on behalf of municipal entity or obligated person with respect to municipal financial products or issuance of municipal securities, or to undertake certain solicitations of either, unless the person registers, or qualifies for exemption, as a municipal advisor.

b. The Dodd-Frank Act amends the Securities Exchange Act of 1934 to impose on non-exempt municipal advisors a fiduciary duty to municipal entities for which they act as a municipal advisor.

c. The SEC has adopted final rules to, among other things, define who is a municipal advisor and clarify exclusions and exemptions, including those for which Underwriters can qualify.

1) Exclusion for broker/dealers serving as an underwriter to the extent engaged in activities within the scope of an underwriting.

2) Independent registered municipal advisor (IRMA) exemption.

D. What Happens When There is More than one Underwriter?

1. “Syndicate” - A group of Underwriters formed to purchase (underwrite) a new issue of municipal securities from the issuer and offer it for resale to the general public. The syndicate is organized for the purposes of sharing the risks of underwriting the issue, obtaining sufficient capital to purchase an issue and for broader distribution of the issue to the investing public. One of the underwriting firms will be designated as the syndicate manager or lead manager to administer the operations of the syndicate.

a. “Lead Manager” (or “Book-Runner”) - The underwriting firm serving as head of the syndicate; generally handles negotiations in a negotiated underwriting of a new issue of municipal securities. Hires counsel and allocates securities among the members of the syndicate according to the terms of the syndicate agreement and orders received.

b. “Co-Managers” - Any underwriting firm which is the member of an underwriting syndicate other than the lead manager.


c. “Selling Group Member” - A securities broker or dealer that assists in the distribution of a new issue of securities. Selling group members are able to acquire new issue securities from the underwriting syndicate at syndicate terms (i.e., less than the “total takedown”) but do not participate in residual syndicate profits nor share any liability for any unsold balance. Selling Group Members are not very common in recent years.

E. Why does this happen in some deals and not others?

1. Size of the financing.

2. Type of product being offered and expertise of underwriting firms in certain investor markets.

3. Issuer’s preference – “local” involvement of brokers or compliance with MBE/WBE requirements. Issuers may specify particular firms as Co-Managers.

4. In a conduit financing, Borrower’s preference usually prevails.

F. How does the Underwriter get paid?

1. Negotiated Sale - The fee is negotiated between the Issuer/Borrower and the Underwriter prior to the engagement, generally based on a percentage of the principal amount of the bonds. Alternatively, may include the components described below.

2. Competitive Sale - Fee set by bid or is in the “spread.”

a. What is the “spread?” For new issue municipal securities, the difference between the price paid to the Issuer by the Underwriter for the new issue and the prices at which the securities are initially offered to the investing public, a/k/a the “gross spread” or “gross underwriting spread.” There are four components to the spread:

1) Expenses. The costs of operating the underwriting syndicate for which the lead manager may be reimbursed.

2) Management Fee. The amount paid to the lead manager for handling the affairs of the underwriting syndicate.

3) Takedown. Normally the largest component of the spread, similar to a commission, which represents the income derived from the sale of the securities. If bonds are sold by a member of the syndicate, the seller is entitled to the full takedown (a/k/a, the “total takedown”); if bonds are sold by a dealer which is not a member of the syndicate, such seller


receives only that portion of the takedown known as the concession or the dealer’s allowance, with the balance (a/k/a, the “additional takedown”) retained by the syndicate.

Typically includes Underwriter’s Counsel fees.

4) Risk or Residual. The amount of profit or spread left in a syndicate account after meeting all other expenses or deductions. A portion of the residual is paid to each member of the syndicate on a pro rata basis according to the number of bonds each dealer has committed to sell without regard to the actual sales by each member.

3. Under MSRB Rule G-17, underwriters’ compensation cannot be so disproportionate to the nature of underwriting and related services performed as to constitute an unfair practice in violation of G-17 (see Section VII(C) below).

III. Background – Structuring a Bond Issue

A. Who decides the terms and conditions of the bonds to be offered (fixed, variable, auction, term, security, credit enhancement, etc.)?

1. The Underwriter (and/or a financial advisor):

a. Analyzes the capital needs or refunding requirements and debt capacity of the Issuer/Borrower;

b. Prepares projections of debt service structure on the bonds based on a variety of assumptions and bond types; and

c. Reviews projections with the Issuer/Borrower and discusses the economic and other advantages of the various options.

2. The Issuer/Borrower then makes selection based on the proposal made by the Underwriter with advice from its financial advisor.

3. Bond Counsel should make sure debt service structure complies with any State law statutory requirements and complies with any federal tax law limitations.

4. The type of obligation and security for such obligation generally dictated by State constitution and statutory requirements. Various alternative legal structures may be considered by the financing team.


5. Under MSRB Rule G-23, the Underwriter must make it clear at all phases of the transaction that it is acting solely as a principal and not as an advisor or agent to the Issuer (see Section VII(C) below).

B. Other Pre-Sale Activities

1. Prepare for rating agency presentations and meetings with credit enhancers and/or institutional investors and assist Issuer/Borrower with responses to questions and comments from such entities.

2. Advise on the market cost or benefit of including certain provisions in the financing documents. Review the financing documents for key terms and provisions.

3. Assist with review of the Preliminary Official Statement or other offering documents.

C. Pricing – How are bonds priced?

1. Competitive Sale -

a. The financial advisor and the Issuer/Borrower select a sale date.

b. Underwriters or underwriting syndicates submit offers on the sale date through bidding process prescribed in Notice of Sale.

c. Award of bond made to the Underwriter or underwriting syndicated offering the lowest interest cost.

2. Negotiated Sale -

a. The Underwriter and the Issuer/Borrower select a pricing date.

b. Monitor the market and enter the market at agreed upon date(s).

c. Bonds are priced based on the type of bond and market that day.

3. MSRB Rule G-17 includes implied representation that the price that the Underwriter pays is fair and reasonable (see Section VII(C) below).

4. Governmental or other approvals may be necessary as a pre-condition to the bond sale or establishing a sale date.

D. How does the Underwriter offer the bonds?

1. Markets the bonds with a Preliminary Official Statement (usually).

2. Circulates pricing information on day of pricing via pricing wire.


3. Different Underwriters may have particularly strong relationships or reputations with certain markets and institutions.

4. May arrange and oversee investor calls and “road shows.”

E. When does the Underwriter buy and sell the bonds?

1. Price the bonds and sell them for delivery on closing date (generally 2 to 3 weeks after sale for fixed rate bonds and shorter period for variable rate bonds).

2. The Underwriter commits to buy the bonds through execution of a Bond Purchase Agreement (negotiated sale).

F. Who buys the bonds?

1. Bond funds.

2. Institutional investors (i.e., insurance companies).

3. Individuals (i.e., “retail” investors or “mom and pop” investors).

4. Sometimes there are separate “pricing” days for institutional and retail investors.

IV. Responsibilities of Underwriter’s Counsel

A. Preparation of the Official Statement.

1. The Preliminary Official Statement (“POS”) and final Official Statement (“OS”) are the primary disclosure and marketing documents.

2. Both documents are generally prepared by Underwriter’s Counsel (one of the main functions), except in those situations where an Issuer has retained special disclosure counsel (e.g., City of New York, District of Columbia, Miami-Dade County).

a. The POS is generally the “deemed final” official statement for purposes of Rule 15c2-12, except for certain pricing information that is determined on the sale date. Thus, it should be substantially identical to the final OS except for such pricing information.

b. The POS and OS generally set forth the security for the bonds, plan of finance, sources and uses of funds, debt service schedule, bondholders’ risks, material financial and operating data on the Issuer/Borrower, information on any credit enhancers and summaries of the bond documents.


3. Certain sections of the POS and OS (i.e., financing document summaries; feasibility reports, financial statements, bond counsel opinion) are prepared by other parties such as bond counsel, feasibility consultants, accountants, credit enhancers, etc. Underwriter’s Counsel is responsible for reviewing and commenting on these sections.

4. What level of disclosure is appropriate?

a. Underwriter’s Counsel will help advise on what level of disclosure is appropriate for the financing. See SEC Release No. 34-26100 (1988), accompanying the SEC’s explanation of Rule 15c2-12, setting forth the SEC’s view that Underwriters must form a reasonable belief in the accuracy and completeness of key representations set forth in the disclosure documents.

b. In financings where the Issuer retains special disclosure counsel, the question of the accuracy and completeness of the disclosure will be worked through by both Underwriter’s Counsel and the Issuer’s special disclosure counsel.

c. This duty applies for both negotiated and competitive offerings and depends on the factors and circumstances surrounding the issue. These factors include, but are not limited to:

1) The extent to which the Underwriter relied on municipal officials, employees, experts, and other persons whose duties have given them knowledge of particular facts.

2) The role of the Underwriter (as manager, syndicate member or dealer).

3) The type of securities being offered (general obligation, revenue or private activity).

4) The past familiarity of the Underwriter with the Issuer.

5) The length of maturity of the securities.

6) The presence or absence of credit enhancement.

5. Primary concerns in drafting and producing the POS and OS:

a. Clarity and accuracy (i.e., “Plain English”).

b. Appropriate disclosure of material information including risks related to purchase of the bonds.


6. Recent emphasis on crafting disclosure policies and procedures for municipal issuers.

a. Identification of the types of disclosures covered by the policy.

b. Explanation of the processes that the Issuer uses to prepare its disclosures and the processes to demonstrate compliance with the policy.

c. Examination of the role of the Issuer’s officers, employees and governing body in the disclosure process and the creation of a system where such officers or employees are adequately supervised and duties appropriately apportioned among such officers or employees.

d. Explanation of the process for educating applicable officers or employees regarding their duties under securities laws and under the issuer’s disclosure policy, including provisions for specific training of individual officers or employees.

7. Collateral matters in preparing the POS and OS.

a. Seeking appropriate consents for use of information prepared by and reference to experts in the POS and OS (accountant, feasibility consultant or consulting engineer, verification agent).

b. Coordination of Agreed Upon Procedures Letter/Consent with the accountants and appropriate sign off prior to printing. Advising the Underwriter as to whether such letters should be required and disclosure regarding their absence.

c. Coordination of cover and overall document production with the printer and/or electronic dissemination agent.

8. Reference sources:

a. Government Finance Officers Association, Disclosure Guidelines for State and Local Securities (1991 Edition).

b. NFMA, various “Recommended Best Practices” and “White Papers.”

c. ABA Section of Urban, State and Local Government Law, Disclosure Roles of Counsel In State and Local Government Securities Offerings (Third Edition, 2009).

d. National Association of Bond Lawyers, Crafting Disclosure Policies (August 20, 2015)


B. Bond Purchase Agreement.

1. Competitive Sale - Bond Purchase Agreements are not used in competitive sales. The notice of sale constitutes the terms and conditions of the sale, bids represent offers to purchase on the terms set forth in the notice of sale, and the award is the acceptance of the offer of the Underwriter or the underwriting syndicate.

2. Negotiated Sale - Bond Purchase Agreements are used in negotiated underwritings to commit to writing between the Issuer and the Underwriter (and the Borrower in a conduit financing):

a. Pricing terms upon which the Underwriter agrees to purchase the bonds upon their issuance.

b. Representations and warranties of the Issuer/Borrower relating to the offering and sale of the bonds.

c. Closing conditions (e.g., delivery of certain documents, certificates, opinions, etc.).

d. “Outs” or events which, if they occur, would allow the Underwriter to refuse delivery of the bonds.

e. Indemnity provisions, choice of law, severability, etc.

f. NOTE: A form of Bond Purchase Agreement is located at www.sifma.org for reference.

3. Generally the form of Bond Purchase Agreement is developed by Underwriter’s Counsel. In some cases, Underwriters have standard forms (or at least standard provisions) that they require or request to be used based on a desire to provide uniform rights, duties and obligations for all transactions. Many of those standard forms are based on the SIFMA model bond purchase agreement. However, in many cases there are somewhat standard forms that have been historically utilized based on a particular Issuer. Recently, in-house counsel of the Underwriter has begun to review the Bond Purchase Agreement in circumstances where the form used is not supplied by the Underwriter.

4. Following the MSRB Rule G-23 amendments (and interpretive guidance to MSRB Rule G-17), many Underwriters are requiring the following disclaimer language in Bond Purchase Agreement forms:

a. The purchase and sale of the bonds is an arm’s-length commercial transaction between the Issuer/Borrower and Underwriter;


b. The Underwriter is acting solely as a principal and not as an advisor, agent or a fiduciary of the Issuer/Borrower;

c. The Underwriter has not assumed a fiduciary responsibility in favor of the Issuer/Borrower with respect to the offering of the Bonds or the process leading thereto or any other obligation to the Issuer/Borrower except the obligations expressly set forth in the Bond Purchase Agreement; and

d. The Issuer/Borrower has consulted with its own legal and financial advisors to the extent it deemed appropriate in connection with the offering of the bonds.

C. Continuing Disclosure Agreement.

1. Continuing Disclosure Agreement (“CDA”) is an undertaking required by SEC Rule 15c2-12 for certain municipal bonds that are publicly offered. This undertaking may be in a separate CDA or contained within other financing documents (e.g., a loan agreement).

2. CDAs generally require the Issuer or “obligated person” (as defined by SEC Rule 15c2-12) to provide certain annual financial information (e.g., audited financial statements and other financial operating data included in the OS), as well as timely notice of certain enumerated events described below.

a. Prior to July 1, 2009, the information was provided to the Nationally Recognized Municipal Securities Information Repositories (“NRMSIRs”), commonly through the “Central Post Office” operated by the Texas Municipal Advisory Council.

b. As of July 1, 2009, all disclosure filings must be submitted in electronic format to the MSRB’s Electronic Municipal Market Access (EMMA) web-based system.

c. While the EMMA system simplifies filings, the EMMA system does not contain the filings previously made to the NRMSIRs, and any search for filings made prior to July 1, 2009 cannot be made through EMMA.

3. Pursuant to SEC Rule 15c2-12, the Issuer or obligated person must also provide notice within 10 business days of the occurrence of the following events with respect to the particular issue subject to the continuing disclosure undertaking:

a. Principal and interest payment delinquencies;

b. Non-payment related defaults, if material;


c. Unscheduled draws on debt service reserve fund reflecting financial difficulties;

d. Unscheduled draws on credit enhancements reflecting financial difficulties;

e. Substitution of credit or liquidity providers, or their failure to perform;

f. Adverse tax opinions, the issuance by the IRS of proposed or final determinations of taxability, Notice 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

g. Modification to rights of security holders, if material

h. Bond calls, if material, and tender offers;

i. Defeasances;

j. Release, substitution, or sale of property that secures the repayment of the securities, if material;

k. Rating changes;

l. Bankruptcy, insolvency, receivership or similar event of the obligated person;

m. The consummation of a merger, consolidation or acquisition involving an obligated person or the sale of all or substantially all of the assets of the obligated person (other than in the ordinary course of business), the entry into a definitive agreement to undertake such action or the termination of a definitive agreement relating to any such actions, other than pursuant to its terms, if material; and

n. Appointment of a successor or additional trustee, or the change in name of the trustee, if material.

4. Primary drafting concerns:

a. Accurately describing the continuing disclosure undertaking in the POS/OS (sometimes included as an exhibit).

b. Determination of the annual financial information to be included in continuing disclosure undertaking.


c. Disclosure regarding material non-compliance with prior continuing disclosure undertakings under SEC Rule 15c2-12 for the past five years. This was main premise for the recent MCDC Initiative.

d. Remedies for non-compliance with undertaking (i.e., specific performance remedy or covenant default in bond documents).

e. Consideration of amendments to existing continuing disclosure undertaking in light of changes to SEC Rule 15c2-12 relating to EMMA filings, especially for refunding of debt issued prior to July 1, 2009 or where an Issuer hasn’t issued debt since July 1, 2009.

D. Remarketing Agreement (Variable Rate Issues).

1. Pursuant to the Remarketing Agreement, the Underwriter or another designated member of the underwriting syndicate agrees to use its best efforts to remarket any bonds that are tendered and determines interest rate resets.

2. Primary concerns in drafting the Remarketing Agreement:

a. Appropriate limitations on the obligations of the Remarketing Agent (best efforts, agent);

b. Coordination with the provisions in the bond documents on the obligations of the Remarketing Agent; and

c. No obligation to purchase if bonds cannot be remarketed.

d. Procedures for resignation or removal of Remarketing Agent (consistent with provisions in the bond documents).

E. Agreement Among Underwriters and Selling Group Agreement.

1. Agreement Among Underwriters - Agreement among the Senior Managing Underwriter and the other Co-Managers setting forth the original participation of each, the financial agreement among the parties and the responsibilities of each of the parties. Based on a standard industry form (see, The Bond Market Association 1997 form and SIFMA form Master Agreement). Once a formal document that Underwriter’s Counsel was responsible for preparing, the common form is now a wire sent by the Senior Manager to the Co-Managers.

2. Selling Group Agreement - Letter of instruction to members of the selling group regarding availability of disclosure and details regarding bonds. These were often prepared by the Underwriters but rarely utilized today.


F. Due Diligence

1. What exactly is “due diligence”?

a. The term due diligence refers to the investigation by an Underwriter into the business, legal and financial affairs of the Issuer or other obligor concerned in connection with securities offerings or other corporate transactions. A reasonable investigation can provide a future defense in response to securities law or common law claims stemming from a transaction or offering that has gone bad.

b. The Underwriter cannot assign their due diligence responsibilities to lawyers or anyone else. Lawyers do not “do due diligence.” They assist the Underwriter in portions of its due diligence undertakings where lawyers can be useful.

c. In general, the purpose of due diligence is to provide the Underwriter with defenses to claims (see below); however, there is an expanding body of SEC interpretive and enforcement law which is changing the underlying basis of “due diligence” from that of establishing due diligence defenses to the affirmative undertaking of certain due diligence responsibilities (primarily related to disclosure).

2. What should conducting due diligence accomplish?

a. Provide backup for the disclosure document. Due diligence involves document review and interviews with personnel knowledgeable about such matters during the course of preparing the disclosure document.

1) Frequently, the preparation of disclosure materials occurs in conjunction with the conduct of “due diligence” activities.

2) Confirms the accuracy of the POS/OS and the 10b-5 “negative assurance” letter. The antifraud provisions of the 1933 and 1934 Acts and SEC Rule 10b-5 apply to municipal securities. In order to give its letter (and potentially meet its obligations under these provisions), Underwriter’s Counsel needs to conduct a due diligence investigation.

3) End result for an Underwriter: Receipt of a 10b-5 letter (i.e., “Underwriter’s Counsel” letter).


b. Review the basis for the tax-exempt status of the bonds. Although Underwriter’s Counsel usually assumes no responsibility for the validity or tax-exempt status of the securities in question, they generally review the underlying support for bond counsel’s opinion respecting those matters. For guidance in the tax area, refer to BAW 2005, “Tax Due Diligence and Documentation.” In doing so, Underwriter’s Counsel seeks to confirm that the bond counsel opinion:

1) has a reasonable basis;

2) addresses the issues necessary to be addressed in the transaction;

3) is given by counsel who are competent; and

4) is one upon which the Underwriter may reasonably rely.

c. Address federal and state law securities questions.

1) Federal securities registration and exemption.

2) MSRB provisions.

3) State blue sky and legal investment laws.

d. Confirm compliance with existing continuing disclosure obligations of the Issuer.

1) SEC Rule 15c2-12 requires that the offering document state whether the Issuer has failed to comply “in all material respects” with its previous continuing disclosure undertakings under the Rule for the previous five years.

This should always be a due diligence question posed by Underwriter’s Counsel.

Should discuss with the Underwriter the level of due diligence review the Underwriter expects as part of the Underwriter’s Counsel engagement.

Some Underwriters are employing other service providers to conduct due diligence review of EMMA filings (e.g., DAC).

2) A due diligence inquiry of MSRB/EMMA provides the Underwriter a reasonable basis for reliance on the Issuer’s


continuing disclosure representations in the offering document.

3. The form of due diligence request varies based on the type of transaction, prior history with the Issuer/Borrower and the Underwriter and Underwriter’s Counsel preference or practice.

a. Underwriter’s Counsel frequently circulates to the Issuer/Borrower a list of documents that it will need to review and a questionnaire for the Issuer/Borrower to respond to in writing or on a due diligence call.

1) Documents on the due diligence list should include financial information (audits), board minutes, tax returns, material contracts, articles and bylaws, budgets, insurance coverage information, environmental information, feasibility studies, litigation, and regulatory information. In the case of qualified 501(c)(3) bonds, certain issues related to tax-exempt status need to be reviewed (such as proper accreditation, proper tax filings to maintain 501(c)(3) status (Form 990 and 990-T), proof of current 501(c)(3) status by the IRS – IRS Determination Letter).

2) Areas of concern include potential material financial liabilities, any threat to status as a qualified Issuer/Borrower of tax-exempt bonds and accuracy of disclosure regarding the Issuer/Borrower in the POS/OS.

4. The “Document Review” session.

a. Who normally goes out to do the diligence? Associates for Underwriter’s Counsel, bond counsel and borrower’s counsel.

b. What About Interviews? It depends on the entity, but could involve CEO, CFO, strategic/planning person, risk manager, general counsel (re: litigation and/or regulatory issues), board members, project manager, among others.

5. Does Underwriter’s Counsel produce a due diligence report or other document? This depends on a particular firm’s practice. Some firm produce a short memo (which documents the responses from the Q & A session) for internal files. Some Underwriters request a due diligence memo from time to time from Underwriter’s Counsel. Underwriter’s Counsel due diligence file should include notes, documents collected from due diligence, completed questionnaire and any support necessary for 10b-5 negative assurance letter.


6. Recent practice has been to hold a formal due diligence call with working group members to document responses to certain due diligence questions.

7. The “Due Diligence” defense.

a. Section 11 of the 1933 Act permits the purchaser of a security to bring an action based on an untrue statement of a material fact in, or omission of a material fact from, a registration statement.

b. Section 11 does not apply to municipal securities; nevertheless, the SEC has taken the position that parties to exempt transactions are under obligations of investigation similar to those that form the basis of the due diligence defense set forth in Section 11(b) of the 1933 Act. This Section exempts from liability any person other than the Issuer who can prove that he or she made a reasonable investigation of the underlying facts and had reasonable grounds to believe, and did believe, that the statements made were true.

c. There is an expanding body of SEC interpretive and enforcement law that is changing the underlying basis of due diligence from that of establishing a defense to an affirmative undertaking of certain due diligence responsibilities. An underwriting constitutes an implied recommendation about the securities (SEC Proposing Release for Rule 15c2-12). Also derived from “fair dealing” theory (MSRB Rule G-17 discussed below).

G. Blue Sky Survey.

1. What are blue sky laws?

a. State securities laws. Each state has its own laws for sale of securities. These laws are designed to prevent fraudulent practices, to, in some cases, require registration of entities selling or offering securities and to, in some cases, register the securities or provide notice of sale.

b. As a general rule, municipal general obligation securities are exempt from state securities registration. Nonetheless, recent defaults by the Issuer on non-general obligation securities for the bonds may result in registration requirements. In addition, the type of sales (institutional vs. retail) will impact the application of the blue sky laws.

c. The National Securities Markets Improvement Act of 1996 amends the 1933 Act to preempt important areas of the blue sky laws affecting national markets. The effect of the new legislation is that municipal securities are classified as “covered securities,” which prohibits states from regulating, with certain exceptions such as


information filings. One exception is that a municipal security is not deemed to be a covered security in the state in which the Issuer is located.

2. Prepare Preliminary Blue Sky Survey.

a. Summary document.

b. Lists assumptions about the structure of the bonds.

c. Confirms which states will require action for sale of the bonds, which will not require action and in which states the Underwriter has instructed counsel to proceed with the required action.

d. Generally delivered around time of printing the POS directly to the Underwriter.

3. Assist the Underwriter with any required filings.

4. Prepare the final Blue Sky Survey or bring-down letter - Summary at sale and closing of which states have been cleared for sale of the bonds.

5. Occasionally with the Blue Sky Survey, the Underwriter requests a “Legal Investment Survey.” This generally is intended to provide information on which institutional investors are allowed to own bonds under the laws of the investor’s state.

6. Some Underwriter’s Counsel outsource blue sky survey work to other specialty firms.

H. Underwriter’s Counsel Opinion Letter

1. Who is it addressed to?

a. The Underwriter.

b. In some cases, the Issuer, or a Reliance Letter to the Issuer (the 10b-5 portion of the opinion should never be given to the Issuer).

2. What does it generally cover?

a. Neither the sale of the bonds to the Underwriter nor the resale of the bonds by the Underwriter to the public requires that the bonds be registered under the Securities Act of 1933. (Sometimes broader – not necessary to register any security.)

b. The Bond Indenture or similar instrument need not be qualified under the Trust Indenture Act of 1939, as amended.


c. The 10b-5 or “negative assurance” statement - On the basis of the Underwriter Counsel’s participation in the transaction, but without independent verification of factual matters, nothing has come to our attention that would lead us to believe that the Official Statement, as of its date and as of this date, contains any untrue statement of material fact or omits to state any material fact necessary to make the statements therein, in light of the circumstances under which they were made, not misleading. Generally excludes financial and statistical data and lists certain excluded sections of the Official Statement. Note: This is not a legal opinion, only a factual statement.

d. Compliance of the continuing disclosure undertaking with SEC Rule 15c2-12 with respect to form.

e. Should rely on bond counsel opinion for tax exemption in order to reach the conclusion in a. and b. above. May also need to rely on counsel to the credit enhancer.

V. Special Disclosure Counsel.

A. Role of Special Disclosure Counsel.

1. In recent years, Issuers have increasingly retained “special disclosure counsel” to prepare the Issuer’s official statements or other disclosure documents, to provide disclosure advice to the Issuer and to provide limited comfort to the Issuer on such disclosure.

2. Special disclosure counsel also frequently assists the Issuer in preparation for the Underwriter’s due diligence calls and investor calls.

B. Effect on Role of Underwriter’s Counsel.

1. While Underwriters sometimes decline to retain counsel when special disclosure counsel is involved, most Underwriters recognize that special disclosure counsel does not provide the Underwriter with assistance in the “due diligence” investigation and does not provide advice generally to the Underwriter on disclosure matters and other matters affecting the legal duties of the Underwriter.

2. The presence of special disclosure counsel often means that Underwriter’s Counsel is not the primary drafter of the POS/OS, but Underwriter’s Counsel customarily reviews the POS/OS and provides advice to the Underwriter on its organization and adequacy. Commonly special disclosure counsel and Underwriter’s Counsel work together to address challenging disclosure issues.


3. Underwriter’s Counsel often includes in the Bond Purchase Agreement a closing requirement that special disclosure counsel deliver an opinion or a “10b-5” or “negative assurance” letter to the Underwriter. The opinion or letter often specifically points out that the special disclosure counsel has not advised the Underwriter on its responsibilities under the federal securities laws or otherwise served as counsel to the Underwriter.

VI. Practice Tips

A. Who is the Client?

1. Questions exist as to who is the client - The underwriting syndicate as a separate “entity”? The Senior Manager? The Co-Managers? The underwriting syndicate and all selling group members?

2. When the Issuer selects Underwriter’s Counsel or Underwriter’s Counsel pool. Some active, large Issuers actually recommend the firm who serves as Underwriter’s Counsel (or select a pool of law firms from which an Underwriter must select its counsel). Even in these instances, the Issuer is not the client; the Underwriter is. A practitioner who is confronted by this arrangement should always be mindful of this.

3. Think through the conflicts implications and specify the arrangement in the engagement letter.

4. Consider what is proper disclosure of any conflicts or relationship among parties in the POS/OS.

B. Offering Period - Make sure you know if all bonds are sold immediately. Otherwise the underwriting period is still “open” and this has consequences under the Bond Purchase Agreement.

C. “Firm” underwriting v. “best efforts” - The modern structure of the Bond Purchase Agreement is a hybrid. Be very clear about the exceptions that allow the Underwriter not to close the transaction.

VII. MSRB – What is it and Why Do You Need to Know About it?

A. What is the MSRB?

1. Background: The Securities Act Amendments of 1975 created the 15 member Municipal Securities Rulemaking Board (“MSRB”) as a self-regulating rulemaking organization, subject to substantial control by the SEC.

2. Authority: The MSRB’s rulemaking authority extends to municipal brokers and dealers, but not to Issuers.


3. Responsibilities:

a. Development of a system for registration and regulation of dealers engaged in underwriting and trading municipal securities.

b. Promulgation of rules governing professional qualifications of dealers in municipal securities, record keeping, quotations and advertising.

c. Proposing and adopting rules to effect the purposes of the Securities Exchange Act of 1934 with respect to municipal securities transactions.

d. After July 1, 2009, operate its web-based system known as EMMA, located at http://emma.msrb.org (as described further under Section V., below).

e. With passage of Dodd-Frank Act, directed by Congress to protect municipalities.

4. Possible structural and jurisdictional changes in pending legislation, including regulation of financial advisors.

B. MSRB Rules.

1. Purpose: MSRB rules are designed to prevent fraudulent and manipulative acts and practices, to promote equitable trade practices, to foster cooperation and coordination among persons engaged in facilitating transactions, to remove impediments to a free and open market in municipal securities, and generally to protect investors and the public interest.

2. Approval: MSRB rules are generally subject to approval by the SEC. MSRB rules have the force of law.

3. Powers: The MSRB has the power to interpret its rules, but has no inspection or enforcement powers. Inspection and enforcement powers belong to a variety of regulatory bodies, including the SEC, the Financial Industry Regulatory Authority (FINRA) and federal banking agencies.

C. Summary of MSRB Rules Most Likely to be Encountered.

1. Rule G-11 sets forth the rules for sales of new issue municipal securities during the underwriting period.

2. Rules G-17 through G-39 are known as the “fair practice” rules which prohibit brokers and dealers from engaging in fraudulent or manipulative acts and practices.


3. Rule G-17 broadly prohibits any “deceptive, dishonest or unfair practice.”

a. Rule G-17 contains an anti-fraud prohibition; however, does not merely prohibit deceptive conduct on the part of the dealer and establishes general duty to deal fairly even in absence of fraud.

b. Rule G-17 requires the Underwriter, in a negotiated underwriting, to make certain disclosures to the Issuer to clarify its role and its actual or potential material conflicts of interest.

c. Rule G-17 prescribes timing and manner of disclosures and requires the Underwriter to attempt to receive written acknowledgement by an official of the issuer of receipt of the disclosure.

d. Rule G-17 also prescribes disclosures by the Underwriter on aspects of routine or complex financings.

4. Rule G-21 regulates the advertising of the sale of municipal securities. The Rule prohibits any dealer from publishing materially false or misleading advertisements.

5. Rule G-23 – Key amendments in November 2011 which redefines the Underwriter’s role and relationship to the Issuer. In general, Rule G-23 has been amended to prohibit a dealer that serves as financial advisor to the Issuer for a particular issue sold on either a negotiated or competitive bid basis from switching roles and underwriting the same issue.

a. Rule G-23 is solely a conflicts-of-interest rule and does not establish normative standards for dealer conduct (i.e., it does not determine whether advice permitted by Rule G-23 would cause a dealer to be considered a “municipal advisor” that is subject to a fiduciary duty under Section 15B(c)(1) of the Act).

b. Under Rule G-23, an Underwriter may provide advice concerning the structure, timing, terms and other similar matters concerning an issue of municipal securities that it is underwriting if:

1) it clearly identifies itself in writing as an underwriter and not as a financial advisor from the earliest stages of its relationship with the issuer with respect to that issue (e.g.,in a response to RFP or in promotional materials provided to an Issuer);

2) the writing makes clear that the primary role of an underwriter is to purchase securities in an arm’s-length commercial transaction between the issuer and the


underwriter and that the underwriter has financial and other interests that differ from those of the issuer; and

3) the dealer does not engage in a course of conduct that is inconsistent with an arm’s-length relationship with the issuer in connection with such issue of municipal securities.

6. Rule G-32 sets forth the disclosure requirements for brokers, dealers and municipal securities dealers in connection with new issues and sets forth certain admission requirements with respect thereto to the MSRB’s EMMA system.

a. Requires that brokers or dealers who sell municipal securities deliver to the customer (i) an official statement (or, if no official statement is being prepared, a written notice to that effect), and (ii) in negotiated sales of new securities, information about the underwriting spread, dealer fees and the initial offering price for each maturity offered by the Underwriters (“Confirms”).

b. Also sets out the responsibilities of managing Underwriters, sole Underwriters and financial advisors.

c. Covers underwriter submissions to EMMA (including notices if no preliminary or no official statement is being prepared).

d. If a POS or OS is amended or “stickered” during the primary offering disclosure period, the broker, dealer or municipal securities Underwriter must send the amended official statement to EMMA within one business day of receipt from the Issuer.

e. Underwriters are required to submit final Official Statements, advanced refunding documents, together with Form G-33, electronically.

7. Rule G-34 sets forth requirements for obtaining CUSIP numbers for new securities, making new securities depository eligible (DTC) and filing certain documents with the MSRB relating to variable rate municipal securities (i.e., variable rate demand obligations or VRDOs).

8. Rule G-37 requires municipal securities dealers to file reports with information on political contributions made. The Rule also prohibits dealers from engaging in municipal securities business with an Issuer within two years of making a non-exempt contribution to an official of such Issuer. Rule G-37 requires dealers to file reports, which the MSRB makes public, that detail the contribution amount, the contributor, and the official to whom the contribution was made. In Blount v. SEC, 61 F.3d 938 (D.C. Cir. 1995), Rule G-37 withstood both a First Amendment


freedom of speech challenge and a Tenth Amendment state sovereignty challenge.

9. Rule G-38 prohibits payments by a broker, dealer or municipal securities dealer to any affiliated person obtain municipal securities business from an Issuer. There are transitional payment rules in effect for agreements with consultants made prior to August 29, 2005, which must be in writing, must be disclosed in writing when related to any Issuer with which the broker, dealer or municipal securities dealer is engaging or seeking to engage in municipal securities business information and must be disclosed quarterly to the MSRB.

10. Proposed Rule G-42 sets forth standards of conduct and duties of municipal advisors when engaging in municipal advisory activities other than the undertaking of solicitations. Comments were received through March 2014, the SEC approved Rule-42 on December 23, 2015, and the Rule will become effective on June 23, 2016.

D. Underwriter’s Counsel Responsibilities with Respect to Compliance with MSRB Rules.

1. Generally, in-house counsel is responsible for compliance with MSRB rules. Occasionally, Underwriter’s Counsel asked to weigh in on MSRB rules compliance issues.

2. Certain MSRB rule requirements reflected in terms of the Bond Purchase Agreement (i.e., delivery of Official Statements).

3. Working knowledge of MSRB rules is very beneficial.

Sources for further review:

Websites:

1. MSRB: www.msrb.org (“Rules, Forms and Glossary” icon) 2. Securities Industry and Financial Markets Association: www.sifma.org3. NABL: www.nabl.org

Publications:

1. NABL, “Rule 15c2-12 Handbook” (May 1, 1996) 2. NABL, “Model Letter of Underwriter’s Counsel” 3. ABA “Disclosure Roles of Counsel in State and Local Government Securities Offerings,”

3d Edition



09. The Role of Underwriter’s Counsel


I. Introduction – Role of Underwriter’s Counsel

• Assist in the structuring of the financing.• Review financing and authorization documents.• Advise Underwriter on disclosure and securities matters.• Draft/assemble offering documents and sale/underwriting documents.• Assist the Underwriter in meeting “due diligence” obligations imposed

under securities laws.• Advise the Underwriter through a blue sky survey of actions required to

sell bonds in certain states.• Review closing documents and opinions to ensure that all conditions of

closing are met.• Deliver required Underwriter’s Counsel opinions at closing.


II. Background – Role and Responsibilities of the Underwriter• Purchases bonds and redistributes to ultimate investors.• The Underwriter is typically hired by the Issuer/Borrower (the “Obligated

Person” under SEC rule 15c2-12).• Negotiated Sale v. Competitive Sale

• Underwriter Responsibilities• In both competitive and negotiated sales

• Commits by contract (or bid in competitive sales) to buy the bonds when issued.• Offers bonds pursuant to a public offering to potential investors.• Complies with SEC Rule 15c2-12, MSRB rules and state blue sky statutes.• Responsible for conducting “due diligence” sufficient to have a reasonable basis for

recommending any municipal securities.• In negotiated sales

• Often serves many of the same functions as a financial advisor; but November 2011 amendments to MSRB Rule G-23 have made it clear that a securities dealer who serves as a financial advisor to an Issuer cannot serve as an Underwriter of the bonds in the same transaction.



• Underwriters and Municipal Advisors• Dodd-Frank Act• SEC rules

• Issues can involve more than one Underwriter• Syndicate

• Lead Manager (or “Book Runner”)• Co-Managers• Selling Group Member

• How the Underwriter gets paid• Negotiated sale

• The fee is negotiated between the Issuer/Borrower and the Underwriter prior to the engagement.

• Competitive Sale• The fee is set by the bid or is in the “spread.”

• What is the “spread?”• MSRB Rule G-17 – Compensation cannot be so disproportionate to nature of the

underwriting and related services as to constitute an unfair practice.



• Who decides the terms and conditions of the bonds to be offered?• The Underwriter (and/or financial advisor) analyzes the capital/refunding needs

and debt capacity of the Issuer/Borrower, prepares projections of debt service structure, and reviews projections with Issuer/Borrower and discusses various options.

• The Issuer/Borrower makes selection.• Bond Counsel ensures debt service structure complies with State and federal

law.• MSRB Rule G-23 – Underwriter must make it clear at all phases of the

transaction that it is acting solely as a principal and not as and advisor.• Other Pre-Sale Activities

• Prepare for rating agency presentations and meetings with credit enhancers.• Advise on the market cost or benefit of including certain provisions in the

financing documents.• Assist with review of the Preliminary Official Statement or other offering

document.


• How the bonds are priced• Competitive Sale• Negotiated Sale • MSRB Rule G-17 – Implied representation that the price the underwriter pays is

fair and reasonable.• How the Underwriter offers the bonds

• Preliminary Official Statement (most common).• Circulates pricing information on day of pricing via pricing wire.• Road shows.

• When the Underwriter buys and sells bonds• The bonds are priced and sold for delivery on the closing date.• The Underwriter commits to buy the bonds through the execution of a Bond

Purchase Agreement.• Who buys the bonds

• Bond funds• Institutional investors• Individuals



• Underwriters and Municipal Advisors• Dodd-Frank Act• SEC rules

• Issues can involve more than one Underwriter• Syndicate

• Lead Manager (or “Book Runner”)• Co-Managers• Selling Group Member

• How the Underwriter gets paid• Negotiated sale

• The fee is negotiated between the Issuer/Borrower and the Underwriter prior to the engagement.

• Competitive Sale• The fee is set by the bid or is in the “spread.”

• What is the “spread?”• MSRB Rule G-17 – Compensation cannot be so disproportionate to nature of the

underwriting and related services as to constitute an unfair practice.



• Who decides the terms and conditions of the bonds to be offered?• The Underwriter (and/or financial advisor) analyzes the capital/refunding needs

and debt capacity of the Issuer/Borrower, prepares projections of debt service structure, and reviews projections with Issuer/Borrower and discusses various options.

• The Issuer/Borrower makes selection.• Bond Counsel ensures debt service structure complies with State and federal

law.• MSRB Rule G-23 – Underwriter must make it clear at all phases of the

transaction that it is acting solely as a principal and not as and advisor.• Other Pre-Sale Activities

• Prepare for rating agency presentations and meetings with credit enhancers.• Advise on the market cost or benefit of including certain provisions in the

financing documents.• Assist with review of the Preliminary Official Statement or other offering

document.


• How the bonds are priced• Competitive Sale• Negotiated Sale • MSRB Rule G-17 – Implied representation that the price the underwriter pays is

fair and reasonable.• How the Underwriter offers the bonds

• Preliminary Official Statement (most common).• Circulates pricing information on day of pricing via pricing wire.• Road shows.

• When the Underwriter buys and sells bonds• The bonds are priced and sold for delivery on the closing date.• The Underwriter commits to buy the bonds through the execution of a Bond

Purchase Agreement.• Who buys the bonds

• Bond funds• Institutional investors• Individuals


IV. Responsibilities of Underwriter’s Counsel

• Preparation of the Official Statement• POS and OS are generally prepared by Underwriter’s Counsel except in

those situations where an Issuer has retained special disclosure counsel.• POS is generally the “deemed final” official statement for purposes of Rule 15c2-12

except for certain pricing information.

• Disclosure• Underwriter’s counsel helps to advise the appropriate level of disclosure.


• Preparation of Official Statement (cont.)• Primary concerns

• Clarity and accuracy.• Appropriate disclosure of material information.

• Recent emphasis on crafting disclosure policies and procedures for municipal issuers.

• Collateral matters in preparing POS and OS• Seek appropriate consents for use of information prepared by and reference to

experts in the POS and OS.• Coordination of Agreed Upon Procedures Letter/Consent with accountant and

appropriate sign off prior to printing.• Coordination of cover and overall document production with the printer.


• Bond Purchase Agreement• Not used in competitive sales.• In negotiated sales, BPAs are used to commit to writing

between the Issuer and the Underwriter:• Pricing terms upon which the Underwriter agrees to purchase the bonds upon

issuance.• Representations and warranties of the Issuer/Borrower relating to the offering and

sale of the bonds.• Closing conditions.• “Outs” or events which, if they occur, would allow the Underwriter to refuse

delivery of the bonds.• Indemnity provisions, choice of law, severability, etc.

• A form of BPA is located at www.sifma.org for reference.• The amendments to MSRB Rule G-23 and guidance on MSRB

Rule G-17 have resulted in many underwriters requiring certain disclaimer language in BPAs.



• Continuing Disclosure Agreement• CDAs are required for certain municipal bonds by SEC Rule 15c2-12.

These undertakings may be in a separate CDA or contained within other financing documents.

• CDAs generally require the Issuer or “obligated person” to provide certain annual information as well as timely notice (10 days pursuant to Rule 15c2-12) of certain enumerated events.

• Primary drafting concerns• Accurately describe continuing disclosure undertaking from CDA document.• Determination of annual financial information to be included in the continuing

disclosure undertaking.• Disclosure regarding material compliance with prior continuing disclosure

undertakings under Rule 15c2-12 for the past five years.


• Remarketing Agreement• Pursuant to the remarketing agreement, the Underwriter of another

designated party agrees to use its best efforts to remarket any bonds that are tendered and to determine interest rate resets.

• Primary drafting concerns• Appropriate limitations on the obligations of the Remarketing Agent.• Coordination with the provisions of the bond documents;• No obligation to purchase if the bonds cannot be remarketed; and• Resignation/Removal

• Agreement Among Underwriters and Selling Group Agreement• Agreement Among Underwriters – Agreement among the Senior Managing

Underwriter and the other Co-Managers.• Selling Group Agreement – Letter of instruction to members of the selling

group regarding availability of disclosure and details regarding the bonds.


• Due Diligence• Refers to the investigation by an underwriter into the business, legal and

financial affairs of the Issuer/Borrower in connection with securities offerings or other corporate transactions.

• Underwriters cannot assign their due diligence responsibilities to lawyers or anyone else.

• Purpose of Due diligence • Form of due diligence requests

• Underwriter’s Counsel will often circulate a list of documents necessary to review and a questionnaire for the Issuer/Borrower to respond to in writing or on a due diligence call.

• The “Document Review” session.• Due diligence reports



• Blue Sky Survey• Blue Sky Laws• Preliminary Blue Sky Survey

• Generally delivered around the time of the printing of the POS.• Final Blue Sky Survey or Bring-Down Letter

• Summary at sale and closing of which states have been cleared for sale of the bonds.


• Underwriter’s Counsel Opinion Letter• Addressed to the Underwriter.

• In some cases, the Issuer, or a Reliance letter to the Issuer.• Opinion covers:

• Neither the sale of the bonds to the Underwriter nor the resale of the bonds by the Underwriter to the public requires the bonds be registered under the Securities Act of 1933.

• The Bond Indenture or similar instrument need not be qualified under the Trust Indenture Act of 1939, as amended.

• The 10b-5 or “negative assurance” statement - On the basis of the UW Counsel’s participation in the transaction, but without independent verification of factual matters, nothing has come to our attention that would lead us to believe that the Official Statement, as of its date and as of this date, contains any untrue statement of material fact or omits to state any material fact necessary to make the statements therein, in light of the circumstances under which they were made, not misleading. Generally excludes financial and statistical data and lists certain excluded sections of the Official Statement. Note: This is not a legal opinion, only a factual statement.

• Compliance of the continuing disclosure undertaking with Rule 15c2-12 with respect to form.

• Should rely on bond counsel opinion for tax exemption in order to reach the first two conclusions above.


V. Special Disclosure Counsel

• Role of Special Disclosure Counsel• Prepares official statements or other disclosure documents, to provide

disclosure advice to the Issuer and to provide limited comfort to the Issuer on such disclosure.

• Assists in preparation for underwriter “due diligence calls” and investor calls.

• Effect on the role of Underwriter’s Counsel• Underwriter’s counsel will oftentimes cease to be the primary drafter of the

official statement.• Underwriter’s Counsel will often include in the BPA a closing requirement

that special disclosure counsel deliver an opinion or a “10b-5” or “negative assurance” letter to the Underwriter.



VI. Practice Tips

• Who is the client?• Is it the Syndicate as a separate entity? The Lead Manger? The Co-Managers?

The Syndicate and all Selling Group Members?• Sometimes large Issuers will recommend Underwriter’s Counsel. Even in these

cases, the Issuer is not the client.• Think through conflicts and specify the arrangement in the engagement letter.• Consider proper disclosure of conflicts/relationships among parties in the

POS/OS.• Offering Period

• Make sure to be aware if all bonds are sold immediately. • “Firm” underwriting v. “best efforts”

• Be very clear about the exceptions that allow the Underwriter not to close the transaction.


VII. MSRB – What is it and Why Do You Need to Know About it?• What is the MSRB?

• Securities Act Amendments of 1975 created the 15 member Municipal Securities Rulemaking Board (MSRB) as a self-regulating rulemaking organization, subject to substantial control by the SEC.

• The MSRB’s rulemaking authority extends to municipal brokers and dealers, but not to issuers.

• Responsibilities


• MSRB Rules• Designed to prevent fraudulent and manipulative acts and practices, to

promote equitable trade practices, to foster cooperation and coordination among persons engaged in facilitating transactions, to remove impediments to a free and open market in municipal securities ,and generally to protect investors and the public interest.

• Generally subject to approval by the SEC.• The MSRB has the power to interpret its rules, but no inspection or

enforcement powers.




10. Bank Loans/Direct Purchases Faculty:Hal Patrick Harris Beach PLLC – Albany, NY Kimberly J. Min Whiteford, Taylor & Preston LLP – Baltimore, MD

Introduction

Prior to the Tax Reform Act of 1986, banks were major purchasers of tax-exempt debt. Sincethe passage of the Tax Reform Act of 1986, now under Section 265(b) of the Internal Revenue Code of 1986, as amended (the “Code”), banks have been prohibited from deducting the carrying cost (interest expense incurred to purchase or carry an inventory of securities) of tax-exempt municipal bonds. Consequently, prior to the 2008 financial crisis, banks were not active purchasers of tax-exempt bonds. Since the outset of the crisis, as a result of the Federal Reserve Board’s stimulus actions, interest on deposit accounts (and the corresponding value of banks’ interest expense deduction) has hovered at de minimus levels. In addition, pending changes in banking regulations made it appear cheaper for banks to take on credit risk as bondholders than by issuing letters of credit to support third party purchases. Consequently, as a result of the financial crisis, banks and bank affiliates have increasingly bought tax-exempt bonds in “direct placements.”

Under an exception to the disallowance of carrying cost deductions, banks may deduct 80% of the carrying cost of a “qualified tax-exempt obligation.” In order for bonds to be qualified tax-exempt obligations the bonds must be (i) issued by a “qualified small issuer,” (ii) issued for public purposes, and (iii) designated as qualified tax-exempt obligations. A “qualified small issuer” is (with respect to bonds issued during any calendar year) an issuer that issues no more than $10 million of tax-exempt bonds during the calendar year ($30 million during calendar year 2009 and 2010). As a result of this treatment of bonds subject to the exemption, those issued under the exemption are characterized as bank qualified (sometimes referred to as “BQ”). Commercial bankers often refer to directly purchased bonds not subject to the exemption as non-bank qualified bonds (or “NBQ”).

1) The 2008 Financial Crisis disrupted the market for variable rate demand bonds and for auction rate bonds

i) Reasons:

(a) Bond insurance unavailable due to failure of insurers of municipal bonds

(b) Bank credits deteriorated, as a result of which:


1. Banks were unable or unwilling to accept exposure to other banks

2. Many banks ceased to have the ratings necessary to support purchases by tax-exempt money market funds

(c) Basel III changed capital reserve requirements, causing banks to favor direct debt over contingent liquidity risk of letters of credit or standby bond purchase agreements

ii) Qualified 501(c)(3) borrowers found access to tax-exempt capital very limited

2) Bank qualified bonds vs. non-bank qualified bonds purchases

In response to the Financial Crisis, the American Recovery and Reinvestment Act of 2009 (ARRA), which expired on December 31, 2010, created several changes for tax-exempt securities issued in 2009 and 2010. A temporary safe harbor was created that permitted financial institutions to deduct 80% of the cost of buying and carrying tax-exempt bonds to the extent their tax-exempt holdings do not exceed 2% of their assets. The $10 million bank qualified bond limit was also changed to $30 million and the qualified 501(c)(3) organization for whose benefit the bond was issued was treated as the issuer of the bond. This allowed conduit issuers to issue up to $30 million in tax-exempt bonds for each qualified borrower.

Following the expiration of ARRA on December 31, 2010, banks have continued to actively purchase non-bank qualified tax-exempt debt. Banks have capital available to lend, and health care and higher education institutions as well as many local governments represent creditworthy opportunities in the current low interest rate climate.

3) Direct purchase structure

i) Typical bond structure

(a) Bond indenture and, for conduit issues, pledged loan/lease agreement

1. Single mode or multi-modal with bank mode

2. Bond purchase agreement and, in conduit issues, a separate agreement with the borrower

3. Trustee required

4. Single bank purchaser, reliance on bondholder voting, or intercreditor agreement

5. Typically used when desired to remarket following the bank holding period


(b) Two-party or, for conduit issues, three-party loan agreement among issuer, borrower, if any, and bond purchaser

1. Can include purchases by multiple banks administered by an agent bank

2. Includes bond purchase agreement representations

3. In conduit financing, includes back-to-back loan agreement provisions

4. Typically provides for extensions with bank consent, but not remarketings in other modes

(c) Security documents

1. Mortgage, collateral assignment and/or pledge and security agreement

2. Pledge of revenues may be provided for in authorizing document without additional security documents

ii) Bank purchaser documents

(a) Continuing Covenants Agreement (between the bank and conduit borrower)

1. Common financial covenants

i. Debt service coverage ratio

ii. Liquidity covenant

iii. Minimum net worth or maximum capitalization ratio

iv. Limitations on additional debt

2. Additional events of default (comparable to loan agreements)

3. Right to cure events of default

4. Default rate of interest

5. Reporting requirements

(b) Common additional bank security requirements

1. Third party guarantees


2. Environmental indemnities

3. Post-closing agreements

4. Most favored nation clauses

4) What are the principal differences between a direct purchase of bonds and a publically offered bond issue?

i) Disclosure

(a) Direct placements are purchased on the basis of the bank’s direct evaluation of issuer or borrower credit and not on the basis of an offering document

(b) Avoids expense of preparation of offering document, accountants’ consents and bring downs, and other due diligence expenses associated with public and private/limited offerings

(c) Attractive to conduit borrowers that prefer confidentiality

ii) Role of underwriter/placement agent

(a) SEC Rule 15c2-12: Even if the bonds are securities, the private placement exemption would likely be available for a direct placement

(b) Registration exemption: If the bonds are non-exempt securities, direct purchases can be exempted from registration under Rule 144A of the Securities Act, because banks are qualified institutional buyers

(c) Placement: A placement agent can assist the borrower in obtaining a commitment to purchase bonds from one or more banks, negotiating deal terms with the selected purchaser(s), and preparing debt amortization schedules. If the bonds are securities, only registered broker-dealers may assist the issuer in placing the bonds with banks

(d) Direct negotiation: Many direct purchases are done without a municipal underwriter, placement agent or financial advisor

iii) Business terms of the debt

(a) Underwriting: Bank purchasers underwrite the debt in the same way they underwrite a conventional term loan:

1. Risk rating


2. Return on investment

3. Events of default under the bank documents may authorize an acceleration of the obligation

(b) Interest Rates: can be variable rate or fixed rate

1. Tax-exempt variable rates will be a percentage of a (typically one-month) LIBOR rate plus a margin; the percentage (typically between 65% and 80%) adjusts LIBOR to an after-tax equivalent

2. Fixed rates will be the after-tax equivalent of a bank’s cost of funds at issuance plus a margin

3. Both fixed and variable rate margins are affected by the length of time the bank purchaser agrees to hold the bonds

4. Banks may offer to provide a hedging arrangement to produce a synthetic fixed rate for the borrower

i. Consideration should be given to the tax issues raised by having the bondholder provide the hedging agreement, it may be necessary to secure the hedging agreement separately from the bonds to preserve the “separateness” of the bonds and the interest rate hedge

5. Increased costs: Typically banks may recover increased costs of holding bonds if laws or regulations change, including changes in capital requirements, marginal corporate tax rates, etc. Publicly offered bonds compensate investors for taking these risks, making interest rate comparisons apples to oranges

(c) Maturity

1. Bank purchasers will specify how long they are willing to hold the bonds, which generally will be for a period shorter than the bond maturity

2. At the end of the bank holding period, the banks may require a mechanism to “put” the bonds back to the borrower

a. Mandatory redemption will require the borrower to retire the bonds or refinance the bonds away from the bank

i. Failure to redeem the bonds is an event of default triggering remedies


b. Mandatory purchase will require the bonds be tendered for remarketing at the end of the bank hold period

i. This gives the borrower more flexibility to extend the bonds, through conversion to a different mode if the Indenture allows for conversion or sale of the bonds to a different QIB, in addition to refinancing or paying off the bonds

ii. Failure to repurchase the bonds is an event of default authorizing remedies

c. In some circumstances a bank may be willing to hold the bonds until maturity (typically not more than 10-12 years)

3. Extension of the Bank hold period

a. Banks will hold direct purchased bonds for a period that is comparable to the maturity they would offer the borrower for a term loan for the same project, based on current market conditions. Banks expect to stay in the credit for the full maturity of the bonds, but are not willing to take market risk beyond the initial bank holding period

i. Extension mechanisms similar to those found in reimbursement agreements for direct pay letters of credit or standby bond purchase agreements can be included in the Continuing Covenants Agreement, generally based on a written request from the borrower at a specified time prior to the end of the bank hold period

ii. If the bonds are not retired at the end of the holding period, but rather are held at a rate with a new margin or are converted to a new mode, a constructive tax reissuance could occur, so additional steps may be required to qualify the extension term as a tax-exempt current refunding issue

(d) Construction Financing

1. Banks are often concerned with construction risk and may require higher interest rates during construction

2. Borrowers are concerned with negative arbitrage on undisbursed funds held during the construction period; bank purchasers may be willing to structure financings as “drawdown” bonds, funding construction


advances as needed, which could significantly reduce negative arbitrage

(e) Prepayment

1. In fixed rate transactions, the bank may agree to earlier call rights than in public offerings, but sometimes with a make-whole prepayment premium to protect the bank against exercise when funds cannot be redeployed at comparable rates

2. Variable rate transactions would not have a prepayment premium; however, if there is a swap, a market-based termination payment will likely apply

3. Borrowers may negotiate for the right to prepay portions of outstanding bonds from internally generated funds, or up to a certain percentage per year

4. Because banks typically have relationships that they wish to preserve with borrowers, they typically will agree to a negotiated prepayment on terms that make them whole and are easier to arrive at than utilizing a tender offer for publicly offered bonds

(f) Events of default and remedies

1. An event of default under the Continuing Covenants Agreement will be an event of default under the Indenture.

As holder of the bonds, the bank can direct the trustee to exercise remedies under the Indenture, including acceleration or mandatory tender

2. Bond interest rate increases to a default interest rate after an event of default, which is less common in publicly offered bond documents

3. Event of taxability - bond interest rate typically increases to a taxable rate

aa. Redemption on taxability event may be required by issuer

bb. Bank may be willing to continue to hold the bonds at the taxable rate and not require redemption


5) Particular issues that may arise in a direct purchase

i) Tax reissuance

(a) A reissuance occurs under federal tax law when there are significant modifications to the bond so that the bond ceases to be the same bond for tax purposes. Significant modifications include a change in annual yield by more than 25 basis points, change in the timing of payments (due to an extension of maturity or deferral of payments), change of obligor, change in security or credit enhancement, change in priority of an obligation (subordination for example), or a change in the nature of the debt instrument

ii) Refunding of bank qualified bonds issued during ARRA

(a) Application of IRC Section 265(b)(3)(g)

iii) Swap agreements

(a) If a Direct Purchase bond is variable rate and a swap is entered into to produce a synthetic fixed rate, tax counsel should be consulted on the collateral securing the swap and with respect to the separateness of bonds and the swap if the bank purchaser is also the swap provider

(b) If the swap is secured with the same collateral as the bonds, it may be useful to have the trustee act as collateral agent for swap agreement

iv) Disclosure of bank indebtedness to rating agencies and on EMMA

(a) Typically not required. No official statement is prepared for a private placement with a bank, and incurring additional debt is not a listed event for which notice must be filed on EMMA under continuing disclosure undertakings. Consequently, investors in outstanding bonds are not required to be given notice of a direct placement until the issuer’s or borrower’s next periodic continuing disclosure filing

(b) NFMA and GFOA advocate filing a voluntary notice of each direct placement, either summarizing relevant terms or uploading an expurgated copy of the relevant transaction documents. Of particular interest are covenants and acceleration provisions that might present a liquidity risk not presented by outstanding bonds. See also Bank Loan Voluntary Disclosure Considerations (May 2013) available on the NABL website

v) Is the bond a security or a loan, and for what purpose?

(a) Parties may wish bank financing to be categorized as a loan rather than as a security, or vice versa, for purposes of complying with securities laws, or


qualifying for league tables, or allocating profit between departments, among other reasons

(b) If a loan is a “security” under federal securities laws, then financial advisors may need to choose between being a municipal advisor or a placement agent intermediary (like an underwriter in a private offering), in order to avoid the MSRB ban on advising and underwriting in the same issue

(c) To treat an issue as a commercial loan, the following should be considered:

(i) The bonds will not have CUSIP numbers while in a bank purchaser rate mode;

(ii) The bonds are issued in a single denomination, or if there are multiple bank purchasers, a single bond for each purchaser;

(iii) Transfers of the bonds are limited to banks or other qualified institutional buyers (“QIBs”);

(iv) The bank purchaser confirms that the bonds are not being purchased with intent of subsequent distribution;

(v) If permitted under state law, documentation resembles loan, rather than bond, documents; and

(vi) If there are multiple purchasers, all purchasers treat the transaction in the same manner

6) Multiple purchasers/participations

i) Large transactions may have more than one bank purchaser, which can be addressed by issuing separate bonds or separate series of bonds to each purchaser

(a) Bondholder voting rights to direct the Trustee should be reviewed carefully

1. Majority or unanimous consent typically required to direct the Trustee

ii) A lead bank may choose to participate its interest in the bonds to other banks

(a) Participant banks should be treated as beneficial owners of a pro rata interest in the bonds held by the bondholder bank

(b) Care should be taken to pass tax ownership of the bonds to the participants


7) Timing/schedule

i) Direct purchase transactions can often be completed more quickly than publically offered bond issues due to the absence of the disclosure process

ii) Timing may be important to the borrower, particularly for refundings



10. Bank Loans/Direct Purchases


• Prior to the Tax Reform Act of 1986, banks were major purchasers of tax exempt debt.Since the passage of the Tax Reform Act of 1986, now under Section 265(b) of theInternal Revenue Code of 1986, as amended (the "Code"), banks have been prohibitedfrom deducting the carrying cost (interest expense incurred to purchase or carry aninventory of securities) of tax-exempt municipal bonds

• Under an exception to the disallowance of carrying cost deductions, banks may deduct80% of the carrying cost of a "qualified tax-exempt obligation." In order for bonds to bequalified tax-exempt obligations the bonds must be

• issued by a "qualified small issuer,"

• issued for public purposes, and

• designated as qualified tax-exempt obligations

• A "qualified small issuer" is (with respect to bonds issued during any calendar year) anissuer that issues no more than $10 million of tax-exempt bonds during the calendar year($30 million during calendar year 2009 and 2010)

• As a result of this treatment of bonds subject to the exemption, those issued under theexemption are characterized as bank qualified (sometimes referred to as "BQ")

INTRODUCTION


Reasons:

• Bond insurance became unavailable due to failure of insurers of municipal bonds• Letters of Credit became much less available:

• Bank credit ratings dropped• Banks unable or unwilling to accept credit exposure to other banks

• Basel III changed capital reserve requirements, causing banks to favor direct debt over contingent liquidity risk of letters of credit or standby bond purchase agreements

• Results:• Existing transactions had to be restructured• Lack of access to tax exempt capital for qualified 501(c)(3) borrowers

THE 2008 FINANCIAL CRISIS DISRUPTED THE MARKET FOR VARIABLE RATE DEMAND BONDS AND FOR AUCTION RATE BONDS



American Recovery and Reinvestment Act of 2009 (ARRA)

• A temporary safe harbor was created - financial institutions allowed to deduct 80% of the cost ofbuying and carrying tax-exempt bonds to the extent their tax-exempt holdings do not exceed 2%of their assets

• $10 million bank qualified bond limit increased to $30 million and the qualified 501(c)(3)organization for whose benefit the bond was issued was treated as the issuer of the bond. Thisallowed conduit issuers to issue up to $30 million in tax exempt bonds for each qualifiedborrower

• ARRA expired December 31, 2010, banks have continued to actively purchase non-bankqualified tax-exempt debt

• Banks have capital available to lend, and health care and higher education institutions as well asmany local governments represent creditworthy opportunities in the current low interest rateclimate

LEGISLATIVE RESPONSE


• Direct Purchase Structure Compared to Typical Bond Structure(a) Bond Indenture

1. Single mode and multi-modal indentures2. Alternatives to bond indenture 3. Role of Trustee / Use of Trustee

(b) Loan agreements or lease-leaseback agreements(c) Security documents(d) Bonds

• Bank Purchaser documents (a) Continuing Covenants Agreement(b) Additional Bank security requirements

DIRECT PURCHASES OF BONDS BY BANKS


• Role of Underwriter/Placement Agent

• Disclosure

• Business terms of the debt

• Maturity

• Construction financing

• Prepayment

• Events of default and remedies

DIRECT PURCHASE OF BONDS VS PUBLICALLY OFFERED BONDS?



American Recovery and Reinvestment Act of 2009 (ARRA)

• A temporary safe harbor was created - financial institutions allowed to deduct 80% of the cost ofbuying and carrying tax-exempt bonds to the extent their tax-exempt holdings do not exceed 2%of their assets

• $10 million bank qualified bond limit increased to $30 million and the qualified 501(c)(3)organization for whose benefit the bond was issued was treated as the issuer of the bond. Thisallowed conduit issuers to issue up to $30 million in tax exempt bonds for each qualifiedborrower

• ARRA expired December 31, 2010, banks have continued to actively purchase non-bankqualified tax-exempt debt

• Banks have capital available to lend, and health care and higher education institutions as well asmany local governments represent creditworthy opportunities in the current low interest rateclimate

LEGISLATIVE RESPONSE


• Direct Purchase Structure Compared to Typical Bond Structure(a) Bond Indenture

1. Single mode and multi-modal indentures2. Alternatives to bond indenture 3. Role of Trustee / Use of Trustee

(b) Loan agreements or lease-leaseback agreements(c) Security documents(d) Bonds

• Bank Purchaser documents (a) Continuing Covenants Agreement(b) Additional Bank security requirements

DIRECT PURCHASES OF BONDS BY BANKS


• Role of Underwriter/Placement Agent

• Disclosure

• Business terms of the debt

• Maturity

• Construction financing

• Prepayment

• Events of default and remedies

DIRECT PURCHASE OF BONDS VS PUBLICALLY OFFERED BONDS?


• Tax Reissuance

• Refunding of bank qualified bonds issued during ARRA

• Swap agreements

• Disclosure of bank indebtedness to rating agencies and on EMMA

PARTICULAR ISSUES THAT MAY ARISE IN A DIRECT PURCHASE


• To assist the Bank Purchaser in treating the transaction as a commercial loan, the following should be considered:• The bonds will not have CUSIP numbers while in a bank purchaser rate

mode• The bond be issued in a single denomination, or if there are multiple bank

purchasers, a single bond for each purchaser • Limit transfers of the bonds to other Qualified Institutional Buyers (“QIBs”)• Obtain certification from the Bank Purchaser that the bonds are not being

purchased with intent of subsequent distribution• If there are multiple purchasers, all purchasers should treat the

transaction in the same manner

IS THE BOND A SECURITY OR A LOAN?


• Multiple purchasers/participations

• Timing/ Schedule

ADDITIONAL ISSUES TO CONSIDER



Differences when GO bonds are issued as a direct purchase

GENERAL OBLIGATION BONDS


Any Questions?



Differences when GO bonds are issued as a direct purchase

GENERAL OBLIGATION BONDS


Any Questions?

General Training Sessions Materials





11. Conduit Issues & Issuers

Faculty:Christopher B. Langhart McManimon, Scotland & Baumann, LLC – Roseland, NJ S. Douglas Williams, Jr. Maynard Cooper & Gale – Birmingham, AL

I. INTRODUCTION.

A. General Types of Municipal Bond Transactions

1. Governmental Bonds-General Obligation of the Issuer

2 Conduit Borrowings- Issuer and Borrower

B. Conduit Bond Issues –Why do Conduit Issuances of Municipal Bonds Make Sense?

1. Interest Rate Advantage- taxable rate v. tax exempt rate

2. Ability to issue tax-exempt bonds.

II. WHAT IS A CONDUIT ISSUER?

A. Types of Entities

1. Quasi-governmental

2. “On behalf of” entities

3. In some states, a general purpose governmental issuer.

B. Powers - State Law Driven- created by statute

C. National Conduit Issuers

III. FOR WHAT AND FOR WHOM DO CONDUIT ISSUERS ISSUE BONDS?

A. Typical Project Financed with Conduit Bonds

1. Health facilities

2. Cultural facilities


3. Housing facilities

4. “Exempt” facilities

5. Education facilities

B. Benefitted Entities

1. Hospitals

2. Senior living organizations

3. Universities and charters schools

4. Religious organizations

5. In some instances, private companies

IV. FINANCING STRUCTURES FOR A CONDUIT TRANSACTION.

A. Four Key Questions:

1. What’s the deal (i.e., Who are the borrower and potential purchasers and what is the parties’ economic agreement or contract)?

2. What is the applicable state law?

3. What are the tax law requirements?

4. How and to whom are the bonds being sold (what are the securities law requirements)?

B Basic Fixed Rate Conduit Structures

1. Security

a) Promise of Conduit Borrower (e.g. pledge of tuition and fees or hospital revenues or other receivables)

b) Revenue- pledge of money from the borrower pursuant to a Loan Agreement or Lease Agreement as stated below

c) Mortgage/Deed of Trust

d) Bond Insurance or County Guaranty –the decline of the bond insurance industry has led to different types of security in transactions

2. Documents

a) Trust Indenture or Mater Indenture


b) Loan Agreement

c) Lease Agreement

d) Installment Sale Agreement

B. Variable Rate Conduit Revenue Bonds – Credit Enhancement

1. Letter of Credit

2. Standby Bond Purchase Agreement

3. Self-Liquidity

C. Interest Rate Swap Agreements

1. Parties

2. Integration

V. SECURITIES ISSUES.

A. Which Securities Laws Apply to Conduit Issues?

1. 1933 Act

2. 1934 Act

B. Are Conduit Bonds Exempt Securities? Determine what exactly constitutes a security.

1. Section 3(a)(2)- general exemption for (i) securities issued or guaranteed by the U.S. or any territory thereof governmental securities, (ii) securities issued or guaranteed by any state, political subdivision or public instrumentality thereof, (iii) issued by a national bank or state bank, and (iv) for certain industrial development bonds.

2. Section 3(a)(4)

3. “Separate Securities” – Rule 131

C. Are the Bond Indentures Exempt?

1. Trust Indenture Act of 1939

D. Antifraud Provisions

1. Section 17(a) of 1933 Act

2. Section 10(b) of 1934 Act-Section 10(b) prohibits the use, in connection with purchase or sale of a security, of “any manipulative or deceptive device”.


3. Rule 10b-5- prohibits use of interstate commerce, mails or national securities exchange to employ any device, scheme or artifice to defraud, or to make any material misstatement or omission, or to engage in any fraud or deceit. Courts recognize private causes of action

E. Continuing Disclosure Requirements

VI. TAX ISSUES.

A. What issues are pertinent to Conduit Issuers?

1. Private Activity Bond restrictions

2. Alternative Minimum Tax

3. Substantial User Requirement

4. Volume Cap

5. Bank Qualification

B. Opinions – 501(c)(3)

1. Reliance on IRS Determination Opinion

2. “Due Inquiry” – has there been anything since the 1023 application that might jeopardize the 501(c)(3) status

3. What are you willing to give as 501(c)(3) counsel and what must you see as bond counsel or underwriter’s counsel?



11. CONDUIT ISSUES AND ISSUERS


• What are conduit bonds?• Who benefits from conduit bond issues?• How are conduit bond issues structured?• Which securities law exceptions are utilized in a conduit issue?• Which tax laws are triggered?

What We Will Cover


A. Two Main Types of Municipal Bonds• Governmental Bonds• Conduit Bonds

• “Private Activity” BondsB. Economics of Conduit Bonds

• For example, if the taxable rate on bonds is 7% and an investor has a 33% marginal tax rate, then the investor will make the same amount of interest with a 7% taxable bond as with a 4.69% tax-exempt bond. The calculation is 7% multiplied by (1 minus the marginal tax rate) or .67 which equals 4.69%. A borrower would much rather pay 4.69% on $10,000,000 than 7%. In the first year alone, the borrower would save $231,000 in this example.

I. Introduction



A. Types of Entities• Quasi-Governmental• “On behalf of” Entities

B. Powers – State Law Driven• Statutorily createdPowers vary by state, including issuing powers beyond its borders

C. Jurisdiction• National Conduit Issuers

II. What is a Conduit Issuer?


A. Type of Projects• Health Facilities• Cultural Facilities• Housing Facilities• “Exempt” Facilities• Education Facilities

III. For What and For Whom do Conduit Issuers Issue Bonds?


B. Benefitted Entities• Hospitals• Senior living organizations• Universities, charter schools and private schools• Religious organizations (beware of The Establishment Clause of U.S.

Constitution)• In some instances, private companies

III. For What and For Whom do Conduit Issuers Issue Bonds? (cont.)



A. Types of Entities• Quasi-Governmental• “On behalf of” Entities

B. Powers – State Law Driven• Statutorily createdPowers vary by state, including issuing powers beyond its borders

C. Jurisdiction• National Conduit Issuers

II. What is a Conduit Issuer?


A. Type of Projects• Health Facilities• Cultural Facilities• Housing Facilities• “Exempt” Facilities• Education Facilities

III. For What and For Whom do Conduit Issuers Issue Bonds?


B. Benefitted Entities• Hospitals• Senior living organizations• Universities, charter schools and private schools• Religious organizations (beware of The Establishment Clause of U.S.

Constitution)• In some instances, private companies

III. For What and For Whom do Conduit Issuers Issue Bonds? (cont.)


Five Areas of Law that Shape a Transaction’s Structure and Documentation• Securities Law 1933• Tax Law 1913• U.S. Constitution 1789• State Law 1783• Law of Contracts (yore)

IV. Financing Structures for a Conduit Transaction


Four Key Questions:• What’s the deal (i.e., Who are the borrower and potential purchasers and

what is the parties’ economic agreement or contract)?• What is the applicable state law?• What are the tax law requirements?• How and to whom are the bonds being sold (what are the securities law

requirements)?

IV. Financing Structures for a Conduit Transaction (cont.)


Financing Structures for a Conduit Transaction (cont.)

Issuer

ConduitBorrower

$ Bond Proceeds

$ Debt Service

Types of document evidencing the debt obligation:

• Trust Indenture• Loan Agreement• Master Indenture• Lease Agreement• Installment Sale Agreement

Basic Fixed Rate Conduit StructuresDocuments



Basic Fixed Rate Conduit StructuresSecurity

• Issuer as a conduit• Conduit Borrower: the entity receiving the bond proceeds

and responsible for paying debt service




$ BondProceeds

$ BondProceeds

$ BondProceeds

$ DebtService

$ DebtService

$ Bond

Project$ Bond

RevenuesProceeds

Proceeds

Bondholders

Underwriters

Trustee

“Conduit” Issuer

“Conduit” Borrower

Basic Fixed Rate Conduit StructuresSecurity - Revenues



$ BondProceeds

$ BondProceeds

$ BondProceeds

$ DebtService

$ DebtService



$ Bond

ProjectProceeds

Bondholders

Underwriters

Trustee Various collateral/security

possibilities

Basic Fixed Rate Conduit StructuresSecurity – Revenues + ?



Basic Fixed Rate Conduit StructuresSecurity

• Issuer as a conduit• Conduit Borrower: the entity receiving the bond proceeds

and responsible for paying debt service




$ BondProceeds

$ BondProceeds

$ BondProceeds

$ DebtService

$ DebtService

$ Bond

Project$ Bond

RevenuesProceeds

Proceeds

Bondholders

Underwriters

Trustee



Basic Fixed Rate Conduit StructuresSecurity - Revenues



$ BondProceeds

$ BondProceeds

$ BondProceeds

$ DebtService

$ DebtService



$ Bond

ProjectProceeds

Bondholders

Underwriters

Trustee Various collateral/security

possibilities

Basic Fixed Rate Conduit StructuresSecurity – Revenues + ?


• Security determined by state law• Deed of Trust• Mortgage


$ BondProceeds

$ DebtService



$ Bond

ProjectProceeds

Trustee Mortgage orDeed of Trust

Revenues

Bond Proceeds

Pledge / Assign

• Security Agreement• In Equipment

• Other Collateral• Assignment of Liens, receivables, etc.

Basic Fixed Rate Conduit StructuresSecurity – Mortgage/Deed of Trust



Basic Fixed Rate Conduit StructuresSecurity – Bond Insurance$ Bond

Proceeds

$ BondProceeds

$ BondProceeds

$ DebtService

$ DebtService

Issuer

ConduitBorrower

$ Bond

Project

$ Bond

RevenuesProceeds

Proceeds

Mortgage/DT

Bond InsurancePremiumor Fees

Pledged


Bondholders

Underwriters

Trustee



Bondholders

Underwriters

Trustee

Issuer

Conduit Borrower

Remarketing Agent

Put Rights

Put Purchase Price

Liquidity Provider

Potential “Bank Bonds”

Recall: Common these days for single bank / institution to purchase Bonds, either variable, fixed for a certain period and/or “swapped” to fixed. I.e., “direct purchase” bonds.

Variable Rate Conduit Structures



$ BondProceeds

$ BondProceeds

$ BondProceeds

$ DebtService

$ DebtService

Issuer

ConduitBorrower

$ Bond

Project

$ Bond

RevenuesProceeds

Proceeds

Mortgage/DT

Letter of Credit, Standby Bond

Purchase Agreement

& Self-LiquidityPremiumor Fees

Pledged


Bondholders

Underwriters

Trustee

IV. Financing Structures for a Conduit Transaction (cont.)Variable Rate Conduit Revenue Bonds –

Letter of Credit, Standby Bond Purchase Agreement and Self-Liquidity


Current Issues on Credit Enhancement

• The demise of bond insurance and downgrades of banks’ ratings . . . and its lingering vestiges

• The advent of “failed remarketings” . . . and “bank bonds” (rates, amortizations, collateral)

• The rise of direct purchase bonds

• Relative scarcity and difficulty to obtain bond insurance andbank support (LOC’s and Standby Bond Purchase

Agreements)

• New regulatory issues



Interest Rate Swap Agreements

• Parties – Borrower and Swap Counterparties

• Integration – Conduit Issuer Role




$ BondProceeds

$ BondProceeds

$ BondProceeds

$ DebtService

$ DebtService

Issuer

ConduitBorrower

$ Bond

Project

$ Bond

RevenuesProceeds

Proceeds

Mortgage/DT

Letter of Credit, Standby Bond

Purchase Agreement

& Self-LiquidityPremiumor Fees

Pledged


Bondholders

Underwriters

Trustee

IV. Financing Structures for a Conduit Transaction (cont.)Variable Rate Conduit Revenue Bonds –

Letter of Credit, Standby Bond Purchase Agreement and Self-Liquidity


Current Issues on Credit Enhancement

• The demise of bond insurance and downgrades of banks’ ratings . . . and its lingering vestiges

• The advent of “failed remarketings” . . . and “bank bonds” (rates, amortizations, collateral)

• The rise of direct purchase bonds

• Relative scarcity and difficulty to obtain bond insurance andbank support (LOC’s and Standby Bond Purchase

Agreements)

• New regulatory issues



Interest Rate Swap Agreements

• Parties – Borrower and Swap Counterparties

• Integration – Conduit Issuer Role



V. Securities Law Issues

Bondholders

Bond Issuer

Conduit Borrower

Bond Insureror Letter of

Credit

Bond(Security #1)

Guaranty of Debt Service(Security #3)

Loan/Lease(Security #2)

A. What is a Security?


B. Registration Provisions1. 1933 Act Registration Requirement

• Section 5 requires a registration statement be filed with the SEC before selling securities

• Security is broadly defined• Includes bonds, notes, other evidences of indebtedness and investment

contracts, guarantees• Encompasses bonds, notes, certificates of participation, guaranteed

investment contracts, letters of credit, surety bonds, leases, loan agreements, etc.

V. Securities Law Issues (cont.)


B. Registration Provisions2. Section 3(a)(2)

• Issued or guaranteed by U.S. or any territory thereof• Issued or guaranteed by any state, political subdivision or public

instrumentality thereof• Issued by a national bank or state bank• Certain IDBs

3. Section 3(a)(4) – 501(c)(3) securities4. Section 3(a)(8) – Insurance policies5. Section 3(a)(11) – Intrastate offerings6. Rule 131 – Separate security doctrine




B. Registration Provisions7. Trust Indenture Act of 1939


• Indenture is broadly defined• Exempt securities exempt from all Indenture Act

requirements• Exempt transactions exempt from Indenture qualification

requirement



C. Antifraud Provisions• Objectives of 1933 Act and 1934 Act

• Disclosure of material information about securities to allow investors to make informed decisions

• Prohibit misrepresentation or other fraudulent conduct in connection with the purchase or sale of securities

• Municipal securities exempt from registration are not exempt from the antifraud provisions• Section 17(a) of 1933 Act• Section 10(b) of 1934 Act/Rule 10b-5



C. Antifraud Provisions1. Section 10(b) prohibits the use, in connection with purchase or sale

of a security, of “any manipulative or deceptive device”2. Rule 10b-5 – prohibits use of interstate commerce, mails or national

securities exchange -• To employ any device, scheme or artifice to defraud, or• To make any material misstatement or omission, or• To engage in any fraud or deceit

Courts recognize private causes of action




D. Continuing Disclosure 15c2-12• Who is obligated?• What information needs to be updated?• Who needs to “deem” final the Preliminary Official Statement?



A. What is Different for Conduit Issuers?1. Private Activity Bond restrictions2. Alternative Minimum Tax3. Substantial User Requirement4. Volume Cap5. Bank Qualification

B. Opinions – 501(c)(3)1. Reliance on IRS Determination Opinion2. “Due Inquiry” – has there been anything since the 1023 application that

might jeopardize the 501(c)(3) status3. What are you willing to give as 501(c)(3) counsel and what must you

see as bond counsel or underwriter’s counsel?C. 2014 NABL Report on 501(c)(3) opinions.

VI. Tax Issues





12. State Law Issues

Faculty:M. Jason Akers Foley & Judell, L.L.P. - New Orleans, LA Rod Kanter Bradley Arant Boult Cummings LLP – Birmingham, AL

This outline and presentation are intended to address (1) the basic issues in state law that affect the ability of bond counsel to give its validity opinion and (2) distinct variations in state law that may be material to a bondholder’s analysis of the investment. The goal is to guide participants to consider these issues as they draft various deal and disclosure documents.

I. The Bond Counsel Opinion.

A. Validity and Enforceability.

Bond Counsel1 is traditionally engaged to provide an objective legal opinion as to validityand enforceability. Validity remains essential to a first step to both tax-exempt status and securities law exemption.

“... [I]t is clear from these cases discussing the purpose of that exclusion [Section 103 of the Internal Revenue Code] that the courts have recognized as an initial matter that the interest must be incurred through the exercise of state’s borrowing power. Unauthorized exercise of such power would not invoke the Section 103(a)(1) exemption even when there is a reasonable probability that unauthorized contracts would be upheld by a state court on an implied contract theory.... The word “obligations” was not intended to extend to every obligation including the payment of interest but only to those obligations that were created in the exercise of the state’s borrowing power.” Power Equipment Co. v. United States, 748 F.2d 1130, 1137-38 (1984).

The validity opinion is the sine qua non of the Bond Counsel opinion. It is still of tremendous economic significance that the largest default in the history of public finance, by the Washington Public Power Supply System (“WPPSS”), was a state law validity case. Chemical Bank v. Wash. Pub. Power Supply Sys., 666 P.2d 329 (Wash. 1983) (Although the court found the municipal participants had the authority to purchase electricity, it refused to imply the authority to enter into “take or pay” contracts to purchase the chance to obtain energy. As a result, the

1 For a summary of the evolution of Bond Counsel, see The Function and Professional Responsibilities of Bond Counsel, Third Edition (available at www.nabl.org/uploads/cms/documents/nabl_function_and_professional_responsibilities_of_bond_counsel.pdf).


contracts which were to have provided the revenues to support the bonds were voided, and WPPSS defaulted on over $2.25 billion in revenue bonds.)

There have been significant cases holding that ultra vires borrowings are void and unenforceable, placing the burden on the party contracting with a municipal entity to ensure validity. Los Angeles Dredging Co. v. Long Beach, 291 P. 839 (Cal. 1930). Note that there is no recovery in quasi contract or equity, so if the debt is void the municipality keeps the money and does not have to pay it back. Example: Orange County, California, threatened to repudiate certain of its debt (claiming invalidity) as a part of its bankruptcy case and thus would not have to repay the debt.

B. The NABL Opinion Standard.

It is critical to know all the applicable law because as Bond Counsel, firms are expected to deliver an approving legal opinion in accordance with the “NABL Standard” which states in part:

Bond counsel “may render an ‘unqualified’ opinion regarding the validity and tax exemption of bonds if it is firmly convinced (also characterized as having a ‘high degree of confidence’) that, under the law in effect on the date of the opinion, the highest court of the relevant jurisdiction, acting reasonably and properly briefed on the issues, would reach the legal conclusions stated in the opinion.”

See Model Bond Opinion Report, NABL Committee on Opinions and Documents, 2003 Edition (“2003 Report”), page 7. Prior to the 2003 Report, the accepted standard was “it would be unreasonable for a court to hold to the contrary”, Model Bond Opinion Report, NABL, 1997 Edition.

C. Becoming Firmly Convinced.

Bond Counsel must take many steps involving state law considerations to become “firmly convinced” and meet the NABL Standard.

1. Approval Process.

a. Is the issuer or borrower properly in existence? i. Was it duly created?

ii. Were its members correctly elected/appointed?

b. Is the issuer authorized to issue the debt and is the borrower authorized to borrow the debt?

i. What is the source of the issuer’s authority? 1. Home Rule: Local government’s right to rule itself

cannot be taken away and is limited only by reference to state and federal constitutions.

2. Dillon’s Rule: Local government’s authority comes only from the state and can be taken away by the state.

ii. What are the constitutional and statutory requirements for the issuance of debt and have they been met?


1. Have required findings been made? 2. Have approvals been properly received?

Open public meetings laws. Quorum requirements. Number of readings. Application of referendum. Election requirements (e.g. proper ballot

measure, proper voter approval and validation).

Requirements for competitive sales. Debt policies (e.g. may impact authority and

other related issues such as minimum savings targets for refunding obligations).

iii. Is the proposed financing structure authorized under state law? Is the pledge of security authorized under state law? What state/local requirements must be satisfied prior to issuing the debt?

iv. Are there practical considerations to keep in mind? 1. Budgetary constraints. 2. Debt management policies. 3. Limited debt capacity.

2. Various Financing Structures.

a. General Obligation Debt. i. At its most basic level, a general obligation bond carries a

pledge of the full faith and credit of the issuer. “Full faith and credit” of the issuer is a promise to use all available resources, including the power to raise/levy taxes, to pay debt service. (A good reference is the NABL paper on General Obligation Debt.)

ii. There are three general categories of general obligation bonds: unlimited tax general obligation bonds (“UTGOs”), limited tax general obligation bonds (“LTGOs”), and general obligation bonds payable from the issuer’s general fund (“GFGOs”). In some states, it is also possible that a general obligation bond may be issued as a “double-barreled bond”, which is also secured by another defined source of revenues (e.g., water or sewer revenues or excise taxes).

iii. In broad terms, the characteristics of UTGOs, LTGOs, and GFGOs are set forth in the following table, though depending upon the state and local law at issue there are many variations on these concepts:


UTGO LTGO GFGO

Full Faith and Credit May be secured by full faith and credit of the issuer.

May be secured by full faith and credit of the issuer.

May be secured by full faith and credit of the issuer.

Taxing Power May be secured by apromise to levy advalorem propertytaxes, unlimited as torate or amount, leviedby an issuer on alltaxable propertywithin its territoriallimits. In many states,this is a separatelyidentified mill levy(levied solely to paydebt service) and thetax revenues from thelevy are sometimes segregated from other issuer revenues.

May be secured by alimited ad valoremproperty tax. The tax may be limited as torate or amount. Theissuer cannot becompelled to levy inexcess of the rate or amount. In somestates, this is notseparated from themill levy for thegeneral fund but insome states it is aseparately identified mill levy and the taxrevenues aresometimes segregatedfrom other issuer revenues.

No specific pledge of taxing power. Theissuer cannot becompelled to increasetaxes but may berequired in good faithto use its generalrevenue-producingpowers.

Voter Approval Voter approval oftenrequired.

Voter approval isoften not required.

Voter approval isoften not required.

Statutory Obligationto Repay

May be accompanied by an affirmativestatutory requirementto provide for maturing debt servicein the annual budget.



b. Revenue Bonds. i. In special fund revenue bonds, the debt authorizing

documents restrict repayment of the debt to funds deposited in a special fund, whether from specific taxes, utilities or other revenue-producing properties of the issuer. Frequently, the special fund is not supplemented by other funds of the issuer.

ii. Revenue bonds are more like commercial loans than most


other bonds. Bond counsel must consider several traditionally commercial aspects:

When does the lien attach? When is the lien perfected? How is the lien perfected?

iii. The pre-2001 UCC broadly excluded transactions involving states or the governmental entities of those states. The new UCC allows states to either continue the broad exclusion or narrow the exclusion so that it applies only to the extent that another statute expressly governs the creation, perfection, priority or enforcement of a security interest granted by a state or governmental entity of a state. (See Revised UCC Section 9-109.)

c. Certificates of Indebtedness. i. Bonds backed by an agreement to pay debt service from

any available funds. ii. The bond documents typically contain a promise to budget

revenues and make payments regardless of budgetary or other constraints.

d. Moral Obligations. i. Bonds backed by an agreement to “request” appropriations

annually to pay debt service. ii. The bond documents typically contain “non-appropriation”

language, meaning the issuer’s failure to appropriate funds does not cause a default.

iii. Issuer’s obligation not be a debt as long as there is no legal obligation on it to provide financial assistance to meet debt service requirements. See, e.g., Harrison v. Day, 202 Va. 967, 121 S.E.2d 615 (1961) (revenue bonds of port authority not general obligation debt even though authority required to “urgently request” appropriations to cover cost of project and there was an “expectation” of appropriations); Baliles v. Mazur, 224 Va. 462, 297 S.E.2d 695 (1982) (upheld authority created to finance public buildings from revenue bonds payable from lease payments from state agencies, citing “special fund” doctrine; where there is no pledge of full faith and credit, bonds are not general obligations even if special fund consists entirely of state appropriated money); Dykes v. Northern Virginia Transportation Commission, 242 Va. 357, 411 S.E.2d 1 (1991) (even though “practical effect” was that county would continue to make payments, no debt created where county’s payment obligation was expressly contingent upon county’s appropriation of funds for such payments).

e. Service Contracts – Continuing service contracts where the


municipality agrees to pay in installments for water, electric or other public services may be excluded from debt limitations depending on whether the payment is conditional and contingent on provision of service or an unconditional obligation which only postpones the time of payment. See Armstrong v. County of Henrico, 212 Va. 66, 182 S.E.2d 35 (1971) (county agreement to procure materials and services necessary to operate sewer system did not create “debt”); Board of Supervisors v. Massey, 210 Va. 253, 169 S.E.2d 556 (1969) (upholding contract for furnishing transit services as contract for services conditioned on performance and not a present liability for future payments); McBean v. City of Fresno, 112 Cal. 159 (1896) (holding that City incurs debt each year on five-year sewage disposal contract only to the extent of services provided during that year).

f. Lease Obligations. i. Can be closely related to moral obligations (obligation to

pay rent is an annual appropriation), special fund doctrine (the revenues from lease payments are the “special fund” from which payments are made), or service contracts (obligation is a current expense for benefit provided).

ii. Important to distinguish operating leases from capital leases. The elements of a capital lease are: The life of the lease is 75% or greater of the assets

useful life, The lease contains a purchase agreement for less than

market value, The lessee gains ownership at the end of the lease

period, or The present value of lease payments is greater than

90% of the asset’s market value. iii. Many states require annual payments to be “fair market

value” for facilities financed. iv. Note the distinction between “leases subject to annual

appropriation” and “leases subject to abatement.” The first is usually “all or nothing” and in the second formulation a portion of the obligation (the part not subject to abatement) may be treated as debt.

g. Short Term obligations. i. Short-term (current fiscal year) borrowings in anticipation

of revenues or taxes. ii. Short-term obligations are typically excluded from debt

limit calculations. See Davenport v. City of Rock Hill, 432 S.E. 2d 451 (S.C. 1993). The general rationale is that these types of obligations are payable from currently levied taxes and, therefore, are not debt.


h. Anticipation notes (BAN, TRAN, TAN, RAN, GAN). i. Issued in anticipation of bonds, taxes, revenues, grants, etc. ii. Depending on term of obligation and source of repayment

and security, may, or may not, be considered debt for debt limit purposes.

i. Interfund Loans. i. Limited and temporary transfers or “interfund loans”

among the funds of a taxing district where the funds are not put at risk of insolvency may not constitute indebtedness of the taxing district.

ii. Procedural requirements may be required under state law (e.g. loan must be approved by official action of legislative body, term may not be longer than three years, must have plan in place for repayment, etc.)

iii. Tax increment & special assessment financing – Forms of financing historically used to promote development in a particular target geographic area. Procedures vary among states but to the extent that the general credit of the issuer also provides security for the TIF obligation, then the debt ceiling/limit and special procedures are likely to apply.

3. Debt Limits and Exceptions.

a. Debt limit: a constitutional or statutory limit upon the incurrence of debt.

b. Debt limits are intended to protect taxpayers from the burdens of excess taxation caused by “ruinous” debt levels. Across the states, there is a large variety of restrictions and no uniformity.

c. Forms of debt limits: i. Absolute amount (dollar figure).

ii. Most common, forbids indebtedness in excess of a certain percent of the value or assessed value of taxable property; some also depend on size of population in the unit or prior expenditure level (note that valuation methodology differences will affect the debt ceiling).

iii. Limits on indebtedness linked to income and/or revenue (a percentage of average general fund revenues, a percentage of total tax revenues, a percentage of state appropriations).

d. Debt limit calculation is generally done at the time the bonds are issued or the obligation is incurred.

e. In order to calculate debt, you must understand what is considered “debt” for purposes of such calculations and what may be an exception. Tests vary widely across the states.


f. Offsetting Outstanding Debt. i. Some states allow issuers to credit against their outstanding

debt certain assets for purposes of statutory debt limitations.

ii. Assets may include taxes levied in the current year and cash on hand received for the purpose of paying obligations due in the current year (RCW 39.36.030).

g. Refunding Obligations. i. Refundings that generate savings but with an increase in

principal pose unique questions. ii. Increased principal amount may constitute new “debt” for

debt calculations, but some statutory exceptions may apply.

D. Use of Proceeds.

1. Use must be permitted under state law and within the scope of the authorizing documents.

a. Ballot measure, if applicable.

b. Ordinance, resolution or trust indenture.

c. Capital purpose vs. operating expense, if applicable.

d. Nexus with revenue producing enterprise.

2. Public Purpose.

a. This concept restricts public funding to activities that serve the interests of the public at large and precludes governmental participation in activities that benefit solely private interests. Sometimes this is not explicitly in the state constitution but courts have usually “found” it there.

i. There is no concrete or uniform definition of the public purpose doctrine, violation of which is sometimes expressed as (I) a public source of payment that benefits a private entity (thus basing the limitation on the need to protect the public treasury), or (II) an impermissible aid or franchise to one group over another with the blending of public and private roles, together with the concomitant concern that government should not be involved in the determination of which group to aid or benefit.

ii. Note the rapid evolution of the public purpose doctrine — today, the use of government debt or taxing power to finance economic development (jobs, housing, pollution control, sports facilities, student loans, mortgages, urban


redevelopment, tourism) is common. This concept of financing private enterprise is derived from the anticipation that the entire community will benefit from job growth, higher education, home ownership and higher levels of private economic activity. Such expansion of the traditional concept is often paired with a deferral by the courts to the government involved for the determination of “public benefit.”

In Kelo v. City of New London et al., 545 U.S. 469, 125 S.Ct. 2655 (2005), the United States Supreme Court reviewed the condemnation powers of a local government under the Takings Clause of the Fifth Amendment of the United States Constitution. Property owners challenged the condemnations arguing that the development plan did not constitute a “public use” and that the plan was primarily for private benefit. The Connecticut Supreme Court upheld the condemnation on the grounds that the city had statutory authority to condemn the land as part of an economic development plan and that the Connecticut Legislature had expressed its intent that such a taking is a “public use” and in the “public interest.” The U.S. Supreme Court upheld the condemnations and held that the purposes articulated by the city satisfied the public use requirement of the Fifth Amendment. Id. at 485. In its reasoning, the Court deferred to the judgment of the local government and stated that the city had fulfilled the public use requirement by carefully formulating a program of “economic rejuvenation” that was thoughtfully designed to “provide appreciable benefits to the community, including – but by no means limited to – new jobs and increased tax revenue” in furtherance of clear statutory authority to engage in economic development. Id. at 483.

Board of County Commissioners of Muskogee County v. Lowery, 136 P.3d 639 (Okla. 2005) (holding that economic development alone does not constitute a public purpose and therefore does not constitutionally justify the County’s exercise of eminent domain. In light of Kelo, the case is decided under Oklahoma’s constitution).

City of Norwood v. Horney, 853 N.E.2d 1115 (Ohio 2006) (City failed to show the taking of blighted property for redevelopment was for public use as required under Ohio constitution).

In re Condemnation by Redevelopment Authority of Lawrence County, 962 A.2d 1257 (Penn. 2008) (Pennsylvania law does not permit eminent domain to be


used to foster economic development).

3. Lending of Credit/Gift of Public Funds.

a. State law may prevent a local government from guaranteeing the debt of a private entity (e.g. lending its credit) or using its public funds (e.g. bond proceeds) for private purposes.

b. Board of Directors of the Industrial Development Board of the City of Gonzales v. All Taxpayers, 938 So. 2d 11 (La. 2006) (City designated tract as an economic development district and its voters have approved rededication of sales taxes, of which there are as of yet none, to make them available to service sales tax increment bonds to be purchased by retail merchant, the proceeds to be used in part to construct a store for lease to the merchant, with an option to purchase it. Rival merchants challenge the financing, but “we conclude the Project does not constitute a prohibited loan, pledge or donation of public funds” as the arrangement is not “gratuitous.” Nor does the financing violate equal protection.)

c. State ex rel. Ohio Congress of Parents and Teachers v. State Board of Education, 857 N.E.2d 1148 (Ohio 2006) (“(W)e hold that community schools, also known as ‘charter schools,’ in and of themselves, are not unconstitutional.” State’s guaranty of such schools’ loans doesn’t violate constitution’s restrictions on lending of the state’s credit and the state’s assumption of debt, as they bar lending of credit to private business enterprises, and the assisted charter schools are non-profit entities. Nor does the program violate the thorough and efficient test, though state aid is shifted to the charter schools based on a per pupil formula. And the result is not an unconstitutional diversion of school taxes, as state funds are at issue and “follow the student; [while] local funds do not.”)

E. Securities Law - Registration of Bonds.

Section 2(1) of the Securities Act of 1933 defines a “security” to include “any note, ... bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement ... investment contract, ... any put,...or, in general, any interest or instrument commonly known as a ‘security’, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee or, or warrant or right to subscribe to or purchase, any of the foregoing.” Most, but not all, obligations of states, political subdivisions and public instrumentalities are exempt from registration under Section 3(2) of the Securities Act of 1933.

II. Disclosure and State Law.

A. Rule 10b-5 Standard.

“Rule 10b-5: Employment of Manipulative and Deceptive Practices”:


It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, (a) To employ any device, scheme, or artifice to defraud, (b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

The U.S. Supreme Court has stated that “an omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote.” See TSC Industries, Inc. v. Northway, Inc. 96 S. Ct. 2126 (1976).

B. Security and Source of Payment.

1. General Obligation.

See prior discussion on the variation of general obligation bonds from state-to-state. The nature of the full faith and credit pledge, any procedural requirements necessary to enforce the pledge, and the limitations on the pledge are material to an investor’s analysis of the investment. Because of the variations state to state, it is critical to be familiar with and to accurately describe the nature of the pledge in the disclosure document. Disclosure associated with primary offerings of general obligation bonds is an evolving issue.2 State law considerations to keep in mind include:

a. Procedural and substantive components of the pledge. i. Are there procedural steps that an issuer must take to

generate sufficient revenue in the event of a shortfall? Such steps may include: 1. Budgetary approval. 2. Voter approval. 3. Legislative approval to appropriate. 4. Notice to State Regulators. 5. Are any of the steps discretionary or conditional? 6. Do any of the steps require action by another

governmental entity? 7. Timing of collections – will the revenue be

collected in time to pay debt service? ii. Is the full faith and credit pledge, in substance, a pledge of

the general fund or a stream of restricted or unrestricted funds?1. Property taxes. 2. Sales taxes. 3. General fund may be comprised of multiple sources

of revenue. Is that revenue available to pay debt service?

2 See 2014 Report of the NABL General Obligation Disclosure Task Force.


Property taxes. Utility taxes/revenues. Sales taxes. Hotel/motel (lodging) taxes. Business and occupation taxes. Real estate excise taxes.

iii. What are the limitations on the ability to raise and/or collect taxes? 1. Statutory and constitutional limitations. 2. Uniformity requirements. 3. Assessed value – methodology used to determine

assessed value of property subject to taxation may be important when determining property tax limitations.

4. State statutes frequently control the method of giving notice of delinquency, the division of taxes among various taxing districts in the event of a delinquency, and the ability to collect past due payments.

b. Does the bondholder have rights under state or local law to seek payment from another political subdivision? Disclosure documents frequently note that the debt does not constitute a debt or indebtedness of the state, any controlling entity, or other political subdivisions other than the issuer.

2. Pledge of and Security Interest in Revenues/Property and Applicability of UCC Provisions.

a. Bondowners may or may not have a security interest in particular revenues or assets of the issuer. As noted by The Report of the National Association of Bond Lawyers Opinions and Documents Committee Re: Revised Article 9 of the Uniform Commercial Code, July 17, 2000, there is some variation among states regarding the treatment of security interests created by a government or governmental subdivision or agency.

b. General obligation debt may be treated as “unsecured” without a security interest in particular revenues. State law may not permit a “priority” lien on tax proceeds. Alternatively, state statutes may grant a priority lien on tax collections without the necessity of making a UCC filing. For instance, Section 39:1430.1 of the Louisiana Revised Statutes of 1950, as amended, states in pertinent part as follows:

Any pledge of and grant of security interest in taxes, income, revenues, monies, … or receipts … made by a public entity in connection with the issuance of securities shall be valid, binding,


and perfected from the time when the pledge is made. The taxes, income, revenues, monies … or receipts … so pledged and then held or thereafter received by the public entity or any fiduciary shall immediately be subject to the lien of such pledge and security interest without any physical delivery thereof or further act, and the lien of such pledge and security interest shall be first priority and valid and binding as against all parties having claims of any kind in tort, contract, or otherwise against the public entity, whether or not such parties have notice thereof…. No filing with respect to such pledge and security interest made by a public entity need be made under Chapter 9 ... for the perfection or priority of such pledge and security interest.

c. In revenue obligations, the concept of “lien position” (senior, parity and junior) becomes important primarily because of the limited source of revenues available for repayment. Some additional bonds tests are created by statute or regulation; others are the result of contractual bargains. State law may grant a statutory lien on revenues without the necessity of making a UCC filing.

d. Note the interrelationship between general obligation bonds (subject to debt limit and can be considered unsecured) and revenue bonds (meeting the special fund exception with a perfected security interest) in Double Barrel Bonds.

e. The authority to grant a security interest in real or personal property as collateral for an obligation is determined by state law. Many state constitutions limit or prohibit a seizure of public funds or property, so a mortgage may often be of limited utility. (See “Events of Default and Remedies – Seizure of Public Property” on the following page.)

f. State law disclosure considerations: i. Nature of the pledge.

ii. Unsecured or secured. iii. Limitations on source of revenue. iv. Whether a UCC filing is required. v. Lien position.

vi. Authority for and limitations on foreclosure or liquidation of assets securing obligation.

C. Events of Default and Remedies.

Remedies available to bondholders in the event of a default depend on a number of factors, including the type of breach (payment default vs. technical default), the availability of remedies under constitutional, statutory, and contractual provisions, and the type of remedy being sought. State law, judicial actions and local rules may provide for and limit remedies available to bondholders upon the occurrence of an event of default.


1. Seizure of Public Property.

“Remedies that are ordinarily available to reach the debtor’s assets do not generally apply against a governmental entity. So garnishment of public funds or seizure and sale of property devoted to public use are almost uniformly unobtainable. The immunity to execution process is predicated on express exemptions in some jurisdictions and on resort to policy considerations like the public use or public trust doctrine in others.” See John Martinez, Bondholder Remedies—General Obligation Securities, 4 Local Government Law § 25:24 (October 2013) (citations omitted).

2. Acceleration.

Because the taxes or other rates and charges pledged to pay debt service on many governmental bonds cannot be accelerated, most non-private activity bonds are generally not themselves subject to acceleration. In the event of a default, bondowners will generally not be able to declare all outstanding principal due and payable. In the event of multiple defaults in payment of principal of or interest, bondholders would need to bring a separate mandamus or other enforcement action for each such payment not made.

Availability of this remedy varies state to state, issuer to issuer, and the nature of the security (e.g. conduit financing secured by general revenues of a private college may be subject to acceleration in the event of default).

3. Writ of Mandamus.

a. The principal remedy available to governmental bondholders is to seek a writ of mandamus to compel performance of non-discretionary or ministerial duties (e.g. impose or collect taxes or rates and charges).

b. Similar to other remedies, procedural steps to compel performance may be dictated by state or local law, discretionary, conditional, or out of the control of the issuer (e.g. procedural steps that are required to be undertaken by governmental officers or entities other than the issuer).

4. Other Rights and Remedies.

a. In many states, the power to appoint a receiver to undertake budgetary or other issuer functions may be available as a remedy under statute (legislative appointment) or compelled by a court (judicial appointment). The powers of receiver vary widely by state and may depend upon the source of the power of appointment. Depending on the powers granted to the receiver, the receiver may effectively supplant the powers, functions and responsibilities of some or all elected officials of the issuer. Alternatively, the receiver may have a more limited role providing oversight (e.g., budgetary approval) of issuer actions. In some circumstances, a receiver may be legislatively granted with powers


that go beyond those enjoyed by elected local officials. Note, however, that the powers of a receiver is likely very limited in a Chapter 9 bankruptcy context.

b. Unless expressly authorized by statute, attachment and execution are not generally permitted against a municipality, but an exception may be made in some jurisdictions where the property is held in a proprietary capacity. Same with mechanics’ liens. See ManlyMfg. Co. v. Broaddus, 94 Va. 547, 27 S.E. 438 (1897) (mechanics’ lien laws do not apply to public buildings or structures erected by states, cities or counties for public uses, unless the statute creating the lien expressly so provides).

c. “In some New England states where local inhabitants are personally liable for the debts of the local government unit, bondholders may obtain execute process against private property. Consequently, the most effective remedy for the general obligation bondholder aims at the general taxing power of the issuer, whereas the revenue bondholder’s best resort is the revenue-generating capacity of the project.” See John Martinez, Bondholder Remedies—General Obligation Securities, 4 Local Government Law § 25:24 (October 2013) (citing Town of Bloomfield v. Charter Oak Nat. Bank, 121 U.S. 121, 129, 7 S. Ct. 865, 30 L. Ed. 923 (1887) (noting that in Massachusetts and Connecticut, and some of the other New England states, the individual liability of the inhabitants is maintained, which is an exception to the general rule, being peculiar to their customs and laws)).

d. State law often contains detailed statutory notice, timing and other requirements that must be fulfilled to exercise tax liens and other remedies. Protections are also frequently afforded to delinquent taxpayers that may impact the value of the remedy (e.g. homestead exemptions). The value of the property subject to the lien, competing rights to the proceeds of any sale and any limitations on a bondholder’s right to seek a deficiency judgment against the property owners will also be material to an investor’s decision.

D. Chapter 9 Bankruptcy.

1. Filing Considerations.

a. Municipal bankruptcy is must rarer than corporate bankruptcy. Recent municipal bankruptcies (such as Jefferson County, Alabama; Harrisburg, Pennsylvania; and Detroit, Michigan) have brought national attention to the issue.

b. Bankruptcy is different than default.

c. Many states either limit, or do not permit, chapter 9 bankruptcy filings, and municipalities cannot be forced into involuntary


bankruptcy.

d. In many States, express authorization is required.

States that Authorize Municipal Bankruptcy Filings AL, AZ, AR, ID, MN, MO, MT, NE, OK, SC, TX, WA

States that Conditionally Authorize Municipal Bankruptcy Filings

CA, CT, FL, KY, LA, MI, NJ, NC, NY, OH, PA, RI

States with Limited Authorization to File for Bankruptcy CO, OR, IA, IL Bankruptcy Filing is Prohibited GA Other states are unclear or do not have specific authorization

See NABL’s 2015 Report—Municipal Bankruptcy: A Guide for Public Finance Attorneysavailable on the NABL website.

e. Even with authority to file for bankruptcy, municipal issuers must satisfy various procedural requirements to obtain bankruptcy protection.

2. The Automatic Stay.

a. Application of the automatic stay provisions creates additional bondholder risk.

b. Automatic stay provisions may force a municipality to stop paying debt service on its obligations once the bankruptcy petition is filed, but adherence to this rule is not universal. See Moody’s Investors Service, Key Credit Considerations for Municipal Governments in Bankruptcy, January 19, 2012.

3. Special Revenue Pledge.

a. Investors should be made aware that bankruptcy proceedings treat general obligation debt and revenue debt differently.

b. “Special revenues” acquired by a municipality after the commencement of the Chapter 9 case remain subject to any lien resulting from any security agreement entered into by the municipality before the commencement of the case. Special revenues are defined in Section 902(2) of the Bankruptcy Code as:

i. receipts derived from the ownership, operation, or disposition of projects or systems of the debtor that are primarily used or intended to be used primarily to provide transportation, utility, or other services, including the proceeds of borrowings to finance the projects or systems;

ii. special excise taxes imposed on particular activities or transactions;


iii. incremental tax receipts from the benefitted area in the case of tax increment financing;

iv. other revenues or receipts derived from particular functions of the debtor, whether or not the debtor has other functions; or

v. taxes specifically levied to finance one or more projects or systems, excluding receipts from general property, sales, or income taxes (other than tax-increment financing) levied to finance the general purposes of the debtor.

E. State Tax Exemption.

1. Tax-exempt bonds may also be exempt from state income taxation. Whether or not the bonds are exempt from state income taxation would be material to an investor.

2. Not all states have an income tax.

3. Check local laws to determine if interest on the bonds is exempt from state or local income taxes. Best practice is to quote the relevant language of the law as closely as possible.

F. Refunding/Defeasance of Bonds.

1. Rights of redemption, as provided for in the bond ordinance, resolution or indenture, are customarily disclosed to investors. Limitations under state or local law that may impact the availability of such rights should also be disclosed. For instance, state law, local law, or policies may only permit a refunding in the event that it results in savings, possible at certain minimum levels.

2. State law may also limit eligible investments for an escrow fund, or alternatively, allow certain investments that are not unconditionally guaranteed by the United States.

3. Typically, bonds may be defeased prior to their redemption, either via advanced refunding or other devices. In many states, a bondholder no longer has an interest in the original security following a defeasance, and the security becomes the investments deposited in escrow to pay the debt service coming due on the bonds. The promises and covenants of the bond documents are released too. This is important to disclose to potentialbondholders.

G. Post-Issuance State Law Consideration.

1. Most post-issuance considerations are covered in depth in tax and securities law panels.


2. Many states have filing requirements and record retention requirements.

3. Change in use may impact federal tax law and state law.

III. Practical Tips for the Bond Lawyer

A. Ethical Considerations 1. Who do you represent?

2. Can you represent them/it?

B. Understand “debt” from “non-debt debt.”

C. Don’t steal the money.

D. Look at old transcripts and try to figure out why each item is in there. What part of the Bond Counsel opinion does it back up?

E. Simpler structures work better than more complicated ones. If you cannot explain it, will your client/the issuer or a court understand it?

F. Follow the money. Whenever money travels from one party to another, make sure you know (and the documents say): 1. When?

2. Why and what is the authority for the transfer?

3. How much?

4. What happens if it does not get paid, on time? or ever?

5. Who enforces payment?

G. Know the hierarchy of authority: the U.S. Constitution (due process, etc.) trumps federal law which usually trumps the State Constitution which trumps state statutes which override local ordinances.

H. Remember the NABL Standard for the bond opinion.



12. State Law Issues


I. Bond Counsel Opinion

General Scope Purpose NABL Standard


II. Validity & Enforceability

• Home Rule –v- Dillon’s Rule

State Constitution Considerations Debt Limit Referendum Requirements

Filings

Instrument Type (e.g. warrant versus bond) Purpose Principle terms of the instrument (e.g., redemption)



III. Financing Structures

General Obligation Debt

Revenue Bonds Moral Obligations Lease Obligations

Short Term Indebtedness Service Contracts Anticipation Notes


IV. Lending of Credit

Lending of Credit

Gifts/Investments

Incentives/Economic Development


V. Disclosure and State Law

10b-5

Security/Source of Payment

Other State Law Particularities E.g. remedies, bankruptcy, etc.



VI. Events of Default and Remedies

Special Interest Rates

Acceleration

Bankruptcy





13. Document & Default Administration – The Trustee’s Perspective

Faculty:Angela W. Adolph Kean Miller LLP - Baton Rouge, LA David J. Fernández Buchanan Ingersoll & Rooney PC – New York, NY

I. Introduction

II. Who is the Trustee?

A. Contractual Relationships Created by the Trust Indenture

1. Trustee and Obligor 2. Obligor and Bondholders 3. Trustee and Bondholders

B. Role of the Trustee

1. Administrator 2. Enforcer

III. The Trustee’s Perspective

A. Pre-default Duties

1. Contractual in nature 2. Dependent on terms in the documents 3. Express duties; no implied duties

B. Misconceptions about Trustee Duties

1. Has discretionary decision-making authority 2. Serves as lender 3. Able to grant waivers 4. Has duty to investigate, inquire, or engage in affirmative monitoring 5. Has investment authority 6. Responsible for disclosure compliance

C. Post-default Duties

1. Heightened standard of care 2. Fiduciary in nature 3. Exercise rights and powers vested by indenture

a. Acceleration b. Collection actions c. Foreclosure


d. Liquidation of collateral e. Remedial efforts to preserve security

D. Post-default Issues

1. Control of proceedings 2. Authority to settle claims 3. Non-impairment clauses (protecting minority bondholders) 4. Use of advisors and experts 5. Recovery of costs and expenses 6. Indemnification and exoneration

IV. Document Review Practice Pointers

A. Discretion over Investments and Materiality

1. Avoid Trustee discretion or responsibility over investment selection (even if exculpated from loss) of funds held in trust accounts, “Eligible Investments,” or “Permitted Investments.”

2. Avoid terms calling for material adverse affect on bondholders to be determined by the Trustee

B. Affirmative Review of Documentation

1. Avoid Trustee responsibility to affirmatively review or evaluate borrower financial reports, management reports, rebate certificates or continuing disclosure reports

2. Conditions for releasing funds from trust estate should be thorough and obvious

3. Avoid responsibility to affirmatively review or evaluate construction fund requisitions or supporting materials or to exercise discretion regarding same

C. Waiver of Bondholder Rights

1. Avoid terms that would give Trustee discretion to waive rights or remedies 2. Be wary of requests by insurers for novations with respect to their transfers to

successor insurers a. Many of these requests contain blanket waivers of the resigning

insurer and “inadvertent” gaps created by the obligations assumed by the new insurer

3. When dealing with new bond issues where less than the majority of the bonds are insured, be certain that the Indenture expressly clarifies the insurer’s right to direct the Trustee, as opposed to the holders of the uninsured Bonds

D. UCC Perfection

1. Avoid stated or implied responsibility for initial UCC perfection

E. Trustee as “Lender”

1. Avoid terms treating the Trustee as a “Lender” exercising business discretion (pre-fault) in the administration of a loan (unless accompanied by a clear objective standard to apply)


F. Standard of Care

1. Avoid any deviation from the commonly accepted pre-default (strictly contractual) and post-default (“prudent person”) Trustee standard of care

G. Jurisdiction & Governing Law

1. Governing law of documents and jurisdiction for lawsuits should match 2. Always check companion documents, i.e., deposit account agreements, to

make sure governing law and jurisdiction are the same as in indenture 3. Arbitration

a. Should never accept a provision limiting its remedies in arbitration, nor should it accept arbitration as the only means for dispute resolution

4. Trial by Jury

a. If waived, this right should be waived by ALL parties

H. Indemnification

1. The Trustee should be provided complete indemnification from any expenses, loss and liability (including attorney’s fees and expenses) incurred in the acceptance or performance of its duties or administration of the trusts which it has been charged to administer (often qualified to exclude losses caused by its own [gross] negligence or willful misconduct)

2. Recovery of amounts due to the Trustee should be included as a secured obligation in all granting language; and given priority lien in application of moneys upon an event of default

3. The Trustee should be granted a charging lien ahead of bondholders 4. The Trustee must NEVER give any indemnification to another party!!! 5. There should be an express recitation of the standard, commonly accepted

Trustee immunities and protections 6. The indenture should specify that the Trustee is not required to make any

injury or investigation into the facts or matters stated in any resolution, certificate, statement, instrument, opinion, report, notice, request, direction, consent, order, approval, bond, debenture, or other paper or document other than those created by the Trustee

I. Trustee Resignation

1. The indenture must limit the time period in which a successor will be appointed after resignation or removal of the Trustee

a. 60 Day Maximum b. The Trustee must have the right to petition a court of competent jurisdiction to appoint a successor (at the expense of another party such as the Issuer of the Borrower)

J. Implied or Express Responsibility for Tax-Exempt Qualification


1. Avoid any terms that would impose on the Trustee responsibility for maintain tax-exempt qualification of the bonds

K. Notice

1. The Trustee can agree to accept and act upon instructions or directions sent by unsecured e-mail, facsimile transmission or other similar unsecured electronic methods as long as the Trustee is protected

V. Best Practices

A. Drafting for Default

1. Transaction must anticipate default! 2. The structure of transaction allocates risk-be sure to tighten any loopholes that

could leave the Trustee responsible for acting without direction 3. Clearly define defaults/events of default and remedial procedures 4. Address the concepts of “Trustee Default” and “Trustee Cure Period”,

especially in forward purchase or forward delivery agreements 5. Prepare for the worst-litigation or bankruptcy 6. Each material provision of an indenture must be considered from the

perspective of bondholders trying to maximize their recovery after default and giving the Trustee clear guidance on how to enforce the documents and maximize the Bondholder’s recovery

7. Trustee’s counsel should think about mechanical steps, timing, and the allocation or risk, for any instruction to Trustee regarding servicing/administrative functions

8. Careful drafting anticipates pragmatic solutions that minimize cost, confusion and heartburn

9. Bond documents must be solid vis a vis anticipating claims and defenses under applicable law

10. Trustee needs express authority to use moneys in trust accounts to enforce remedies and protect rights of bondholders (including payment of trustee’s fees and expenses)

VI. Final Thoughts

VII. Questions?



13. Document & Default Administration:

The Trustee’s Perspective


• Who is the Trustee?• The Trustee’s Perspective• Document Review Practice Pointers• Best Practices• Final Thoughts• Questions?


• Different Contractual Relationships Created by Trust Indenture• Trustee and Obligor• Obligor and Bondholders• Trustee and Bondholders

• Role of the Trustee• Administrator• Enforcer



• Pre-Default Duties• Contractual in nature• Dependent on terms in the documents• Express duties; no implied duties

• Misconceptions about Trustee• Has discretionary decision-making authority• Serves as lender• Able to grant waivers• Has duty to investigate, inquire, or engage in affirmative monitoring• Has investment authority• Responsible for disclosure compliance


• Post-default Duties• Heightened standard of care• Fiduciary in nature• Exercise rights and powers vested by indenture

• Acceleration• Collection actions• Foreclosure• Liquidation of collateral• Remedial efforts to preserve security


• Post-default Issues• Control of proceedings• Authority to settle claims• Non-impairment clauses (protecting minority bondholders)• Use of advisors and experts• Recovery of costs and expenses• Indemnification and exoneration



• Discretion over Investments• Avoid Trustee discretion or responsibility over investment selection

(even if exculpated from loss) of funds held in trust accounts, “Eligible Investments,” or “Permitted Investments”

• Example: “Funds held in the [___] Account shall be invested in Eligible Investments selected by the Trustee…” or “Funds held in the [___] Account shall be invested in Eligible Investments selected by the Borrower or, if the Borrower shall fail for three (3) consecutive Business Days to so instruct the Trustee, by the Trustee.”

• The Trustee is not a “Municipal Advisor.”• The Trustee should always receive WRITTEN direction from another

party


• Discretion over Materiality• Avoid terms calling for material adverse affect on bondholders to be

determined by the Trustee• Example: Indenture amendment section permitting amendments meeting stated

criteria, followed by something like: “Notwithstanding any term herein to the contrary, the Trustee shall not enter into any amendment having a material adverse effect on bondholders.”

• “Material adverse effect on bondholders” should be defined in the indenture, or avoided as a Trustee action standard altogether (unless expressly conditioned upon an opinion of counsel)


Affirmative Review of Documents• Avoid Trustee responsibility to affirmatively review or evaluate borrower

financial reports, management reports, rebate certificates or continuing disclosure reports

• Example: Terms stating or implying review or approved by the Trustee, or calling for the same to be “in form and content acceptable” to the Trustee; or failing to state affirmatively that the Trustee is not under a responsibility to review or examine the content

• The Trustee should never accept responsibility to determine whether form and content are acceptable

• Also, note that Trustee’s are increasingly rejecting the responsibility of being a repository of such reports, and other information



Affirmative Review of Documents (cont.)• Conditions for releasing funds from trust estate should be thorough and

obvious• Avoid responsibility to affirmatively review or evaluate construction fund

requisitions or supporting materials or to exercise discretion regarding same

• Example: Terms allowing withdrawal upon requisition “approved by Trustee,” or “in from or content acceptable to Trustee,” or “upon such requisition and supporting materials as the Trustee may require,” or calling for surveys, title reports, etc. to be “acceptable to the Trustee or as it may require”


• Waiver of Bondholder Rights• Avoid terms that would give Trustee discretion to waive rights or

remedies • Bad Example:

• “The Trustee may waive any Event of Default hereunder and its consequences and rescind any declaration of maturity of principal of and interest on the Bonds; provided however that the Trustee shall not waive any Event of Default, if there is a draw under a Credit Facility until such time as the stated amount of the Credit Facility shall be reinstated.”

• Good Example:• “The Trustee may waive any Event of Default hereunder and its consequences and rescind

any declaration of maturity of principal of and interest on the Bonds upon the written request of the Owners of a majority in aggregate principal amount of all the Bonds then Outstanding; provided however that the Trustee shall not waive any Event of Default, if there is a draw under a Credit Facility until such time as the stated amount of the Credit Facility shall be reinstated.”


Waiver of Bondholder Rights (cont.)• Be wary of requests by insurers for novations with respect to their

transfers to successor insurers. Many of these requests contain blanket waivers of the resigning insurer and “inadvertent” gaps created by the obligations assumed by the new insurer.

• Example: “By signing this Certificate of Consent to Transfer, as the duly authorized representative of the Bondholders, you hereby consent and agree on behalf on the Bondholders:

To the transfer by X and Y (the “Transfer”) and the assumption by Y from X (the “Assumption”), of all of X’s rights, title and interest and all future liabilities and obligations, in, to and under the Policy;…”

• If Trustee consents, it has consented to a gap in coverage without obtaining Bondholder consent, potentially exposing the Trustee to liability



Affirmative Review of Documents (cont.)• Conditions for releasing funds from trust estate should be thorough and

obvious• Avoid responsibility to affirmatively review or evaluate construction fund

requisitions or supporting materials or to exercise discretion regarding same

• Example: Terms allowing withdrawal upon requisition “approved by Trustee,” or “in from or content acceptable to Trustee,” or “upon such requisition and supporting materials as the Trustee may require,” or calling for surveys, title reports, etc. to be “acceptable to the Trustee or as it may require”


• Waiver of Bondholder Rights• Avoid terms that would give Trustee discretion to waive rights or

remedies • Bad Example:

• “The Trustee may waive any Event of Default hereunder and its consequences and rescind any declaration of maturity of principal of and interest on the Bonds; provided however that the Trustee shall not waive any Event of Default, if there is a draw under a Credit Facility until such time as the stated amount of the Credit Facility shall be reinstated.”

• Good Example:• “The Trustee may waive any Event of Default hereunder and its consequences and rescind

any declaration of maturity of principal of and interest on the Bonds upon the written request of the Owners of a majority in aggregate principal amount of all the Bonds then Outstanding; provided however that the Trustee shall not waive any Event of Default, if there is a draw under a Credit Facility until such time as the stated amount of the Credit Facility shall be reinstated.”


Waiver of Bondholder Rights (cont.)• Be wary of requests by insurers for novations with respect to their

transfers to successor insurers. Many of these requests contain blanket waivers of the resigning insurer and “inadvertent” gaps created by the obligations assumed by the new insurer.

• Example: “By signing this Certificate of Consent to Transfer, as the duly authorized representative of the Bondholders, you hereby consent and agree on behalf on the Bondholders:

To the transfer by X and Y (the “Transfer”) and the assumption by Y from X (the “Assumption”), of all of X’s rights, title and interest and all future liabilities and obligations, in, to and under the Policy;…”

• If Trustee consents, it has consented to a gap in coverage without obtaining Bondholder consent, potentially exposing the Trustee to liability


Waiver of Bondholder Rights (cont.)• When dealing with new bond issues where less than the majority of the

bonds are insured, be certain that the Indenture expressly clarifies the insurer’s right to direct the Trustee, as opposed to the holders of the uninsured Bonds


UCC Perfection• Avoid stated or implied responsibility for initial UCC perfection

• Example: “The Trustee shall take such action as may be necessary to perfect the security interest granted hereunder” or “The Trustee shall prepare and file the Initial UCC Statements, and shall take such other actions, as may be necessary to perfect and priority of the security interests granted hereunder.”

• It is permissible and standard practice to have the Trustee prepare and file the UCC Continuation Statements. However, it is in the Trustee’s best interest if this is handled directly by the creditor, or at the least provided by the creditor along with a direction to file.


Trustee as “Lender”• Avoid terms treating the Trustee as a “Lender” exercising business

discretion (pre-default) in the administration of a loan (unless accompanied by a clear objective standard to apply)

• Example: Covenants prohibiting or restricting actions “unless consented to by the Trustee” or allowing actions “upon such terms as the Trustee may approve” or calling for required opinions or similar deliverables to be “as may be required by the Trustee”

• Specify that the Trustee is acting solely in its capacity as the Trustee and have all such actions and decisions be directed by the requisite percentage of bondholders



Standard of Care• Avoid any deviation from the commonly accepted pre-default (strictly

contractual) and post-default (“prudent person”) Trustee standard of care• Bad Example:

“The Trustee shall take whatever action is necessary to protect the interests of Noteholders”• Good Example:

“Except upon the occurrence and during continuance of an Event of Default the Trustee shall have only such duties as are expressly set forth in the Indenture… Upon the occurrence and during continuance of an Event of Default, the Trustee exercises such of the rights and powers vested in it by the Indenture, using the same degree of care and skill in their exercise, as a prudent person would under the circumstance in the conduct of his or her own affairs”


Jurisdiction and Governing Law• Governing law of documents and jurisdiction for lawsuits should match• Always check companion documents, i.e., deposit account agreements, to

make sure governing law and jurisdiction are the same as in indenture• Arbitration

• Should never accept a provision limiting its remedies in arbitration, nor should it accept arbitration as the only means for dispute resolution

• Trial by Jury• If waived, this right should be waived by ALL parties


Indemnification• The Trustee should be provided complete indemnification from any expense, loss and

liability (including attorneys fees and expenses) incurred in the acceptance or performance of its duties or administration of the trusts which it has been charged to administer (often qualified to exclude losses caused by its own [gross] negligence or willful misconduct)

• Example: “The Issuer shall pay the Trustee reasonable compensation for its services hereunder, and also all its reasonable expenses and disbursements, and shall, to the extent permitted by law, indemnify and hold the Trustee harmless against any liabilities which it may incur in the proper exercise and performance of its powers and duties hereunder, except with respect to its own willful misconduct, negligence or breach of its obligations hereunder”

• Note that in the administration of defaults it is not uncommon for Bondholders to request that indemnity by joint but not several, and limited to the extent of their holdings

• Recovery of amounts due to the Trustee should be included as a secured obligation in all granting language; and given priority lien in application of moneys upon an event of default



Indemnification (cont.)• The Trustee should be granted a charging lien ahead of bondholders

• Bad Example:“In the event the Trustee incurs expenses or renders services in the course of performing its duties hereunder, the Trustee shall apply to the Borrower for reimbursement under Section [__] of the Agreement“

• Good Example:“The Borrower has covenanted and agreed, pursuant to the Agreement to pay to the Trustee compensation for all services rendered by it hereunder and under the other agreements relating to the Bonds to which the Trustee is a party in accordance with the terms agreed to from time to time, and, subsequent to default, in accordance with the Trustee’s then-current fee schedule for default administration (the entirety of which compensation shall not be limited by any provision of law regarding compensation). The Trustee shall have a lien prior to the lien securing the Bonds, which it may exercise through a right of setoff, upon all property or funds held or collected by the Trustee pursuant to this Indenture.”


Indemnification (cont.)• The Trustee must NEVER give any indemnification to another party!!!

• Bad Example:[From a Deposit Account Control Agreement where the Trustee is the Secured Party]”… To the extent such obligations of indemnity are not satisfied by Company within five (5) days after demand on Company by Bank, Secured Party will indemnify.”


Indemnification (cont.)• There should be an express recitation of the standard, commonly accepted

Trustee immunities and protections, such as:• Trustee ability to rely on documents it receives in good faith without investigation• Ability to receive and rely on advice of counsel• Trustee not liable for errors of judgment unless grossly negligent in ascertaining facts• Trustee not obligated to take action unless indemnified to its satisfaction against expense

and liability (including attorney’s fees)• The indenture should specify that the Trustee is not required to make any injury

or investigation into the facts or matters stated in any resolution, certificate, statement, instrument, opinion, report, notice, request, direction, consent, order, approval, bond, debenture or other paper or document other than those created by the Trustee



Trustee Resignation• The Indenture must limit the time period in which a successor will be

appointed after resignation or removal of the Trustee• 60 Day Maximum• The Trustee must have the right to petition a court of competent jurisdiction to

appoint a successor (at the expense of another party such as the Issuer of the Borrower)


Express or Implied Responsibility for Tax-Exempt Qualification• Avoid any terms that would impose on the Trustee responsibility for maintaining tax-

exempt qualification of the bonds• This is beyond matters the Trustee can be or should be responsible for

• Bad Example: “Notwithstanding any term herein to the contrary, the Trustee will not take any action that would cause interest on the bonds to fail to be exempt from federal taxation”


Notice• The Trustee can agree to accept and act upon instructions or directions sent by

unsecured e-mail, facsimile transmission or other similar unsecured electronic methods as long as the Trustee is protected

• Specific language to include:• The party giving directions to the Trustee must provide an incumbency certificate listing

the designated persons with authority to provide such instructions (including updating the list as needed)

• The Trustee’s understanding of such instructions shall be deemed controlling• The Trustee shall not be liable for any losses, costs or expenses arising directly or

indirectly from the Trustee’s reliance upon and compliance with such instructions• The party agrees to assume all risks arising out of the use of such electronic instructions

and directions to the Trustee



Drafting for Default:• Transaction must anticipate default!

• Investors expect clear path to sources of payment and security• Strength of credit is no defense for poor drafting• Lack of clarity in documents is recipe for disaster• Document provisions regarding administration of remedies expose Trustee to

significant risk• Follow best practices for all transactions• Make sure that remedies provisions are fully integrated between all financing and security

documents


Drafting for Default (cont.)• The structure of transaction allocates risk-be sure to tighten any loopholes that could leave the Trustee

responsible for acting without direction• Clearly define defaults/events of default and remedial procedures:

• Set limits for cure period-including time limits for subsequent notices and determinations• Provide for notice and parties to be notified:

• Consider use of filing on EMMA (or the current Repository) as means for providing Notice where possible• Address changes in insurers or credit enhancers right to direct proceedings in the event of rating downgrades or

breach of other financial covenants• Expressly address what is or how to determine “material and adverse effect” on bondholders• Provide for covenant (non-payment) breaches• Provide alternative terms regarding removal, replacement and resignation of Trustee

• Address the concepts of “Trustee Default” and “Trustee Cure Period”, especially in forward purchase or forward delivery agreements

• Prepare for the worst-litigation or bankruptcy:• Watch out for statutes of limitation-valuable to expressly disclaim Trustee’s responsibility for running of statutes of

limitation absent proper direction• Always provide Trustee with rights to consult with/obtain an opinion of counsel, of their choice• Understand and protect attorney-client privilege


• Each material provision of an indenture must be considered from the perspective of bondholders trying to maximize their recovery after default and giving the Trustee clear guidance on how to enforce the documents and maximize the Bondholders’ recovery

• Trustee’s counsel should think about mechanical steps, timing, and the allocation of risk, for any instruction to Trustee regarding servicing/administrative functions



• Careful drafting anticipates pragmatic solutions that minimize cost, confusion and heartburn

• Incomplete or ambiguous instructions can lead to complex and protracted litigation

• Bond documents must be solid vis a vis anticipating claims and defenses under applicable law

• Trustee needs express authority to use moneys in trust accounts to enforce remedies and protect rights of bondholders (including payment of trustee’s fees and expenses)



• Careful drafting anticipates pragmatic solutions that minimize cost, confusion and heartburn

• Incomplete or ambiguous instructions can lead to complex and protracted litigation

• Bond documents must be solid vis a vis anticipating claims and defenses under applicable law

• Trustee needs express authority to use moneys in trust accounts to enforce remedies and protect rights of bondholders (including payment of trustee’s fees and expenses)



14. Leases & Other Non-Traditional Financings

Faculty:Stephen E. Weyl Hinckley, Allen & Snyder LLP – Boston, MA Matthew O. Gray Butler Snow LLP – Denver, CO

This panel will provide an overview of those transactions that just do not fit typical structures but are common nonetheless, including leases, installment payment contracts, special district or revenue financing and pool programs.

I. TRADITIONAL AND NON-TRADITIONAL FINANCINGS

A. General Obligation Bonds

1. Overview. General obligation bonds are the “traditional” form of financings for municipalities. As mentioned in the Basic Structuring panel, general obligation bonds* (a) are backed by the issuer’s full faith and credit; (b) are supported by the issuer’s ability levy and collect taxes (particularly property/ad valorem taxes); and (c) generally, require voter approval.

*Of course, there is always a caveat. Constitutional and statutory provisions relating to general obligation debt vary from state to state. For instance, in some states, general obligation debt is secured solely by the issuer’s obligation to levy and collect ad valorem property taxes sufficient to make payments on the debt, while in others, the issuer’s full faith and credit and amounts in the general fund are pledged.

2. Benefits. Because general obligation debt is typically supported by the taxing power of the issuer, it poses a relatively low risk to investors and, therefore, provides the lowest cost of borrowing for municipal issuers. General obligation debt generally provides a dedicated source of revenue for payment of the debt, often in the form of increased taxes approved by voters for that purpose. In addition, the documentation for general obligation debt is generally simpler than for other municipal debt, in part because state statutes often specify the specifics of issuance and repayment.

3. Limitations and Disadvantages. Issuers need alternatives to general obligation debt for several reasons. First, state law generally limits the use of proceeds of general obligation debt, and not all projects an issuer wishes to fund will qualify for general obligation funding. Second, in some cases, there may be debt limit restrictions in the state constitution or statutes that constrain the issuer’s ability to issue general obligation debt. Third, an issuer may not be able to get voter approval for the proposed debt or may want to avoid the


time-consuming process of getting voter approval. Fourth, the issuer may want or need to use a different source of revenues to repay the debt. Depending on state law and the needs of the issuer, there may be additional reasons for an issuer to choose non-general obligation debt.

B. Alternatives to General Obligations

If, for any reason, an issuer wants or needs to issue debt other than general obligation debt, there are many alternatives to the “traditional” general obligation financing. The type of financing to be used will depend on many factors, including, but not limited to, the nature of the proposed projects, any relevant statutory restrictions, and the preferred source of repayment. Following are several types of non-traditional financings that may be used:

Leases and Installment Sale Contracts Revenue Bonds Double-Barreled Obligations Bond Anticipation Notes Grant, Revenue and Tax Anticipation Notes Assessment Financings Tax Increment Financings Special District Financings Debt Limitation Exceptions

Not covered in this outline are conduit financings for the benefit of non-municipal entities; see the outlines for “Conduit Issues and Issuers,” “Qualified Small Issue and Exempt Facility Bonds,” and “Qualified 501(c)(3) Bonds.”

II. LEASE FINANCINGS

A. Definition

“Leasing” is a financing technique by which state and local governments acquire real and personal property. It may involve documents labeled variously as a “lease,” a “municipal lease,” a “lease-purchase agreement,” an “installment purchase contract,” an “installment sale contract,” a “purchase order,” or simply a “contract,” among others. The common elements of such agreements are (1) installment payments, characterized as rent or otherwise, that include a specified interest component, and are being made by a state or political subdivision for the purpose of acquiring the use of, and, in many cases, title to, real or personal property and (2) in most jurisdictions, carefully drafted documents to ensure that the agreement does not constitute “debt” for state law purposes. Leases most often are either (1) “capital leases” or (2) “true leases” or “tax-exempt use leases.” Most “capital leases” involve the transfer of title to the real or personal property to the state or political subdivision at the end of the lease (either by operation of the documents or upon payment of a de minimis purchase price). In this way, a “capital lease” has the same end result as a loan with respect to title to the real or personal property. A “true lease” or a “tax-exempt use lease” differs from a “capital lease” in that the “true lease” involves no transfer of title to the property to the state or political subdivision at the end of the term. Instead, title to the property remains with the lessor at the end of the term.


Accordingly, a “true lease” or “tax-exempt use lease” is not normally permitted to be treated as a tax-exempt obligation for federal income tax purposes. In this outline, the term “lease,” except when specifically identified as a “true lease” or tax-exempt use lease,” is used as the generic term to include all the various types of capital lease agreements that make up this financing technique.

The following discussion will first examine the evolution of the lease as a financing technique, and second provide a general checklist of matters to be considered in rendering an opinion that a particular lease is duly authorized and a valid and binding obligation of a governmental lessee and that the interest component of the rentals due under the lease or of the installment payments due under an installment sale contract to be made by the governmental lessee is excluded from gross income for federal and/or state income tax purposes.

B. Forms of Leases

1. Annual Quid Pro Quo Leases. Although the legal analysis upholding the validity of leases, including “true leases,” varies from jurisdiction to jurisdiction (due primarily to variations in constitutional, statutory and charter provisions relating to the authority for such obligations and the applicable debt and budget limitations), leases have often withstood challenges that they create unlawful indebtedness because the governmental lessee is only liable to pay rents during each fiscal period in an amount equal to the value of the use and possession of the leased property during that period. In this respect, the obligation of the governmental lessee is comparable to that incurred, for example, in hiring a police officer: for one day’s work, one day’s pay is owed. Because the lease obligation does not create an immediate liability for all rents or other amounts scheduled to be paid during the term of the lease, but only a liability to the extent of the contemporaneous value received, it does not create unconstitutional or illegal “indebtedness.” This legal analysis applies to both capital or financing leases and “true or tax-exempt use leases.” Unlike a financing or capital lease, a “true lease” or “tax-exempt use lease” can be defended even in situations where the obligation to pay rent is not expressly conditioned on annual appropriations by the state or local government, because under common law the lessee has no obligation to pay rent until it comes due under the terms of the lease and there is no right of acceleration of future rents upon default by the lessee. See 1 HERBERT THORNDIKE TIFFANY,THE LAW OF LANDLORD & TENANT 166 (1910). As already stated, it is questionable, however, whether a “true lease” or “tax-exempt use lease” can be structured as a tax-exempt obligation given the federal tax law requirement that the lessee build up equity in the leased property. SeeRev. Rul. 55-540 and PLRs 8235056 and 8347058.

(a) Current Liability. City of Los Angeles v. Offner, 19 Cal.2d 483 (Cal. 1948), involved a lease/lease-back arrangement under which the city leased a site to a contractor, the contractor built a facility on the site and leased both the site and the facility back to the city. In holding that the lease-back to the city did not create an unconstitutional debt, the Court stated, “If the lease or other agreement is entered into in good faith and creates no immediate indebtedness for the aggregate installments therein provided for but, on the contrary, confines liability to each installment as it falls due, and each year’s payment is for the consideration actually furnished that year, no violence is done to the constitutional provision.”


(b) Fair Rental Value. Although not always expressly stated in court decisions, the notion that the rents payable pursuant to a lease during each fiscal period represent fair consideration for the use and occupancy of the property during that period -- i.e., the concept of “fair rental value” -- is implicit in the supporting legal analysis. See, e.g., id. at 487; Dean v. Kuchel, 218 P.2d 521, 523 (Cal. 1950). Thus, for example, “front-end loading” rental payments or fully-amortizing the cost of 30-year property over a 5-year lease term could raise questions concerning whether the governmental lessee is purchasing property on an installment basis, and thus has incurred debt because such arrangements would arguably result in the payment of rent in each fiscal period greatly in excess of the value of the use and occupancy of the property during that period, with a resulting equity build-up. Because the concept of fair rental value, where expressly recognized, is “judge-made” law, there are no precise standards for determining fair rental value. For example, how much should a leasing company charge a public school district to rent a fleet of school busses under an agreement that is subject to annual renewal/termination? Won’t the actual annual installment payments under a financing lease involving a tax-exempt rate inevitably be less than the commercial “fair rental value” for such property in such a case?

2. Annual Appropriation Leases. In many jurisdictions, leases have been upheld because the governmental unit has the option to terminate the lease at the end of each fiscal period by not appropriating the funds needed to pay the rent coming due in the next fiscal period. Based on this provision, the lease does not obligate public moneys in a future year and, therefore, does not constitute “indebtedness.” The underlying concept is that a “debt” is something that binds the governmental unit to make payments in future budget years. Without a binding obligation that extends beyond the current fiscal period, there is no “debt” in the requisite sense. Annual appropriation leases often include (a) a limited non-substitution clause which prohibits the governmental unit for a short period of time from leasing or acquiring other similar property if the lease is terminated due to the failure to appropriate money for the rent (however, see I.D.1.(b) below), (b) an essentiality clause which has the governmental unit acknowledging that the property subject to the lease is being used by the governmental unit in providing its essential service or services, and (c) a good faith clause which requires the governmental unit to use its best efforts to appropriate the money necessary for the rent. This concept has been the subject of a great deal of scrutiny as opponents of lease financings continue to attempt to have such leases declared to be “debt,” and, therefore, invalid, in part, because applicable constitutional, statutory or charter procedures for the creation of “debt” were not followed.

(a) Legal Liability. One such case, State ex rel. Kane v. Goldchmidt,783 P.2d 988 (Or. 1989), involved a financing agreement whereby the state’s interest in the financed property would automatically terminate at the end of each fiscal period unless the legislature appropriated the funds necessary to pay the amounts scheduled to come due in the next fiscal period. Subject to payment of all scheduled amounts under the agreement, the state would receive title to the property at the end of the term. In sustaining the validity of this arrangement against a challenge that it constituted unconstitutional indebtedness, the Court analyzed the law as follows:

The debates on the floor of the [constitutional] convention left little doubt as to the purpose of the debt limitation. The central concern was that


future generations should not be saddled with the excessive undertakings of an imprudent legislature. The debt limitation was therefore adopted to protect against burdensome and excessive taxation. ... “Long-term obligations create a fixed charge against future revenues and can impair the flexibility of planning and the ability of future legislatures to avoid a tax increase.” . . .

This court has looked at not less than two basic characteristics in deciding whether action violates Article XI, section 7: (1) the fund from which payments on the obligation are made; and (2) the degree to which the public body is liable for repayment of the loan.

The state’s promise of repayment is conditioned on the willingness of future legislative assemblies to appropriate the funds. The state does not promise that future legislatures will appropriate any funds. The lenders take the risk of non-payment. This aspect of the legislation does not create a fixed charge against future revenues, nor does it impair the flexibility of planning and the ability of future legislatures to avoid a tax increase. 308 Or. at 580, 581 and 586. (Citations omitted.)1

(b) Compulsion to Appropriate. Because the failure to appropriate funds necessary to pay rents coming due in the next fiscal period can have severe adverse consequences for the governmental unit (such as a downgrading of its credit rating or payment of a premium on its outstanding and future obligations, as well as the loss of its equity in the financed property), it is often argued that while the governmental unit may not be legally bound to appropriate funds for future fiscal periods, it is economically compelled to do so as a practical matter and thus the arrangement is the functional equivalent of “debt.” This argument has been rejected by numerous courts; however, it continues to be a key argument in challenges to the validity of annually renewable/appropriation leases.

(1) Loss of Credit Rating: In rejecting an argument premised on the loss of credit rating in the event of nonappropriation, the Court in Kane stated:

Nor does the fact that the legislature may feel compelled to make payments in a future [fiscal period] out of the fiscal concern to protect its credit rating convert the state’s obligation into a legal one subject to [the constitutional restrictions on the incurrence of indebtedness]. The economic and fiscal consequences of either continuing the agreements or

1 Id. at 991-992. See also Dykes v. North Virginia Transportation District Commission, 411 S.E.2d 1 (Va. 1991); Dieck v. Unified School District of Antigo, 477 N.W.2d 613 (Wis. 1991); State Department of Ecology v. State Finance Committee, 804 P.2d 1241 (Wash. 1991); In re Anzai, 936 P.2d 637 (Haw. 1996); State ex rel. Charleston Building Commission v. Dial, 479 S.E.2d 965 (W. Va. 1996); Employer Insurance Co. of Nevada v. State Board of Examiners, 21 P.3d 628 (Nev. 2001) (supporting the proposition that nonappropriation leases do not constitute “debt”). But see Brown v. City of Stuttgart, 847 S.W.2d 710 (Ark. 1993) (finding that a lease constituted “interest bearing indebtedness” which was prohibited by the state constitution); Montano v. Gabaldon, 766 P.2d 1328 (1989) (holding that a lease constituted unlawful indebtedness since it had not been approved by the voters as required by the state constitution).


allowing them to terminate by failing to appropriate money merely becomes [sic] a factor in the public policy calculus of a political system that automatically subjects the economic wisdom of such projects to [biennial] review by future taxpayers and their elected representatives. [Citation omitted.] These consequences are of no constitutional significance.2

Contra: The contrary result was reached in Witzenburger v. State, 575 P.2d 1100 (Wyo. 1978), rehearing denied 577 P.2d 1386 (Wyo. 1978). Also, in the very recent past, rating agencies have lowered all outstanding debt obligations of municipalities that have failed to appropriate sufficient money to pay debt service on leases or other obligations that are clearly identified in the offering documents as subject to such appropriation. Such examples include Vadnais Heights, Minnesota, and Lombard, Illinois.

(2) Loss of Equity: The Court in Kane, supra, held that an unconstitutional “debt” could be created if, upon a failure to renew the lease for a succeeding year, the state stood to lose its entire equity in the financed property:

A common lease-purchase agreement generally allows the lessee to terminate the transaction without further liability if the lessee no longer needs, wants, or can afford the leased property. This does not create a debt or liability [footnote omitted]. The situation is more questionable if, upon terminating the agreement, the state stands to lose more than what remains to be paid on the acquired property, for instance, if most of the agreed price of an outright purchase, including interest, has been paid but termination will cause the state’s entire valuable property (worth more than the unpaid balance) to pass into the hands of the seller or lender. In that situation, the agreement confronts future legislators with the choice between the financial cost of continued cash payments or the financial cost of losing valuable nonmonetary property. This contingency may appear to create a liability, prohibited by [the state constitution]. . . . We therefore hold no more than that the participation agreements are not on their face forbidden as a future debt or liability contrary [to the state constitution], so long as the state stands to lose property or the use of property worth no more than the unpaid balance under the agreement.3

On the other hand, in the case of Wayne County Citizens Association for Better Tax Control v. Wayne County Board of Commissioners, 328 N.C. 24 (N.C. 1991), the North Carolina Supreme Court sustained the validity of an installment purchase contract where the obligation to make installment payments was subject to annual appropriation and the County’s obligations under the contract were secured by a security interest in the property covered by the contract. The Court concluded that “debt,” within the meaning of the state constitution, included only those obligations for which the taxing power of the governmental unit was pledged. The fact

2 Kane, 783 P.2d at 995-996. See also id. at n. 12 (citing similar cases from other jurisdictions).

3 Kane, 783 P.2d at 997-998.


that upon default, or nonappropriation, property of the governmental unit having a greater value than the unpaid balance of the installment purchase payments could be forfeited was held not to be problematic. What is being pledged is the constitutionally significant factor. Unlike general obligation bonds, wherein the taxing power of the governmental unit is pledged, in installment purchase contracts, only the property improved is pledged. The possibility that appropriations that might include income from tax revenues will be used to repay the indebtedness under the contract is not a constitutionally significant factor.” Id. at 31. In reaching this conclusion, the Court expressly noted that both the enabling statute and the contract itself barred any deficiency judgments against the County, presumably a significant fact because of the possibility that deficiency judgments could be subject to satisfaction out of tax revenues.

In jurisdictions where the constitutional concept of “debt” is not expressly linked to a pledge of the taxing power (as it was in Wayne County, supra) but is more broadly defined to include any obligation extending beyond the current fiscal period for which any assets of the governmental unit are at risk (as in Goldschmidt, supra), the logic employed by the Oregon Court would seem equally applicable to annual appropriation leases. Thus, in jurisdictions similar to Oregon, it may be prudent to limit the lessor/trustee’s remedies in a nonappropriation situation to sale of the leased property and recovery of the balance of the scheduled rents, with any excess, i.e. the “equity,” being remitted to the governmental unit.

3. Abatement Leases. In moving from the “true lease” considered in Offner, supra (where the city only had the option to purchase at fair market value), to a capital or financing lease, the courts in certain states such as California have fashioned the concept of “abatement leases,” which are not considered to violate the constitutional limitations on indebtedness. An abatement lease has the following characteristics:

(a) Vesting of Title at End of Term. At the end of the lease term, upon the payment of all rents, or prior to the end of the term upon prepayment of the unpaid principal components of the lease payments and accrued and unpaid interest thereon, title to the property covered by the lease vests in the governmental unit. In sustaining this automatic vesting of title, the Court reasoned:

We find no logical distinction between the Offner case and the one at the bar. It is true that [in Offner] there was an option to purchase [at fair market value]. . . rather than a vesting of title at the end of the term [as] in the instant case, but as far as liability is concerned, the state under the instrument here is in a better position, for it gets title without the payment of anything other than the rental. The essence of the Offner rule is that the payments are for a month to month use of the building. Here it is clearly stated that the rentals are for that purpose. There is no substantial or logical difference between the option to purchase in the Offner case and the vesting of title at the end of the term in this case. True, the city was not bound to execute the option and thus pay the purchase price, but it was required to pay the rentals. Here the rentals also must be paid but the state


need not pay any more.4

(b) Rents Subject to Abatement. If the property is not available for use by the governmental unit, or if there is substantial interference with the governmental unit’s use or occupancy of the property, then the rents otherwise payable under the lease must be proportionately abated.

(1) Abatement Generally: In Starr v. City and County of San Francisco, 72 Cal. App. 3d 164, 172 (Cal. Ct. App. 1977), the Court pointed out the characteristics of the lease in question (which comply with the requirements of Offner, supra,and Dean, supra) and noted that “[t]he base rental is for specified amounts to be paid by the City to the Agency ‘as rental for use and occupancy of the Project,’ with rent abatement provisions if the project is not substantially completed and ready for occupancy by July 15, 1980, or if there is a subsequent substantial interference with use and occupancy of the premises.”

(2) Covenant to Appropriate/General Fund Obligation: Because this approach to holding that the lease does not constitute “debt” is based on the fact that liability for rents is confined to “each installment as it falls due and each year’s payment is for the consideration actually furnished that year” (see Offner, supra), the governmental unit is obligated to make the rent payments as they come due (subject only to abatement) and can be compelled to appropriate money for that purpose. This generally results in inclusion of a covenant to appropriate money from the general fund sufficient to pay the rents due in each fiscal period. The net effect is what might be called a “general fund limited tax obligation subject to abatement,” a binding and enforceable obligation payable out of any lawfully available money of the governmental unit (including general fund tax revenues) but for which the governmental unit cannot be compelled to levy taxes beyond those authorized for general purposes and that is subject to abatement to the extent of any substantial interference with use or occupancy of the property.

Nevertheless, there is no right to accelerate the rents upon default. Rather, the lessor/trustee is limited to suing to collect each rental payment as it comes due.

(3) No Obligation During Construction/Acquisition Period: In keeping with the abatement theory (i.e., the municipal lessee has no liability for rent except to the extent the property is available for use and occupancy), until the property subject to the lease has been acquired or constructed, the governmental unit’s obligation to pay rents must be limited to sources other than its own funds or assets - e.g., the capitalized interest fund and interest earnings on the acquisition/construction fund created under the financing documents and funded with the proceeds derived from the sale of the lease obligation. This aspect of the abatement lease thus incorporates an element of the special fund doctrine in terms of providing a constitutionally permissible source other than ad valorem taxes from which to pay interest during the acquisition/construction period.

4. Limited Tax Full Faith and Credit Leases. In certain jurisdictions, it may be possible to structure a lease where the obligation to pay rent is a limited tax, full faith and

4 Dean v. Kuchel, 218 P.2d at 523 (Cal. 1950).


credit obligation of the governmental unit that is not subject to abatement. An example is found in Oregon in the case of cities, school districts and certain special districts. These types of governmental units have the ability to levy property taxes for general purposes and to issue unlimited tax general obligation bonds (i.e., bonds payable out of property taxes levied as necessary without regard to rate or amount). They are not, however, subject to any general constitutional debt limitations, as are counties and the state. Thus, to the extent permitted by statutory or charter provision, they can enter into lease-purchase arrangements having the following characteristics:

(a) Obligation to Pay Rents: The governmental unit is obligated to make the rent payments and can be compelled to appropriate money for that purpose. This aspect of the governmental unit’s binding obligation is generally recognized by the inclusion of a provision making the obligation to pay rents a full faith and credit obligation payable out of any lawfully available source of funds, including property taxes that the unit is otherwise authorized to levy in accordance with, and subject to, the limits of the state constitution.

(b) Obligation Unconditional; No Abatement: The obligation to pay rents is unconditional and not subject to abatement. Rather, the arrangement is structured as a true financing arrangement where the risk of loss, or interference with use and occupancy, is borne by the governmental unit.

(c) No Fair Rental Value Requirement: Because the legal theory is based on the governmental unit’s ability to enter into lease-purchase arrangements as authorized by statute or charter, and unencumbered by constitutional debt limits, there is no express requirement that the payments represent fair rental value. Rather, the term of the lease is generally governed by the governmental unit’s ability to pay and accounting concepts relating to amortization of the cost of capital items over their economic life.

(d) Right to Accelerate Rents On Default: The lessor-trustee can be given the right to accelerate all unpaid lease payments upon default.

5. Special Fund Leases and Related Variants. In several jurisdictions, lease financings are evolving to incorporate features such as pledges of specific revenues normally associated with the special fund doctrine. (See discussion under “Other Common Non-Traditional Financings” below.) One example of this is found under the Kentucky Governmental Leasing Act (Ky. Rev. Stat. §§ 65.940-65.956), which authorizes two forms of lease transactions:

(a) Special Fund Leases. If the lease is payable solely from “revenues,” it may be for a term in excess of one year and it need not be subject to annual appropriation. Ky. Rev. Stat. § 65.940(13) defines “[r]evenue” to mean “all funds received by a governmental agency which are not taxes, including but not limited to excises, transfer, service and occupational license fees and assessments.” Ky. Rev. Stat. § 65.924(1) states that “[l]eases which are payable exclusively from or are secured solely by revenues, may exceed a one (1) year period.”


(b) Annual Appropriation Tax-Supported Leases. If the lease is payable in whole or in part from taxes, it must be structured so that the obligation of the governmental unit does not exceed one year - i.e., it must be subject to annual appropriation. Ky. Rev. Stat. § 65.940(17) defines “[t]axes” to mean “taxes properly levied upon real or personal property.” Note: This definition of “taxes” is limited to property taxes. Excise taxes are included in the definition of “revenues.” Ky. Rev. Stat. § 65.942(1) states that “[l]eases payable in whole or in part from taxes shall be obligations of the governmental agency for a period that does not exceed one (1) year.”

In addition, Ky. Rev. Stat. § 65.942(2) states that “[A] governmental agency may pledge taxes as security for payment under leases which provide that the governmental agency may terminate its obligations under the lease at the expiration of each year during the term of the lease. A governmental agency may pledge any revenue other than taxes as security for payment under a lease regardless of any right to terminate.” Under this statute, the pledge of taxes for an annual appropriation lease would appear to give the holder of the obligation the right upon default or nonappropriation to seize the pledged taxes only to the extent needed to cover the appropriated (current year’s) rents. [NOTE: California Government Code Sections 5450 et seq. do not authorize a pledge of anything, but provide the method for perfection and priority of the pledge of revenues as collateral to secure bonds (defined broadly, including leases) that are issued pursuant to statutory authority that does not itself provide for the method of perfection and priority.]

6. “Asset Transfer” Lease Financing Transactions. If permitted by state law, a governmental unit may wish to enter into an “asset transfer” lease financing transaction, in which the governmental unit leases or sells an existing asset that it already owns to a lessor and simultaneously leases it back. The proceeds generated from the sale or leasing of the existing asset are used for one or more other governmental capital projects.

(a) State Law Issues. State and local law may only allow a governmental entity to sell or otherwise dispose of property that it owns if the governing body determines that the property is obsolete, unfit or surplus property, which is no longer needed by the governmental entity, or may require that such a sale or disposition be authorized by its voters or by public auction. Other state law considerations under applicable state laws and judicial interpretations would be whether or not this form of lease purchase financing represents a type of “cross collateralization” that constitutes invalidly incurred debt in the jurisdiction or a “mortgage” of public property that is not permitted.

(b) Potential Advantages. If state law issues can be resolved, the practical advantages of an asset transfer lease financing include the elimination of construction risk (because the asset securing the lease is already in existence) and the potential need for capitalized interest, having an asset to secure the lease that is potentially more essential to the governmental unit than the asset or assets that need to be financed, or being able to finance improvements to existing buildings that otherwise might be unsuitable for lease financing on a separate basis or cause a “compulsion to renew” because of “over-collateralization.” In addition, an asset transfer lease can help alleviate concerns about abatement. In such leases, the municipal issuer may covenant to find a new piece of property to lease if the original property is destroyed or would otherwise be subject to abatement.


C. Categories of Lessors

1. Private entities, financial institutions and insurance companies. These entities usually hold the lease for their own account during the entire term of the lease or sell interests in the lease with an instrument known as a certification of participation (a “COP”). COPs represent for an investor (the “COP Investor”) a fractionalized interest in a lease and the rights thereunder, the rental payments and the security for the lease (collectively, the “Assigned Lease”). The mechanism used for such fractionalization of the Assigned Lease is assignment of the Assigned Lease to a trustee pursuant to a trust indenture. The trust indenture establishes the rights of the various COP Investors in the Assigned Lease and mechanisms and procedures for enforcement of rights under the Assigned Lease by the trustee for the benefit of all of the COP Investors. The fractionalization of the Assigned Lease can be either vertical, whereby the COP Investors are acquiring rights in the stream of rental payments over the life of the Assigned Lease (for example, purchasing 50% of the rental payments coming due on each and every rental payment date) or horizontally, whereby the COP Investors are purchasing the rights in the principal component of rental payments for only certain rental payment dates, as well as the interest component of rental payments that accrues on said purchased principal component payable on each of the rental payment dates. COPs representing vertical fractionalization usually have one interest rate attributable to each and every principal component of rental payments (but are not required to), while COPs representing horizontal fractionalization usually have separate interest rates for each principal component maturity date (to avoid large premiums on early maturity COPs and deep discounts on late maturity COPs). Care must be taken to make sure that interest accruing on one principal component of rental payments is not allocated to a principal component with a differing maturity date. Doing so creates a separate security for both federal tax and federal securities law analysis with the probable result of loss of tax-exempt status of interest and loss of security law exemptions.

Inasmuch as COPs are executed and delivered by a trustee to whom the underlying lease has been assigned by virtue of a trust indenture and evidence a direct and proportionate interest of the COP Investors in the rental payments under the lease, several questions are raised as to what the COPs are and what they should be to preserve the tax-exempt treatment of distributions which represent the interest component of the underlying lease payments and to maintain the Section 3(a)(2) exemption from registration for the COPs.

2. “On Behalf Of” Lessors. These entities are created by specific state laws or by the governmental unit for the specific purpose of serving as the lessor for the governmental unit and to sell obligations (usually tax-exempt obligations) that are payable solely from, and secured exclusively by, the payments under the lease, which proceeds in turn are used to pay the costs of the construction or equipment project. These entities are deemed to be acting on behalf of the governmental unit. See Rev. Rul. 77-164; Philadelphia National Bank v. United States,666 F.2d 834 (3d Cir. (Pa.) 1981).

There are two types of entities which generally qualify as issuers acting on behalf of a state or local governmental unit: (i) entities formed under state law for the express purpose of issuing bonds to effect a public purpose, i.e., “constituted authorities”; and (ii) entities formed under applicable state nonprofit corporation law which comply with the requirements of Rev. Rul. 63-20. Rev. Proc. 82-26 sets forth the conditions under which the IRS will grant a


favorable advance ruling on whether a nonprofit corporation’s obligations are exempt under Section 103(a)(1) of the Code. See also PLRs 8649072, 8643050, 8628081, 8615013, 8601045, 8542104, 8506112, 8402026, 8351040, 8340067, 8334081, 9322006, 9335040 and 200019023.

(a) Constituted Authorities. Constituted authorities are entities specifically authorized by state law to issue bonds on behalf of political subdivisions of a state, among other specific powers granted to such entities in order to further public purposes. In Rev. Rul. 57-187, the IRS addressed industrial development boards in Alabama, which were authorized by state law for incorporation in municipalities to promote industry and develop trade.In furtherance of those purposes the boards were empowered to acquire, improve, furnish, equip, lease, sell and convey industrial projects and to issue bonds in furtherance of the boards’ purposes. The boards were controlled by the local municipality’s governing body. State law provided that bonds were payable solely out of revenues from the board’s sale or lease of projects. Each board was a public nonprofit corporation whose earnings and property upon dissolution reverted to the municipality in which it was located. The IRS ruled that bonds issued by the industrial development boards were obligations issued “on behalf of a political subdivision” by a constituted authority.

The aforementioned characteristics of the industrial development boards in Rev. Rul. 57-187 have been treated by the IRS for ruling purposes as “criteria” which must be present for an entity to be treated as a constituted authority empowered to issue bonds on behalf of a political subdivision. See Rev. Rul. 60-248; PLRs 8912008, 8906058, 8419029, 8405131, 8232044, 8215025, 8207036, 8139121, 812503, 7911022. In summary, the criteria are: (i) the issuance of bonds must be authorized by a specific state statute: (ii) the bond issuance must have a public purpose (which includes promotion of trade, industry and economic development); (iii) the governing body of the authority must be controlled by the political subdivision; (iv) the authority must have the power to acquire, lease, and sell property and issue bonds in furtherance of its purposes; (v) earnings cannot inure to the benefit of private persons; and (vi) upon dissolution, title to all bond financed property must revert to the political subdivision.

(b) 63-20 Corporations. 63-20 corporations are typically used where applicable state law has not specifically authorized the formation of public corporations which would qualify as constituted authorities under Rev. Rul. 57-187.

The criteria required for constituted authorities under Rev. Rul. 57-187 and the five requirements for 63-20 corporations are substantially the same. The most significant difference is the type of authorizing statute under which each is organized. Proposed regulations published in February 1976, and withdrawn in December 1983, would have required that the entity be formed under the authority of a specific state statute so that corporations formed under general nonprofit corporation statutes would not have been treated as “on behalf of” issuers.

Rev. Proc. 82-26 identifies circumstances in which the five tests in Rev. Rul. 63-20 will be deemed to have been met and, consequently, the IRS will issue a favorable advance ruling. For example, the requirements that the sponsoring political subdivision have a beneficial interest in the 63-20 corporation while its bonds are outstanding and that it obtain full legal


title to the 63-20 corporation’s property upon retirement of the bonds will be deemed met under Rev. Proc. 82-26 if (among other requirements): (i) the [sponsoring governmental] unit may not agree or otherwise be obligated to convey a fee interest in the property to any person who was a user of the property or a related person ... within 90 days after the unit defeases the obligations...; (ii) reasonable estimate of a fair market value of the property on the latest maturity date of the obligations ... is equal to at least 20 percent of the original cost of the property financed by the obligations ... and (iii) a reasonable estimate of the remaining useful life of the property on the latest maturity date of the obligations ... is the longer of one year or 20 percent of the originally estimated useful life of the property financed by the obligations.”

In Philadelphia National Bank v. United States, 666 F.2d 834 (3d Cir. 1981), the court interpreted Treas. Reg. § 1.103-1(b) with respect to entities issuing bonds on behalf of political subdivisions. The issue was whether loans made to Temple University by a private bank, which were obtained to defray operating expenses while the university awaited legislative appropriations, were obligations issued on behalf of the State of Pennsylvania. The court cited C.I.R. v. White’s Estate, 144 F.2d 1019 (2d Cir. 1944), cert. denied. 323 U.S. 792, 65 S. Ct. 433, 89 L. Ed. 632 (U.S. 1945), for the proposition that entities issuing bonds on behalf of political subdivisions must be acting as alter egos of the political subdivisions, and held that Temple University was not a “constituted authority.” It was not acting as an alter ego of Pennsylvania because there was “no identity of interest, control or intent” between the University and the State. It also noted that the loans were for current operating expenses and not capital projects which would revert to the State or be available for public or government purposes, and that the University had alternative sources of revenue through tuition or private solicitation. Thus, Temple University was acting on its own behalf in securing the loan and not on behalf of the State. See also Rev. Rul. 60-248.

In PLR 200019023, the IRS eliminated the requirement of filing a federal income tax return by an entity issuing bonds on behalf of a political subdivision that fits within the classification of an affiliated entity of a governmental unit under Section 115(1) of the Code based on the guidance provided under Rev. Proc. 95-48. According to this Revenue Procedure, an on behalf of issuer may be treated as an affiliated entity of a governmental unit if either (a) it receives a ruling or determination letter identifying it as such an entity, or (b) (1) it is operated, supervised or controlled by a governmental unit, organizations that are affiliates of governmental units or members of the governmental unit’s governing body who are elected by the public, (2) possesses at least two affiliation factors set forth in the Revenue Procedure, and (3) the filing of the federal tax forms would not be necessary to the efficient administration of the internal revenue laws.

D. Basic Lease Concerns. The following is not an exhaustive list of the concerns that a lawyer should address in reviewing a tax-exempt lease or a COP transaction, but it is intended to be of assistance in identifying many of the areas of concern.

1. Is the Lease Valid? Invalidity of a lease can mean not only the loss of future installments, but also possible recoupment of prior installments. Interest on an invalid lease is not excludable from gross income for federal income tax purposes. Yet statutory guidance for lease financing is often not clear, and it is often possible that other statutes unexpectedly will come into play. Some of the primary issues in this regard are:


(a) Is there statutory authority for the particular governmental unit to enter into the lease? Many state statutes provide only generalized language as to authority to “lease” or “purchase” or simply to “acquire” real or personal property or to issue “obligations.” Practice varies from state to state and from lawyer to lawyer as to what statutory authority is sufficient to authorize a lease financing transaction.

(b) Does the lease include provisions that are not authorized by law? Leases and accompanying escrow agreements often include provisions for indemnification of the lessor (its assigns) and/or an escrow agent for contingencies that range from personal injury to loss of tax exemption of interest. Yet, it is the law in many jurisdictions that public bodies cannot indemnify third parties. Another consideration found in some leases is the existence of a condition tying the lessee’s right not to appropriate funds for future lease installments to the lessee’s forbearance from acquiring similar property for some period or for the balance of the original lease term, thereby potentially preventing the lessee from performing an important public function required by state law. Such “nonsubstitution” clauses are considered in some states as unenforceable and in some states may even invalidate the lease. See, e.g., Frankenmuth Mut. Ins. Co. v. Magaha, 769 So.2d 1012 (Fla. 2000) (nonsubstitution clause invalidated lease as debt incurred in violation of constitutional requirement for voter approval). Cf. Miccosukee Tribe of Indians of Florida v. South Florida Water Management. District, 48So.3d 811 (Fla. 2010) (affirming that the absence of a nonsubstitution clause helped render the nonappropriation clause as real and not illusory, thereby preserving the integrity of the nonappropriation clause and helping to prevent the COPs from being characterized as “debt”). At times, leases that include questionable clauses are nevertheless funded, with the thought that invalidity is not clear or that the questionable provision can be isolated by the phrase “to the extent permitted by law” or that, in any event, a severability clause will excise the offensive provision. In this regard, consideration must be given to the basic rule that municipal entities have only those powers expressly authorized by statute; cf. the Richmond (California) Unified School District litigation in which a California Superior Court refused to compel the district to budget and appropriate funds necessary to pay a lease on the grounds that there was no statute clearly creating such a duty. Also, there have been instances where a court has invalidated a lease rather than sever the offending provision. But see Frankenmuth Mut. Ins. Co. v. Escambia County, Fla., 289 F.3d 723 (11th Cir. 2002) in which the court held that the nonsubstitution clause was severable and the lease was valid.

(c) Have procurement laws been observed? Failure to observe public bidding or other procurement laws may not affect validity of a bond issue, but could invalidate a lease. See, e.g., McBirney & Associates v. State, 753 P.2d 1132 (Alaska 1988). Procurement laws may be a morass of requirements, observance of which will involve a fact-laden inquiry. Practice varies, but counsel will often rely on representations of the lessee or local investigation as to such compliance.

(d) Does the lease create unconstitutional or illegal “debt”?Despite general use of nonappropriation clauses, there is sometimes the worry that leases might nevertheless be struck down as unvoted or otherwise unconstitutional debt and such has been the case in New Mexico and Arkansas. Rev. Rul. 87-116 adds to the concern with its determination that interest on an obligation found to be unconstitutional is not tax-exempt from its inception. Case law on this point, however, has generally been favorable in most states like Arizona,


California, Florida, Georgia, Hawaii, North Dakota, Oregon, South Carolina, Virginia, West Virginia and Wisconsin.

Clauses in the lease should be analyzed as to their potential effect on the issue of debt, such as whether the lease should be subject to annual renewal or annual termination; the consequences of damage, destruction or condemnation; when the rental payment obligation may commence as to the lessee; as well as any clauses (such as nonsubstitution) that seek to penalize the lessee for exercising its option to terminate the lease annually.

For example, in Unified School District No. 207 v. Northland National Bank, 887 P.2d 1138 (Kan. App. 1994), a lease purchase agreement was invalidated because it failed to provide specifically, as required by state law, that the school district lessee was obligated only to pay periodic payments from funds budgeted and appropriated for that purpose in the current budget year, and because, upon any early cancellation (as expressly permitted), the school district could not acquire functionally similar equipment during what would have been the full term of the lease purchase agreement. Similarly, in Tokai Financial. Services, Inc. v. Sangre de Cristo School District, No. 94-CV-54, 1995 U.S. Dist LEXIS 21136 (D. Col. Mar. 7, 1995), a lease-purchase agreement was invalidated on the ground that the nonsubstitution clause constituted a “penalty” that precluded the district from accepting or rejecting the lease annually “without penalty.” Therefore, the lease obligation was held to constitute debt that had not been approved in accordance with Colorado law. The court also declined to rely on the severability clause because to do so would have worked a hardship on the district, since the nonappropriation had occurred several years earlier, and to sever the nonsubstitution clause, and enforce the remainder of the agreement, would have placed the district in default and imposed additional penalties on the district.

(e) Does the lease violate positive requirements of state law? It is often not clear whether usury laws or interest rate ceilings that may apply to bonds also apply to leases. At times, leases may be covered by deceptive trade practices laws. Some states have statutes that require certain specific language to be included in a lease, and failure to include that language may invalidate the lease. Many states have specific requirements with respect to leases associated with renewable energy and energy conservation programs. Jurisdictions may have other statutes that unexpectedly affect validity.

(f) Has the lease been properly authorized and entered into?Power Equipment Co. v. U.S., 748 F.2d 1130 (6th Cir. 1984), holds that even interest on an enforceable lease is not exempt if a statutory step (e.g., approval by city council) has been omitted. The decision in United States Leasing Co. v. City of Chicopee, 521 N.E. 741 (Mass. 1988) (mayor’s signature was called for by city charter) is a reminder that these requirements are a precondition to validity, and that the estoppel effect of the government attorney’s favorable opinion may not be much help.

(g) Is any tax levy necessary to pay lease payments within the lessee’s applicable levy limit for operating expenses or, if appropriate under state law, for capital expenditures? Lease payments typically constitute current expenses of each fiscal year during the lease term and must be raised through a tax levy for operating expenses or capital expenditures within a levy limit imposed by state law for the particular political subdivision


entering into the lease. Depending upon how the lease is drafted, the particular state law and the type of political subdivision entering into the lease as lessee, the lessee cannot be obligated to exceed any applicable levy limits in generating money to pay its lease payments without creating the risk that the lease is or may be held to be invalid debt. In addition, a comparison of the level of the required tax levy to any applicable levy limit (considered with and without the proposed additional rental payments) may suggest how likely the risk of nonappropriation may be.

2. Are the Owners’/Investors’ Interests Adequately Protected?

(a) What is the level of “essentiality” of the property that is to be financed with the lease? Generally, rating agencies, insurers and investors view leases that finance the acquisition of real property as more secure than leases that finance the acquisition of equipment because real property is more unique, less easily replaced, and less likely to depreciate in value if properly maintained; thus, reducing the likelihood of any nonappropriation for the lease. In real property transactions, the following questions may be appropriate: Is lease-financed real property essential to the delivery of critical or mandated governmental services, such as courthouses, jails and governmental offices? Or is the real property being acquired for more discretionary purposes, such as entertainment or sports facilities? Is the real property sufficiently distinct and transferable to be susceptible to lease financing?

The following questions may be appropriate in equipment leases: If the lease finances the acquisition of equipment, is the equipment subject to adequate identification and control? Is the equipment standard equipment of proven usefulness, such as school buses and fire trucks, which are unlikely to be the subject of nonappropriation and also would have value if the lease were nonappropriated? Or is the equipment “customized,” “high-tech” or intangible property or systems that are subject to significant risk of not being acquired or completed on time and within budget, or that are subject to unusually fast depreciation in value or technological failure or obsolescence, with a resultant increase in the risk of nonappropriation? Has the governmental lessee certified that the equipment is essential to its governmental operations? Is the equipment or the information stored within the equipment subject to state or federal laws (such as H.I.P.P.A. laws) or prior liens, making collateral recovery difficult?

(b) Is title good? Under the UCC, an unpaid vendor retains title; accordingly, one must be satisfied that the vendor is paid. Used equipment may be subject to competing liens or security interests and, at least for expensive computer units, it may be prudent to trace title back to the manufacturer, checking to see that the serial numbers match those on the invoice. Vehicles should be accompanied by certificates of title, and title to aircraft may be searched and perfected.

(c) Does the lessor own the lease? The basic protection here is, of course, to know the lessor whose paper you are examining, as a UCC search of the lessor’s principal place of business will often be unavailing, and it may be that more than one original counterpart of the lease exists. Purchase of leases from a lessor-merchant in good faith and for value will generally defeat a competing claim, but it is important that the governmental lessee acknowledge the assignment. Some lessors will continue to receive the rental payments to “service” the account for the investor; but the risks of confusion (should the lessor become


insolvent or reassign the paper) call for extreme confidence in the lessor’s financial stability and integrity.

(d) Is the leased property perfected as against the lessee? Revised Article 9 of the UCC went into effect in most states on July 1, 2001. In some, but not all, states, Article 9 now applies to transfers of security interests by state and local governments. Whether or not Article 9 applies, the practice is to file UCC-1s to have the benefit of the public notice that such filing provides. For motor vehicles, lessees generally appear as “registered owner” on the certificates of title, and the investor appears as “legal owner” or secured party.

(e) Is the investor’s security interest perfected vis-a-vis its assignor? Generally, the assignment is considered an outright sale of all of the assignor’s right, title and interest in the lease (and the underlying leased property), rather than an assignment for security, and the lender in any event takes physical possession of the original counterpart of the lease (chattel paper). Article 9, however, specifically applies to the sales of accounts and chattel paper. UCC financing statements covering such sales must, therefore be filed.

Does the assignment insulate the assignee from the risks associated with the bankruptcy of the assignor, at least for the applicable bankruptcy period? The answer to this depends upon whether the assignment is absolute or is intended as collateral security for performance of obligations by the assignor. The assignment document for the lease should be drafted carefully to resolve this question in favor of protecting the lender. Notification of the lessee is contemplated by U.C.C. § 9-318.

At least one court has determined that the “governmental transfer exception” (which was eliminated from Article 9 of the revised model UCC on July 1, 2001) not only applies to security interests but also to payment transfers. MP Star Financial v. Cleveland State University, 837 N.E.2d 758 (Ohio 2005). This case states that the assignment of accounts receivable to an assignee does not obligate a governmental entity to honor a notice of assignment or make lease payments to an assignee. In those states where the “governmental transfer exception” exists, it is important to make sure that assignees (examples of which may include purchasers of lease obligations, as well as trustees in COPs transactions) have the ability to receive rental payments directly from a governmental lessee. Documents requiring the consent of the governmental lessee upon assignment may provide a practical solution.

Impact of Revised Article 9. Unlike the previous version of Article 9 in effect in most states, unless a state adopted a non-uniform amendment, revised Article 9 covers security interests created by a state or a governmental unit of a state except to the extent another statute of the state expressly governs the creation, perfection, priority, or enforcement of such a security interest. Many other changes are included in revised Article 9, including information with respect to where financing statements should be filed and the accompanying information that must be included. It is important to check Article 9 as it is in effect in each applicable state in order to properly perfect an assignment or security interest.

(f) Should credit enhancement, if any, run to the lease or to the COPs? Counsel may differ on the obligation to which any credit enhancement should run.


(g) If the lease includes credit enhancement, does an obligation to reimburse the credit enhancer constitute “debt” for State law purposes? The same legal analysis that applies to whether the lease constitutes debt should also be applied to any reimbursement obligation that the credit enhancer is seeking from the lessee, although credit enhancers may not appreciate the subtle, but substantial, differences between a corporate obligor and a municipal obligor relative to a reimbursement obligation.

3. Does the lease properly match the timing and amount of rental payments to the lessee’s budgetary cycle? The budgetary cycle of a governmental lessee may vary from jurisdiction to jurisdiction and within each jurisdiction as between the state, cities, counties, school districts, etc. Failure to take these considerations into account when drafting a lease may result in a lack of funds available to the lessee to make timely lease payments.

4. In a California-type “abatement” jurisdiction (see discussion in “Forms of Leases” herein), does the lease contain the lessee’s covenant to budget and appropriate money sufficient to pay rental payments, subject to availability for use and occupancy, and in other jurisdictions does the lease impose an obligation of an appropriate budget officer to seek sufficient appropriations to pay rental payments subject to final decision by the governing body of the lessee? The lease must be drafted with sensitivity to the particular lessee’s budgetary process to ensure that the proper steps are taken so that money will be available to make lease payments. The strength of these covenants may vary from jurisdiction to jurisdiction depending on how strong the obligation to budget and appropriate may be without causing the lease to become debt for state law purposes.

5. Does the lease trigger unexpected state or local taxes?

(a) Ad valorem taxes: Even though the lessor is simply providing a financial service, express placement of the title in the lessor may trigger a real and/or personal property tax liability. See e.g,. University of Utah v. Salt Lake County, 547 P.2d 207 (Utah 1976); Pollard v. City of Bozeman, 741 P.2d 776 (Mont. 1987). Often an equipment lessor will attempt in the “lease” to pass title up front to the lessee, retaining a “security interest” so the equipment may be repossessed upon early termination. In certain jurisdictions, this structure may raise “indebtedness” issues. Often, even though this procedure further undermines the lessor-lessee concept, the lessor will never have title to the equipment, asking the vendor to invoice the equipment directly to the lessee instead. On the other hand, in First Union National Bank of Florida v. Ford, 636 So.2d 523 (Fla. App. 1993), placement of title in a bank trustee was held not to deprive the municipal lessee of “equitable ownership” and thus preserved the property tax exemption conferred by Florida law. This same result was reached in Leon County Educational Facilities Authority v. Hartsfield, 698 So.2d 526 (Fla. 1997).

(b) Sales and use taxes: Generally, sales and use taxes apply to the initial purchase from the vendor but do not apply to the lease if the lessor takes title simply to lease the equipment to a public body, provided that proper resale certificates are provided. In some states, however, municipalities are not exempt from payment of sales and use taxes.


(c) Franchise taxes: The business of leasing may itself generate a liability. Failure to qualify in a state might lead to invalidity of a lease. See White Dragon Productions, Inc. v. Performance Guarantees, Inc., 241 Cal. Rptr. 745 (Cal. Ct. App. 1987).

(d) Covenant to Pay All Taxes: Often the tax question is considered to be solved by a clause requiring the lessee to pay any and all taxes applicable to the leased property and the transaction. Although this clause is indispensable, its enforceability may be subject to doubt and, if not properly disclosed to the lessee, may increase the risk of nonappropriation.

6. Has the lessee formally accepted the equipment financed by a lease?Unless provision has been made to hold lease proceeds in a fund for future release, an investor and counsel will want the comfort of knowing the lessee has received and accepted the leased equipment. Although this may be false comfort, as U.C.C. § 2-608 allows revocation of acceptance, see Advanced Computer Sales, Inc. v. Sizemore, 366 S.E.2d 303 (Ga. Ct. App. 1988), it is customary to have the lessee sign an unequivocal acceptance certificate identifying the equipment and the lease.

7. Federal or State Securities Laws Issues.

(a) Are leases and participations “securities” and if they are “securities,” are they exempt governmental securities? The SEC has been reluctant to take a position as to whether a municipal lease financing is a “security” as defined in Section 2(1) of the Securities Act of 1933 (or Section 3(a)(10) of the Securities Act of 1934 or a “municipal security” as defined in Section 3(a)(29) of the 1934 Act). In the Walter E. Heller & Company no action letter (Sept 24, 1982), the Division of Market Regulation said that it would not recommend any enforcement action to the Commission if a firm engaged in arranging municipal lease financings (but retaining no interest therein after the sale of the financing interest to a sophisticated individual or financial institution) did not register as a broker-dealer under Section 15(b) of the 1934 Act. The Staff, however, specifically took “no position as to whether these lease-purchase transactions are securities as defined in Section 2(1) of the 1933 Act or Section 3(a)(10) of the [1934] Act, or municipal securities as defined in Section 3(a)(29) of the [1934] Act.” Prior to the Walter E. Heller no-action letter, the SEC created considerable uncertainty in the municipal lease financing industry when it released an inquiry from the Office of the Comptroller of the Currency regarding Itel Corporation and the SEC’s response to that inquiry. Itel Corporation, SEC Division of Market Regulation Letter to Office of the Comptroller of the Currency, Investment Securities Division (Sept. 1, 1981). The SEC Division of Market Regulation concluded in Itel Corporation that fractionalized participation interests in tax-exempt lease-purchase or installment sale financings were “municipal securities” within the meaning of Section 3(a)(29) of the 1934 Act. “Although it is not possible to reach a conclusion with respect to all participation interests in tax-exempt financing arrangements, it appears that, as a general matter, such a participation interest would represent an obligation of a municipality if the financing arrangement were structured so that the holder of the participation interest looked primarily to the municipality as the source of payment. Based upon this analysis, it appears that such participation interests, including the participation interests in the Lease, are also obligations as that term is used in the definition of municipal securities, and that such interests are municipal securities within the meaning of Section 3(a)(29) of the 1934 Act.”


The Itel Corporation letter was widely reported in the municipal finance and municipal lease finance industries. The publication of Itel Corporation raised the prospect that vendors, other financial intermediaries and persons not customarily subject to securities regulation might find themselves subject to the 1933 Act or the 1934 Act as a result of their participation in municipal lease financing transactions.

The uncertainties created by the Itel Corporation letter were gradually resolved, largely as a result of the SEC’s no-action position in Walter E. Heller and similar requests with respect to the registration of brokers/dealers under the 1934 Act. What has emerged from the series of similar no-action requests and the favorable SEC responses is the practical view that if the conditions described in those letters are followed, the transfer of a whole lease on a non-recourse basis to a sophisticated investor experienced in municipal lease financing investments may not constitute the transfer of a security for purposes of the 1933 Act or the 1934 Act, whereas the fractionalization of that lease interest into COPs will undoubtedly give rise to the issuance of securities for purposes of both Acts.

One may reasonably conclude, based upon the Premium Capital Resources Corp. (May 28, 1984), Walter E. Heller and James O. Hiltenbrand & Associates (Apr. 11, 1985) no action letters, that a non-fractionalized municipal lease financing, in which a single vendor or investor acquires all of the stream of lease payments (whether represented by a single COP or by the lease-purchase agreement itself) should not be deemed to constitute an “investment contract” or a “security” within the meaning of Section 2(1) of the 1933 Act. Because the issue has not been definitively determined, it is customary in single investor (as opposed to single vendor) transactions to obtain an investment letter from the single investor to the effect that (i) the investor is an “accredited investor” within the meaning of Rule 501 of Regulation D promulgated under the 1933 Act (or some similar indication of financial suitability), (ii) the investor has obtained and reviewed certain documents or summaries of documents, including particularly the municipal lease financing documents, (iii) the investor has obtained, or has had the opportunity to obtain, all such financial and other information as such investor has desired from the governmental entity/lessee, and (iv) the investor is experienced in investing in municipal lease transactions.

Any fractionalized municipal lease financing, including COPs, are considered “securities” for purposes of the 1933 Act, but the question is whether they are governmental securities exempt from registration under Section 3(a)(2) of the 1933 Act. COPs are usually created by assignment of the lessor’s interest in the tax-exempt lease, the assets financed and the rental payments to a trustee under a trust indenture pursuant to which the interest in the rental payments, assets financed and legal rights are fractionalized to multiple investors. Since 1977, the SEC in a series of no action letters has provided guidance that the typical fractionalized municipal lease financing will constitute a governmental security of the underlying governmental lessee if certain conditions are met. See Smith, Barney, Harris, Upham & Co., Inc., SEC No-Action Letter, 1977-78 Transfer Binder, Fed. Sec. L. Rep. (CCH) ¶ 80,953, (Jan. 7, 1977) (“Smith Barney”). In Smith Barney, counsel to Smith Barney argued that the governmental entity should be considered the “issuer” of the COPs, and that the nominal role of the seller of the equipment (as lessor or seller) and the ministerial role of the trustee in the financing should be disregarded in determining the availability of an exemption under Section 3(a)(2). Based upon the facts presented in Smith Barney, the SEC agreed not to recommend any enforcement action if


the COPs in the financing agreements were offered and sold to the public by the company without compliance with the registration requirements of the Act in reliance upon the exemption provided by Section 3(a)(2) of the 1933 Act.

Counsel for the State of New Jersey, in the State of New Jersey (May 21, 1984) no-action request, relied upon the SEC’s 1977 no-action letter in Smith Barney and summarized the factors noted by the Staff in Smith Barney as being important to a determination that no registration would be required under the 1933 Act in the case of state and municipal equipment lease or conditional sale programs. The relevant factors include the following:

(1) the obligation of the public body must be a direct obligation in respect of which a COP Investor would have recourse without the necessity of joining a third party;

(2) the obligation of the public body must not be subject to set-off or counterclaim as a result of any dispute between the public body and a third party (e.g., the trustee, lessor or vendor);

(3) the obligation of the public body cannot be dischargeable as a result of damage to, or the destruction of, the subject property;

(4) the public body must be required to maintain the property at its own expense and to make all payments in respect of insurance premiums;

(5) the public body may not be permitted to sell or encumber the property without the consent of COP Investors;

(6) the trustee or fiscal agent acting on behalf of a COP Investor may provide only ministerial services as part of the financing transaction; and

(7) the rights of COP Investors [can] not be adversely affected by any insolvency proceeding to which the trustee or fiscal agent might become subject.

(b) Is there adequate disclosure? Generally, the anti-fraud provisions of the securities laws will apply to lease financing transactions. In this regard, the SEC in a separate Interpretative Release on Disclosure Obligations of Municipal Securities Issuers and Others issued in March, 1994, stated its view that there should be better disclosure in primary offerings and in the secondary market substantially as recommended in industry guidelines, such as those issued by the Government Finance Officers Association and the National Federation of Municipal Analysts.

Rule 15c2-12 of the 1934 Act was finally adopted in respect of primary offerings of municipal securities and amended in 1994 in respect of continuing disclosure obligations for the secondary market. While certain lease financing transactions may not meet the $1,000,000 threshold for application of the Rule or may be structured to comply with the limited offering (or “private placement”) exemption from the Rule, many lease financing transactions (and in particular those involving COPs or lease revenue bonds) are likely to be subject to the Rule.


Reference should be made to other outlines on Rule 15c2-12 for the specific requirements of the Rule generally and its application to each transaction.

In addition to compliance with SEC Rule 15c2-12, underwriters must comply with MSRB Rule G-36, which requires the filing with the MSRB not only of official statements required to be filed under Rule 15c2-12 but also those for smaller transactions in which official statements are prepared.

This outline is not meant to cover the securities laws applicable to lease financing transactions in any comprehensive way. Reference should be made to the current edition of NABL’s Fundamentals of Municipal Bond Law and other pertinent outlines regarding the securities laws.

(c) Do state blue-sky laws apply? The comfort available at the federal level that lease participations will be treated as “bonds” often is not available under state securities laws, that may speak of “bonds” in the literal sense. Commissioners may simply not have thought of the question vis-a-vis leases. In any event, a separate analysis of applicable state securities laws is mandatory in each case and it is a good idea to consult the current edition of NABL’s Blue Sky Law survey.

8. Dodd-Frank Act Issues. The Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub.L. 111-203, H.R. 4173 (approved July 21, 2010) (the “Dodd-Frank Act”), which amended the Securities Exchange Act of 1934 (the “Exchange Act”), requires a “municipal advisor” to register under the Exchange Act if such municipal advisor (1) provides advice to or on behalf of a municipal entity or an obligated person with respect to (a) “municipal financial products” or (b) the “issuance of municipal securities,” or (2) undertakes the solicitation of a municipal entity or obligated person. The application of these requirements to a lessor of municipal lease obligations presents challenging questions as to whether such lessor is a municipal advisor, whether a particular lease obligation is a “municipal financial product” or a “municipal security” or whether such lessor will be determined to be “soliciting” a municipal entity. While the Dodd-Frank Act provides a definition of “municipal advisor” (which includes financial advisors and other financial professionals but excludes broker-dealers and other financial professionals), the type of interaction and advice that a lessor provides a municipal entity often makes the determination of whether a lessor should register as a “municipal advisor” fact and circumstance dependent. A lessor may find itself outside of the scope of the “municipal advisor” requirements of the Dodd-Frank Act in connection with some transactions and within such requirements in connection with other transactions, depending on the nature and extent of the advice being provided, the lessor’s role in the transaction, and the type of financial product(s) being offered (to name a few considerations). Having to register as a “municipal advisor” has consequences, such as owing a fiduciary duty to a particular municipal entity, being subject to regulation by the MSRB (including being subject to MSRB “pay-to-play” prohibitions), supervision and training of employees and record retention, to name a few considerations. It is important to note that, in addition to a lessor and other financial professionals, it is possible attorneys may also fall within the scope of the “municipal advisor requirements” of the Dodd-Frank Act.


9. Federal Income Tax Issues. All the questions that apply to bonds also apply to leases, but with specific nuances and considerations. It is generally assumed, correctly, that what is good for bonds is good for leases, as the same arbitrage temporary periods, private use tests and the like apply.

(a) Is the lessee a state or political subdivision? Entities (e.g. joint planning agencies, library boards, state senators, justices of the state supreme court) that would not dream of issuing bonds often find themselves leasing equipment, and the question is whether they enjoy sufficient sovereign powers or can successfully pass an “instrumentality” analysis. Often it is necessary to have the lease redone so that the lessee is an established political subdivision and its obligation on the lease is clearly a “state or local bond” for federal tax purposes. Alternatively, it is possible for an entity to be able to issue a tax-exempt obligation if such obligation is issued “on behalf of” a state or local governmental unit (see Rev. Rul. 57-187).

(b) Is the lessee building up equity in the leased property as required by Rev. Rul. 55-540 (see e.g., PLRs 8235056 and 8347058)? Almost always, the dollar or nominal purchase option or automatic passage of title at the end of the lease term satisfies this test, but at times lessors will ask for a greater purchase option price, raising the Rev. Rul. 55-540 question of whether the “lease” is a “true lease.”

(c) Is the interest component of the rentals sufficiently distinct and described as required by Rev. Rul. 72-399? Ideally, all tax-exempt leases would include a schedule setting out the principal and interest components of each rental payment, with yet another column setting out any permitted prepayment schedule. Some smaller leases may use a formula for expressing interest and, in such cases, it is important that the formula enable an investor to demonstrate to the IRS the amount of the interest component of each installment.

(d) Is the lease an “obligation” under Section 103(c)(1) of the Code? In PLR 7821068 (February 23, 1978), the IRS found that an “obligation” existed for purposes of Section 103 of the Code in the context of an annual appropriation lease even though the lessee’s obligation was limited to funds appropriated annually and the lessee was entitled to terminate the lease from year to year.

(e) Is the lease in registered form? Section 149(a) of the Code requires that a tax-exempt obligation be in registered form, but implementing a registration system can be awkward in the leasing context. It is generally possible to have the lessee agree to keep copies of all assignments with its leasing records to serve as a record of the lease owners. Any participation or division of interests in a lease, however, leads to multiple owners, whose identity the lessee (or its assignee fiduciary) may not always know. The solution has at times been to have the lessor agree to carry out the registration function. The announcement in 26 CFR § 5f.103-1 that the functionary must do so as “agent” of the issuer has led to confusion, as it may appear anomalous to a lessee that a lessor can be its “agent” for anything.

In PLR 9128034, the IRS ruled that tax-exempt installment sale contracts with governmental entities accepted by the seller of products (or a financing affiliate) in a private placement for the exclusive benefit of the seller and that would not be sold to third parties or pledged as security in financing arrangements of the seller were “not of a type offered to the


public” and did not have to be registered. Of course, publicly-offered certificates of participation in a lease, which represent undivided interests in the lease obligation, must comply with the registration requirement.

(f) Is the property going be used in a way that causes the lease to be treated as a private activity bond? It is imperative to inquire as to the lessee’s intended use of the leased property and customary for the lessee to make certain representations and covenants in the lease which demonstrate that the lease is not and will not become a private activity bond. Covenants against subleases to any nongovernmental entity also should be included in the lease to prevent the private business use test from being met. If the lease-financed property meets the private business use test, the “private security” test of Section 141(b)(2) of the Code will be met because, by definition, the property serves as “security” for the lease obligation.

If the governmental lessee defaults under the lease or does not appropriate base rentals and, therefore does not renew the lease, then federal tax issues will arise concerning continued tax exemption for interest components of the lease payments (that may be evidenced by outstanding COPs) if the real estate or equipment that is the subject of the lease is then leased to other users that are not governmental entities, thus causing a change in use to “private business use.” The special (lease) counsel’s opinion on the tax exemption for the interest component of the lease payments should contain an appropriate exception for this situation, and the official statement should contain appropriate disclosure of the risk of taxability in that situation.

(g) Reporting. Forms 8038-G and -GC have special requirements for leases. As a general rule, a Form 8038-G or -GC should be in hand or filed before the closing is concluded or the opinion is delivered, as it may be difficult to obtain the lessee’s signature at a later time, particularly after the lease is funded. Moreover, some small issuers may not be aware of the requirement, or even of the fact that the lessor intends to treat the interest as tax-exempt. Such an issuer may be unwilling or unable after the lease is entered into to have it treated as tax-exempt because to do so may cause the lessee (as an “issuer”) to exceed the $5 million limit applicable to the small issuer rebate exception and/or the $10 million limit applicable to issuers of “qualified tax-exempt obligations” for banks and other financial institutions.

Recent changes to the 8038-G and –GC forms now require the signature of tax return preparer (i.e. “paid preparer”) in addition to the lessee (in some cases, the paid preparer and the lessee may be the same). To the extent that a lessor provides for or makes determinations in connection with certain information on the 8038-G or –GC form, such as the issue price, weighted average maturity and/or yield, which is a common practice in tax-exempt leasing, consideration must be given as to whether such lessor should sign the applicable 8038-G or –GC as a paid preparer. In addition, paid preparers (including attorneys) must obtain (and pay an annual fee for) a preparer tax identification number (PTIN) and pass a competency exam, which exam is not required of attorneys, CPAs or enrolled agents.

(i) Is the lease federally guaranteed? Even if the lease does not mention it, many leases are in fact paid with moneys derived from federal grants or other assistance, such as grants or aid provided for a welfare department’s computer, for a state’s medicaid program or for a university’s lab. Whether the receipt of a federal grant or other


assistance in amounts determined in whole or in part by reference to the lease payments constitutes a federal guaranty is often a very difficult question.

(j) Is the lease an arbitrage bond? The same basic arbitrage and rebate requirements that apply to bonds must be met for tax-exempt leases, but participants in lease financing often lack computational expertise and the amounts involved are not great enough to pay for the expertise needed, for example, for rebate. To obtain an exception to the rebate requirement for both equipment and real property lease financings, reliance often is placed on the small issuer (under $5 million) exception or the 6-month spending exception.

The arbitrage regulations also contain an 18-month spending exception for any financing eligible for a 3-year temporary period for unrestricted investment of proceeds (generally, where proceeds are used to finance capital purposes or projects, including acquisition of property as well as construction), if all of the gross proceeds are spent according to a required spending schedule over three 6-month spending periods.

Similarly, in a lease financing of a construction project (including “constructed” personal property), the “available construction proceeds” may be eligible for the 2-year spending exception from the rebate requirement for a “construction issue” (an issue in which at least 75% of the available construction proceeds will be used for construction expenditures), if all of the available construction proceeds are spent according to a required spending schedule over four 6-month spending periods.

If any gross proceeds are held in a reasonably required reserve or replacement fund for the tax-exempt lease or an issue of certificates of participation therein, those gross proceeds are not required to be spent to satisfy any applicable spending exception, but generally will be subject to the rebate requirement from the issue date. Reference should be made to other outlines on arbitrage-related topics for the specific requirements applicable to rebate exceptions and arbitrage requirements generally.

(k) Is the transaction an “investment trust with multiple classes”?In the May 2, 1984 Federal Register, the United States Treasury proposed amendments defining “trusts” for federal tax purposes; the final regulations were published in the March 24, 1986 Federal Register. As the Treasury proposal was originally worded, it was feared that a certificated tax-exempt lease with serial “maturities” bearing different interest rates would be treated as a “trust” with multiple classes of interests, such that the trust would be taxable as a corporation. A press release at about that time relating to a State of New Jersey lease transaction substantiated that fear. The final regulations made it clear that pass-through treatment as a grantor trust would result if the interest rate or rates on the certificates matched those formally set out in the underlying lease.

(l) Has the lessee properly designated the lease as a “qualified tax-exempt obligation” for purposes of Section 265(b)(3) of the Code? If a governmental lessee is eligible to designate its lease obligation as a “qualified tax-exempt obligation” for purposes of Section 265(b)(3) of the Code (because the lessee does not reasonably anticipate issuing more than the current maximum threshold allowed of tax-exempt obligations in that calendar year under Section 265(b)(3)), it is generally beneficial to the lessee to do so because


the designation makes the lease more attractive to banks and other financial institutions which is, in turn, taken into account in pricing. Counsel may be asked to give an opinion that the lease is a “qualified tax-exempt obligation” for banks and other financial institutions. Depending on the circumstances, however, that opinion may be difficult to provide because of the extent of due diligence that may be required to determine the amount of outstanding tax-exempt obligations of the lessee and the basis for the “reasonable expectations” of the lessee regarding its eligibility to designate obligations in any particular calendar year. In most cases, a certification by the lessee should be sufficient for this purpose. In addition, if the issuer of the tax-exempt obligation is an “on behalf of” issuer, it is important to remember that such issuer must take into consideration other tax-exempt obligations (and reasonable expectations) of the state or local government on behalf of which the obligation is being issued, when making a determination as to whether a tax-exempt obligation is a “qualified tax-exempt obligation.”

10. COP Transaction Issues.

(a) In COP transactions, should the lessee be a party to the trust agreement between the lessor-assignor and the trustee and also appear in some fashion as a signatory (whether by authentication or otherwise) on the face of the COPs? Practitioners differ as to the desirable level of lessee involvement to demonstrate its participation in the certification process, particularly in light of the paucity of statutory authority as to what actions the lessee is authorized to take in this respect under state law. Generally, it would be advisable to have the issuer-lessee approve, or at least acknowledge, the trust agreement. It does not appear to be common practice for the issuer-lessee to sign or authenticate the actual certificates of participation and such a practice may cause state law problems in respect of the creation of debt.

(b) Is specific legislation required for COP transactions? While specific legislation may be of comfort to those practitioners who render approving opinions with respect to COP transactions, particularly depending upon the nature of the lessee’s participation in the certification process, the number of such transactions in a variety of jurisdictions suggests that the lack of specific legislation is not an impediment to these transactions. If achievable, however, specific legislation supporting the lessee’s participation in the certification process would be desirable.

(c) What opinions should counsel render in COP transactions?The practice differs widely as to the opinions that counsel should render in a COP transaction beyond those opinions that are customary as to the validity of the lease and the tax-exempt treatment of the interest component of lease payments. For example, what opinions should special counsel render as to distributions with respect to the certificates or the due authorization, execution and delivery of the trust agreement by the lessor or the compliance of any continuing disclosure undertaking with local law?

Does interest payable only from earnings on proceeds from the sale of COPs constitute interest on an obligation of a state or local government? COP transactions are often structured so that interest accruing during a construction or installation period is paid from capitalized interest or from interest earnings on the proceeds from the sale of the COPs. In states like California, a lessee generally cannot be obligated to make lease payments before the property is available for


the lessee’s use. Leases in those states frequently provide that the lessee’s obligation to make lease payments during the construction or installation phase is limited to the amount of the capitalized interest or to earnings on the proceeds from the sale of the COPs.

Technical Advice Memorandum (PLR 9721003), dated January 24, 1997, described a transaction in which several local governments (“Districts”) participated in a pool designed to provide funding to meet cash flow needs. Each District executed a promissory note obligating it to pay the principal amount of the note plus interest at a specified rate, but not more than the District’s “Payment Obligation,” which was defined in the COPs documents. A corporation pooled the notes and assigned them to a trustee. The trustee executed and delivered the COPs evidencing undivided interests in the aggregate payments due under the notes. The COPs proceeds were used to purchase an investment agreement at a yield sufficient to pay the interest accruing on the COPs until the Districts drew down the funds to meet operating expenses.

The IRS held that the proceeds of the COPs were not received by the Districts until they were withdrawn from the investment agreement and that prior to the withdrawal the notes were not deemed to be issued. The practical effect of the IRS’ conclusion is that interest accruing on the COPs prior to withdrawal of the funds from the investment agreement is not interest on an obligation of a state or local government. The IRS based its position on a determination that prior to a withdrawal from the investment agreement, the notes represented only a right to draw on the funds rather than an interest in the funds themselves. This determination was based on the fact that each District’s Payment Obligation, and, thus promise to pay under the note, was equal to zero unless a draw was made. The IRS further supported its conclusion that the Districts did not have an interest in the funds by the fact that the trustee for the COPs was directed to invest the COPs proceeds in an investment agreement, which would not have been a permissible investment for the Districts.

Many lease transactions utilize a structure very similar to the one described in the Technical Advice Memorandum. To avoid the adverse results mandated by the Memorandum, the transaction documents should make it very clear that the proceeds of the COPs are the funds of the lessee from the date the proceeds are received and that the lessee has an unequivocal obligation to make the lease payments. In carefully drafted documents, it should still be permissible for the payment obligation to be satisfied only from specified sources of funds, such as accrued interest or investment proceeds. Consistent with the concept that the proceeds of the COPs are the funds of the lessee, proceeds derived from a COP should be invested only in obligations which are permitted investments for the lessee.

E. Provisions Normally Included in Leases. Set forth below are certain typical provisions of a lease financing that are designed to address the concerns of lessors, assignees and/or investors.

1. Lease payments reflecting the expected completion date of the construction of the leased property and the expected remaining useful life of the leased property.

2. Leased property consisting of multiple assets or assets that are more valuable than the total principal portion of the rental payments (thereby reducing the practical risk of nonappropriation); may not be legally possible or feasible.


3. Protections against completion/acquisition risk include:

(a) Entering into the lease after final design and cost estimates are complete and only slightly before commencement of construction or acquisition.

(b) Requirements for construction contract which include builder’s “all risk” insurance during construction, performance and payment bonds and liquidated damages for delay.

(c) Capitalized interest through completion of construction/acquisition and acceptance by lessee.

4. Title insurance in respect of the leased property reflecting ownership or leasehold interest of lessor and mortgage loan or leasehold loan interest of lessor’s assignee (which may be a trustee for the owners of COPs).

5. Analysis of appraised or insured value (replacement cost) of leased property.

6. Provisions relating to condemnation powers of lessee in respect of the leased property. Credit problems coupled with a difficult negotiation situation (i.e., the inability to compromise with the lessor or the lessor’s assignee) may cause a lessee to attempt to condemn the leased property at a value that is less than the principal balance of a lease as in the 1996 Sheridan, Colorado situation.

7. Irrevocable assignment by a lessor to a bank trustee representing COP Investors.

8. Remoteness of risk of bankruptcy of lessor to the COP Investors.

9. Casualty and rental interruption (particular for “abatement” theory) insurance requirements.

10. Reserve fund relating to failure to pay or appropriate rental payments.

11. For purposes of the UCC and in light of the prevalence of electronic searches requiring precise names, incorporation of a provision confirming the lessee’s/debtor’s legal name may be a prudent course of action (especially where the lessee/debtor does not file articles of incorporation with any particular secretary of state).

12. Lessee’s restrictions on further assignments and/or servicing.

13. For installment contracts or leases dependent upon savings (such as energy savings), whether there will be sufficient time for the lessee to realize such savings in relation to the first lease payment, and whether capitalized interest should be considered.

14. Whether a lease is subject to continuous renewal (absent nonappropriation) or whether a lease is subject to annual termination and affirmative renewal.


III. OTHER COMMON NON-TRADITIONAL FINANCINGS

A. Revenue Bonds. Revenue bonds are payable solely from revenues from a specific source or pooled revenues from various sources, and are intended for “self-liquidating” projects. Under the “special fund doctrine,” obligations payable from a specific source rather than ad valorem property taxes or general municipal funds do not qualify as “debt” and are generally excluded from debt limitation calculations in most states. In some states, however, a pledge of gross rather than net revenues can create a debt by obligating the issuer to pay operation and maintenance expenses from general funds. Revenue bonds may be project-based (payable from user fees such as water or sewage charges) or tax-based (payable from specific project oriented taxes such as hotel and motel taxes dedicated to a convention center issue). Questions may arise as to what types of income constitute “revenues.” Also, a practical prerequisite to the validity or enforceability of revenue bonds secured by an encumbrance of the revenue of a system (such as a water and sewage system) is the ownership of the system by the municipal authority issuing the bonds or a valid assignment of some other entity’s revenues.

In Volusia County v. State, 417 So. 2d 968 (Fla. 1982), the Court held that a municipality could not pledge all non-ad valorem revenues received by the county and also covenant to maintain services necessary to collect such fees, fines, etc., as this creates an indirect pledge of ad valorem taxes. Compare with Murphy v. City of Port St. Lucie, 20 Fla. Law W., 666 So. 2d 879 (1995) (holding that special assessment bonds for water and sewer lines were valid without referendum despite the ability to budget and appropriate debt service funds solely from non-ad-valorem revenues. The court distinguished these bonds from Volusia County because the non-ad-valorem revenues were considered a supplemental source of revenue and no provision existed requiring the City to continue services for the purpose of generating income to pay the bonds). In Terry v. Mazur, 234 Va. 442, 362 S.E.2d 904 (1987), state revenue bonds secured by highway user excise and other vehicle taxes violated the special fund doctrine and were considered “debt.”

Issuers typically give bondholders a first lien on revenues, but operating, maintenance, and administrative expenses are usually payable before debt service. In addition, reserve funds and restrictive covenants as to use, maintenance of insurance, continued existence of issuer, etc., are usually required. Restrictions on additional debt (parity tests) and covenants to set rates (rate covenants) at sufficient levels to provide debt service coverage of 1.25-1.5 times maximum annual debt service are also typical.

Bondholders’ security may not be diminished by diverting revenues pledged. U.S. Trust Co. of New York v. New Jersey, 431 U.S. 1, 97 S. Ct. 1505, 52 L. Ed. 2d 92 (1977) (repeal of covenant restricting ability of Port Authority of New York and New Jersey to use certain revenues pledged to bonds is a violation of contract clause of U. S. Constitution). But see EnergyReserves Group, Inc. v. Kansas Power & Light Co., 459 U.S. 400, 103 S. Ct. 697, 74 L. Ed. 2d 569 (1983); Board of Commissioners of Orleans Levee District v. Department of Natural Resources, 496 So. 2d 281 (La. 1986) (under the Energy Reserves test, there is “no showing that the act of legislature has taken from the bonds the quality of an acceptable investment for a rational investor;” absent an “alteration of contract, remedy or security device, or a danger of default,” bondholders cannot reasonably expect to prevent the state from the exercise of its sovereign powers).


B. Double-Barreled Obligations. Double-barreled obligations are secured both by full faith and credit and revenues from a particular project or a specified source. Procedural and other requirements vary in different jurisdictions. They are generally subject to referendum requirements, but may or may not be subject to debt limitations.

C. Bond Anticipation Notes (“BANS”). These short-term obligations are issued by states, municipalities and on behalf of issuers as a means of interim financing until a long-term bond can be issued. They are also used during high interest rate periods to avoid incurring long-term high interest rate debt. BANS may be either revenue or general obligation debt, but they are subject to the same debt limit and other restrictions of permanent financing. Generally, the state or municipality and the on behalf of issuer, if applicable, must adopt a resolution or ordinance providing for the long-term bonds prior to issuance of BANS so that no “political” risk of nonissuance remains, only “market access” risk.

D. Revenue and Tax Anticipation Notes and Grant Anticipation Bonds (“RANS”, “TANS” and “GARVEES”). These short-term borrowings are generally used by municipalities to level cash flows to match revenue and expenditure patterns during the fiscal year. Specific statutory authority generally outlines maturity limits and sources of repayment. Statutory authority for RANS may or may not define “revenues” precisely. In State Bond Commission of La. v. All Taxpayers, Property Owners, and Citizens of State of La., 525 So. 2d 521 (La. 1988), the Court upheld state revenue anticipation notes that pledged accrued revenues slightly beyond the current fiscal year because no new expenses would be incurred and no new revenues would be generated.

TANS are short-term municipal notes secured by taxes collected in the current fiscal year or by taxes receivable for one or more succeeding fiscal years. TANS have traditionally been exempted from debt limits. Davenport v. City of Rock Hill, 432 S.E.2d 451 (S.C. 1993). However, the tax must have actually been levied, and no obligation must accrue to the municipality aside from the obligation to pay from such taxes. See McQuillan, Law on Municipal Corporations § 41.25 (3d ed. 1995); Florence v. Anderson, 95 F.2d 777 (4th Cir. 1938) (tax anticipation note was general obligation of city). Tax and revenue anticipation notes (“TRANS”) combine the characteristics of both TANS and RANS.

Grant anticipation revenue vehicle bonds (“GARVEES”) are used to finance highway and transit projects. The security is federal highway funds as allocated annually to the state transportation agency. Other funds may be available as a backup if federal funds are delayed or canceled. Federal funds are not subject to annual appropriation by state legislatures since they flow directly to the state department of transportation. Although not technically a Garvee issue, the Garvee structure has been further developed so that local governments can issue bonds secured by anticipated state transportation revenues for highway construction. Some issuers have included other revenues as a part of the pledged revenues.

E. Assessment Financings. In many states, local infrastructure development has been financed by assessment financings, which are based upon the general premise that the citizens receiving special or particular benefits from a public improvement should bear the cost and expense of its installation. The cost of an extension of water/sewer services into an area may be assessed against the properties situated within the area that will be receiving the services.


Assessment financings may be secured by ad valorem taxes levied against the taxable property in the district or by special assessments calculated on the value of the benefit of the project received by any individual assessee. Contracts for local improvements where the cost of such improvements is payable from special assessments upon the property benefited and the municipality is not directly liable may be exempt from debt limits. See McQuillin, Law on Municipal Corporations §41.32 (3d ed. 1995); Wall v. Chicago Park Dist., 378 Ill 81, 37 N.E.2d 752 (1941) (holding that proposed lakeshore improvements payable from special assessments do not constitute debt subject to constitutional limitations); but see Covington v. McKenna, 99 Ky. 508, 36 S.W. 518 (1896) (holding it immaterial that such debts were payable from assessments on abutting property where the city is liable if assessments are insufficient).

Although assessment financings have historically been exempt from constitutional voting restrictions, there can be instances in which these types of financings are subject to voter approval. For example, California voters in 1996 adopted Proposition 218, which imposes a ballot protest procedure on assessment financings.

F. Tax Increment Financings. Tax increment bonds are special obligations secured by incremental increases in tax revenues paid by users of developed property or by general increases in taxable valuations within the tax increment area. Initially, tax increment financing (“TIF”) was used to assist in providing infrastructure and other public improvements for redeveloping blighted areas. Redevelopment commissions (or other TIF implementing authorities) are required by state law to identify a blighted area by a set of factors including age, obsolescence, deterioration of improvements, succession of growth and the like. State law may also require a showing that the blighted area will not be redeveloped by normal regulatory processes or the ordinary operation of private enterprise (See, e.g., 65 Illinois Compiled Statutes 5/11-74.4-1 et seq.). Courts have generally not substituted their judgment for that of local bodies in blight determination. But see City of Carbondale v. City of Marion, 155 Ill. Dec. 290, 210 Ill. App. 3d 870, 569 N.E.2d 290 (1991); Reed-Custer Community Unit School Dist. 255-U v. City of Wilmington, 192 III. Dec. 421, 253 Ill. App. 3d 503, 625 N.E.2d 381 (1993), modified on denial of rehearing, appeal denied 202 Ill. Dec. 930, 156 Ill. 2d 566, 638 N.E.2d 1124 (1994); HenryCounty Board v. Village of Orion, 278 Ill. App. 3d 1058, 663 N.E. 2d 1076 (1996) (reversing municipality’s determination of “blight” by rejecting municipality’s broad definition of “vacant” parcels for purposes of blight determination).

More recently, TIF has also been used for purely economic development. State law may permit redevelopment commissions to use redevelopment-like powers to pursue economic development without the determination that blight exists. Economic development purposes are generally fashioned after standards that have been upheld by courts in the context of economic or industrial development bonds. As the concept of redevelopment has evolved to include purely economic development, courts have focused on issues related to “public use” or “public purpose” and generally deferred to determinations by the state legislature and local governing bodies that redevelopment is itself a public use or public purpose. Tax increment financing is available in approximately 40 states. The taxes involved are usually ad valorem real and/or personal property taxes. Some states permit sales tax increment financing. State laws specify the mechanism and process for the implementation of TIF.


In general, the TIF process is similar to that for all economic and community development devices. A redevelopment plan is prepared, specifying a project and costs; a public hearing is set; notice of the hearing is given to affected taxpayers and taxing districts; the hearing is held and the plan and project are approved and adopted. In some cases, a mechanism to reverse it all may follow (e.g., petition and referendum). Incremental taxes may fund a project on a “pay as received” basis, or TIF revenue bonds or TIF general obligation bonds may be issued to pay the project costs.

Tax increment obligations do not generally constitute debt for the purpose of debt limitations. In re Request for Advisory Opinion in Constitutionality of 1986 PA 281, 430 Mich. 93, 422 N.W.2d 186 (1988); Denver Urban Renewal Authority v. Byrne, 618 P.2d 1374 (Colo. 1980). But see Muskogee, 899 P.2d 624 (Okla. 1995); City of Hartford v. Kirley, 172 Wis. 2d 191, 493 N.W.2d 45 (1992). When the TIF obligation is payable from ad valorem taxes, however, some states treat the obligation as municipal debt subject to constitutional restrictions. See City of Tucson v. Corbin, 128 Ariz. 83, 623 P.2d 1239 (1980), in which court held that tax increment bond law violated constitutional debt referendum requirements because the law allowed proceeds from ad valorem taxation to be used to secure payment of the bonds. Other courts have held that any obligation payable from general property tax revenues constitutes debt even though the revenues paid would not have been collected but for the obligation. See Richards v. City of Muscatine, 237 N.W.2d 48 (Iowa 1975); Miller v. Covington Development Authority, 539 S.W.2d 1 (Ky. 1976); Meierhenry v. City of Huron,354 N. W.2d 171 (S.D. 1984).

1. Challenging the Blight Determination in TIF Financings. TIFchallenges are often based in a challenge to the underlying blight determination. See Village of Wheeling v. Exchange National Bank of Chicago, 213 Ill. App. 3d 325, 572 N.E.2d 966, 157 Ill. Dec. 502 (1991) (the determination of finding allowing the taking of property was valid even though condemned parcels were not below code requirements because “blight” relates to the area as a whole); City of Marion, 155 Ill. Dec. 290, 210 Ill. App. 3d 870, 569 N.E.2d 290 (1991); City of Wilmington, 192 III. Dec. 421, 253 Ill. App. 3d 503, 625 N.E.2d 381 (1993); HenryCounty Board v. Village of Orion, 278 Ill. App. 3d 1058, 663 N.E. 2d 1076 (1996) (reversing a municipality’s blight determination where new sewer system was found to not substantially benefit the TIF district when only four of the district’s three hundred improved parcels were blighted due to inadequate sewage facilities and new building was already occurring within the district). Citizens have standing to challenge approval of a city’s condemnation of land for an urban renewal project that will provide a private college with new campus. BPOE v. Planning Bd., 403 Mass. 531, 531 N.E.2d 1233 (1988). But a neighborhood association lacks standing as an aggrieved person to contest a county development commission’s determination that a rural area is blighted. Union Twp. Resident’s Ass’n v. Whatley County Redevelopment Comm’n, Inc.,536 N.E.2d 1044 (Ind. App. 3 Dist. 1989).

2. Other Challenges to TIF Financing. The condemnation authority of TIFs has come under increasing scrutiny after the decision in Kelo v. City of New London, 545 U.S. 469 (2005), and many states are enacting state statutes restricting the condemnation authority of TIFs and municipalities in general.


Challenges to tax increment financing on the basis of constitutional tax limitations are usually resolved in favor of tax increment financing. In Michigan, the Supreme Court upheld a tax increment financing statute finding that it was not violative of the constitutional prohibition limiting the rate of general ad valorem taxes. The constitutional provision was found not to limit the legislature from capturing tax revenues attributable to future increases. In re Request for Advisory Opinion on Constitutionality of 1986 PA 281, 430 Mich. 93, 422 N.W.2d 186 (1988). A constitutional limitation on an increase in a tax base without an approving vote was held not to be violated by the tax increment statute because tax revenues from increased property values were in the nature of special assessments. Dennehy v. Department of Revenue, 305 Or. 595, 756 P.2d 13 (1988). But see City of Hartford, 305 Or. 595, 756 P.2d 13 (1988) (holding that TIF bonds would create debt because tax increments are not independent sources of revenue and the bonds are payable solely from general property tax revenue). Tax increment financing has also been challenged on the basis of an unconstitutional lending of the credit of the state or municipality. The court found that tax increment bonds did not fall within recognized exceptions to the constitutional limitation (a revenue bond exception or a special assessment exception) because the statute permitted the municipality to make a limited tax pledge to back up the bonds of the redevelopment authority. Despite this strict reading of the lending of credit provision, the court gave a broad reading to a public purpose provision that cleared the way for the court to uphold the tax increment statute’s constitutionality. In re Request for Advisory Opinion, 430 Mich. 93, 422 N.W.2d 186 (1988).

G. Special District Financings. The law of some states permits the establishment of single function or multi-function special districts. These districts may be established to provide both governmental services and a financing mechanism, or (as in the case of Mello Roos Community Facilities Districts established in California (Government Code §53311 – 53368.3)) may be created for the primary purpose of being a financing arm for public improvements and services provided by the municipality and not provided by the district itself. The law of some states (as in the case of Marks Roos Joint Powers Authorities established in California (Government Code §6584-6599.3)) allow the creation of bond pools for special districts.

In general, special district financings are supported by special tax levies within the district and do not constitute either debt of the landowners or general obligations of the municipalities. The boundaries of the district area subject to the special tax need not be the same as the jurisdictional boundaries of any local municipality (although creation of extra territorial boundaries may require utilization of joint agency and interlocal cooperation powers).

H. Applicable Debt Limitation Exceptions for These Common Non-Traditional Financings

1. Special Fund Doctrine and Revenue Obligations. In many states, the debt limitation does not apply to obligations which are payable from a special fund. In special fund financings, the debt authorizing documents restrict repayment of the debt to monies deposited in a special fund so that the special fund is not supplemented by the general funds of the issuer or by tax levies. If the special fund is ever insufficient, default on the debt occurs. In those states that apply the special fund doctrine, debt payable as described is held not to be included in calculations of the applicable debt limitation. See Winston v. City of Spokane, 12 Wash. 524, 41 P. 888 (1895) (water works bonds payable solely from system revenues put into


special fund by City; the only obligation assumed by the City was to pay into the special fund and in no manner was the City otherwise liable to pay for the bonds); Libertarian Party of Wisconsin v. State of Wisconsin, 199 Wis. 2d 790, 546 N.W. 2d 424 (1996) (citing the special fund doctrine, court held bonds to be issued by a baseball park district and payable only from stadium sale and use taxes not to be debt for purposes of constitutional debt limits); Baliles v. Mazur, 224 Va. 462, 297 S.E.2d 695 (1982) (upheld authority created to finance public buildings from revenue bonds payable from lease payments from state agencies, citing special fund doctrine); In re Advisory Opinion to the Governor: Public Drinking Water Protection Act of 1987, 556 A.2d 1000 (R.I. 1989) (pure drinking water bonds backed by “water quality protection charges” aren’t debt; “the vast majority of jurisdictions... have reached the same conclusion … by relying ... on the special-fund doctrine”). But see Dykes v. Northern Virginia Transportation District Comm’n., 242 Va. 357, 411 S.E.2d 1 (1991) (Transportation Commission bonds backed by annual appropriation county contracts violate debt limit; special fund doctrine held inapplicable); see also City of Hartford v. Kirley, 172 Wis. 2d 191, 493 N.W.2d 45 (1992) (TIF bonds constitute debt within meaning of constitutional debt limitations where TIF bonds were payable solely from general property tax revenue and city was absolutely obligated to pay for significant period of time. Unlike special assessments, tax increments are not independent sources of revenue nor is there a special tax. By contrast, special assessments are not part of the general property tax revenue); Contra People ex rel. City of Canton v. Crouch, 38 I 11. Dec. 154, 403 N.E. 2d 242 (1980).

Under the special fund doctrine, revenues pledged to the payment of the improvements generally must relate to such improvement. Kaminski v. Higgins, 257 S.C. 222, 185 S.E.2d 365 (1971) (business license taxes not sufficiently related to construction of police and fire house so special fund doctrine does not overcome debt limitation); Asson v. City of Burley, 105 Idaho 432, 670 P.2d 839 (1983) (one of the WPPSS-related cases-special fund doctrine requires revenues be derived from revenue-producing property so repayment contracts did not create revenue producing property because the projects were never completed); McBurny v. Ruth, 527 So. 2d 1265 (Ala. 1988) (state exhibit commission may issue revenue bonds backed by payments in lieu of taxes by a public corporation); Eakin v. State ex rel. Capital Improvement Board of Managers of Marion County, 474 N.E.2d 62 (Ind. 1985) (bonds backed by county hotel/motel tax and food and beverage tax count toward debt limit because tax revenues do not have a sufficient nexus to convention center financed with bonds). City of Hartford v. Kirley, 172 Wis. 2d 191, 493 N.W.2d 45 (1992) (court held that tax increment bonds would create debt because tax increments are not independent sources of revenue and the bonds are payable solely from general property tax revenue; however, it is worth nothing that the infrastructure constructed with the proceeds of the bonds did not generate revenues).

2. Contingent Obligation Exception. The second most prevalent method of avoidance of the debt limitation is the use of contingent obligations. If the obligation is contingent, it is not a debt so the debt limitation does not apply. See, e.g., Woodmansee v. Kansas Court, 346 Mo. 919, 144 S.W. 2d 137 (1940) (holding that bonds issued to enlarge public market and payable from revenues from enlarged market were not debt because they were contingent. If revenues were insufficient to pay for repairs to market, City agreed to use other sources of City income); Fladung v. City of Boulder, 165 Colo. 244, 438 P.2d 688 (1968) (contingent pledge of general credit to pay special assessment bonds after 80% have been retired does not create debt). See also Lillard v. Melton, 103 S.C. 10, 87 S.E. 421 (1915); Board of Supervisors of Fairfax


County v. Massey, 210 Va. 253, 169 S.E.2d 556 (1969). A conditional pledge of the issuer’s credit does not create debt. See Dean v. Kuchel, 35 Cal. 2d 444, 447, 218 P.2d 521 (1950) (contracts for furnishing of property in the future create no liability or indebtedness until consideration is actually furnished).

Not all states recognize the contingent obligation exception. New Mexico has adopted a very broad reading of its debt limitation provisions. In Hamilton Test Systems, Inc. v. City of Albuquerque, 103 N.M. 226, 704 P.2d 1102 (1985), the City was to perform the service of operating its motor vehicle emissions inspection program for five years. The court held that the City had contracted a “debt” and explained that “any agreement by which a municipality obligates itself to pay out of tax revenues, and commits itself beyond revenues for the current fiscal year, falls within the terms of the constitutional debt restriction.”

3. Service Contracts. Continuing service contracts where the locality agrees to pay in installments for water, electric or other public services may be excluded from debt limitations depending on whether the payment is conditional and contingent on provision of service or an unconditional obligation which only postpones the time of payment. See Armstrong v. County of Henrico, 212 Va. 66, 182 S.E.2d 35 (1971) (county agreement to procure materials and services necessary to operate sewer system did not create “debt”); Board of Supervisors v. Massey, 210 Va. 253, 169 S.E.2d 556 (1969) (upholding contract for furnishing transit services as contract for services conditioned on performance and not a present liability for future payments); McBean v. City of Fresno, 112 Cal. 159 (1896) (holding that City incurs debt each year on five-year sewage disposal contract only to the extent of services provided during that year).

4. Moral Obligations. Bonds backed by an agreement to “request” appropriations to make up any shortfall in debt service may not be a debt as long as there is no legal obligation of the municipality to provide financial assistance to meet debt service requirements. See, e.g., Harrison v. Day, 202 Va. 967, 121 S.E.2d 615 (1961) (revenue bonds of port authority not general obligation debt even though authority required to “urgently request” appropriations to cover cost of project and there was an “expectation” of appropriations); Baliles v. Mazur, 224 Va. 462, 297 S.E.2d 695 (1982) (upheld authority created to finance public buildings from revenue bonds payable from lease payments from state agencies, citing “special fund” doctrine; where there is no pledge of full faith and credit, bonds are not general obligations even if special fund consists entirely of state appropriated money); Dykes v. Northern Virginia Transportation Commission, 242 Va. 357, 411 S.E.2d 1 (1991) (even though “practical effect” was that county would continue to make payments, no debt created where county’s payment obligation was expressly contingent upon county’s appropriation of funds for such payments).

5. Short-Term Borrowings. Short-term (current fiscal year) borrowings in anticipation of revenues or taxes typically are not debt. See Davenport v. City of Rock Hill, 432 S.E. 2d 451 (S.C. 1993). The general rationale is that these types of obligations are payable from currently levied taxes and, therefore, are not debt.

6. Involuntary Obligations. In a minority of states, debt limitations are not applicable to an indebtedness or liability imposed by law. See Welch v. Strother, 74 Cal. 413, 16 P. 22 (1887) (salaries of municipal officers fixed by law are not indebtedness within scope of


constitutional debt limits); American Can v. City of Lakeport, 220 Cal. 548, 32 P.2d 622 (1934) (obligation of city to transfer money into a bond redemption fund); State v. Bentley, 98 Kan 442, 157 P 1197 (1916). In addition, many states have held that debt limitations do not apply to involuntary obligations arising as a result of torts. Raynor v. King County, 2 Wash. 2d 199, 97 P.2d 696 (1940); G.W. Jones Lumber Co. v. Marmarth, 67 N.D. 309, 272 N.W. 190 (1937) (debt limit does not invalidate bonds issued to compromise tort judgment).

7. Nonrecourse Obligations. Special districts or authorities may be created with specific (not general) taxing powers or power to levy fees. Usually bonds are exempt from debt limits and referendum requirements where the act authorizing the district or authority specifically provides that neither the city nor the state is liable for the debt. Wein v. City of New York, 36 N.Y.2d 610, 331 N.E.2d 514, 370 N.Y.S.2d 550 (1975) (Stabilization Reserve Corporation could sell bonds with proceeds to be paid by the city without violating prohibition against lending of the city’s credit for a public corporation since Act stated that the city was not liable for the debt and any appropriation would be a gift); Wash. Const., art. VIII, § 9 (authorizing state building authority to issue bonds solely upon its own credit and specifically exempting such bonds from debt limitations). See also Appeal of German, 27 Pa. Commw. 108, 366 A.2d 311 (1976) (development corporation’s bonds are not city debt); In re Request for Advisory Opinion Enrolled Senate Bill 558 (1976 Pa. 240), 400 Mich. 311, 254 N. W.2d 544 (1977) (state building authority could lease a building to the state and use the rental payments to pay its revenue bonds since it was the state’s pledge of its general taxing power, not its use of general taxing power to meet ordinary expenses, which was limited by the constitution); Salmonv. Birmingham Parking Authority, 204 Ala. 226, 314 So. 2d. 687 (1975) (where municipal parking authority was to have access to certain limited city funds and pay excess revenues to the city, bonds were not general obligations of the city since no bondholders could sue the city for payment); Pierce County v. Keehn, 34 Wash. App. 309, 661 P.2d 594 (1983) (no taxpayer initiative is available for county-created local sewer improvement district debt). But see Martin v. Oregon Buildings Authority, 276 Or. 135, 554 P.2d 126 (1976) (state building authority’s bonds constituted invalid debt because bond payment was to come from state’s general fund and was not related to charges for facilities or services).

I. Pooled Financings. Section 149(f)(6)(A) of the Code states, in general, the term “pooled financing bond” means any bond issued as part of an issue more than $5,000,000 of the proceeds of which is reasonably expected to be used to make or finance loans to two or more ultimate (conduit) borrowers. Generally, pooled financing bonds are issued to reduce issuance costs and lower interest rates to the conduit borrowers through an economy of scale concept and enhancement of credit quality by diversifying the credit quality of the conduit borrowers. Pooled financings fall into three basic categories: (i) tax-exempt issues, the proceeds of which are used to make loans that themselves may or may not be tax-exempt, (ii) bond bank type issues, the proceeds of which are used to make loans to, and purchase the tax-exempt obligations of, local government issuers, and (iii) COPs in grantor trusts, the corpus of which is funded with tax-exempt notes of local government issuers. The obligation described in clause (i) (known as a “basic pooled financing”) derives its tax-exemption from the top down, i.e., the overall issue fails the private activity bond and loan tests and may or may not qualify for a rebate exception. The pooled obligations described in clauses (ii) and (iii) arguably derive their tax-exemption and rebate liability or exception from the bottom up, i.e., these obligations are equal to the sum of


their parts in that each local government issuer for its own stand-alone tax-exemption and rebate liability or exception.

1. History. Pooled loan restrictions were first enacted into law as part of the Tax Reform Act of 1984 that placed limitations on bonds issued for consumer loan purposes, providing simply that not more than five percent of the proceeds of the issue could be used to make or finance loans to persons other than governmental or 501(c)(3) entities. The consumer loan provisions were tightened as a part of the Tax Reform Act of 1985 that renamed consumer loans to be “private loans” and limited such loans to the lesser of $5,000,000 or five percent of the proceeds of the issue, treating loans to anyone but governmental entities as private loans. In the years that have followed, both Congress through legislation and the IRS through the Treasury Regulations have imposed additional requirements dealing with tax-exempt bonds and the application of their proceeds to make or finance loans, regardless of whether the loans are made to governmental entities, providing that certain reasonable expectations must be met in order for the bonds to qualify as tax-exempt obligations. Bond banks have existed in Canada for more than 50 years, and have been in use in the United States for over 45 years. The first bond bank in the United States was established in Virginia in 1969. Since then most states have one or more bond banks existing within their borders to serve as an issuer for one or more types of local government issuers.

2. Advantages of Pooled Financings. These often are thought to include (a) economies of scale through reduced issuance costs on a per borrower basis, improved name recognition of a frequent issuer and larger bond sizes sold to investors, and (b) diversification of credit risk.

3. Disadvantages of Pooled Financings. These typically are thought to include (a) the “Weakest Link” Theory, (b) competition with other pool issuers, (c) creation of additional federal tax issues, (d) the elimination of the “qualified tax-exempt obligation” designation under Section 265(b)(3) of the Code, and (e) the creation of additional disclosure issues.

4. Disclosure Issues. Questions that often arise when addressing this subject include:

(a) How active should the local government issuers be in the disclosure preparation? The level of involvement and disclosure is based on the size of the pool, the particular local government issuer’s annual repayment obligations compared to the total annual repayment obligation, the type of repayment obligations being pledged in the pool and the debt service coverage within the pool.

(b) Is the pooled financing a blind pool and dedicated pool or a recycling pool?

(c) How should the obligations of Continuing Disclosure under Rule 15c2-12 be addressed?

5. Basic Federal Tax Issues. Some of the more material basic federal tax issues that arise include the following:


(a) Expectations Requirements/Failure to Realize Expectations for blind pools. This issue normally arises when the pooled financing is a blind pool. Section 149(f)(2) of the Code provides that a pooled financing bonds is not tax-exempt unless at the time of issuance of the bonds, the issuer reasonably expects that at least 30% of the net proceeds will be used within one year to make loans and 95% of the net proceeds will be used within three years to make loans. In order to show compliance with this reasonable expectations test, issuers sometimes conduct some sort of a demand survey. This is not currently required under the applicable laws, but if one is used, then the IRS has closely scrutinized the elements and quality of the demand survey. Therefore, bond counsel needs to review this survey and its results very closely and compare them against any applicable industry standards.

(b) Failure to meet Loan Tests. If an issuer fails to use at least 30% of the net proceeds within one year to make loans and 95% of the net proceeds within 3 years to make loans, the bonds must be redeemed within 90 days of the one year and three year periods in amounts that would result in compliance with these requirements. This will require special redemption provisions for fixed rate bonds in blind pools and may require special termination provisions in swaps relating to variable rate bonds in blind pools.

(c) Written Loan Commitment Requirements. Prior to the issuance of pool bonds, the issuer must have "written loan commitments identifying the ultimate potential borrowers of at least 30% of the net proceeds." What are written loan commitments? Are these commitments from the issuer to the borrowers or from the borrowers to the issuer? In any event, it has to be something less than actual loans having been made since section 149(f)(2)(A)(i) only requires an expectation to loan 30% of the net proceeds within one year. Does the use of the language "ultimate potential borrowers" suggest that there is a problem if the issuer does not in fact make the loans identified in the written commitments? The use of the word "ultimate" suggests that result, but the use of the word "potential" clearly suggests otherwise. Exceptions to written loan commitment requirements include (i) issuers that are states or integral parts of states (e.g., state agencies) issuing bonds to make loans for "subordinate governmental units,” and (ii) state-created issuers "providing financing for water-infrastructure projects through federally sponsored state revolving fund programs."

(d) Multipurpose Allocations. With the promulgation of Treasury Regulations section 1.141-13(d), all multipurpose allocations of bonds for any Code section 141 purpose must comply with the requirements of Treas. Reg. §1.148-9(h). The problems with making a multipurpose allocation include: (i) the excess private use within one loan cannot be offset by no private use within other loans; (ii) in order to have an allocation of pool bonds to each loan that is other than pro rata, the pool bonds have to be structured in a manner that lines up with the loans and, if any of the loans are being made for a refunding, allows for another 1.148-9(h) allocation method to be viable. If all loans are not made at closing, that may only be possible by dictating the loan terms to the local government issuers. In pool deals where the loans are made at subsidized rates (below the issuer's borrowing rate) there are likely to be significant mismatches; and (iii) in the case of redemption of bonds to effect remedial action, care must be taken to redeem the right bonds. The same applies if a local government issuer simply wants to pay off its loan and go forward with no tax restrictions on the financed asset or if a local government issuer wants to refund its way out of the pooled bond financing. The benefits with making a multipurpose allocation include: (i) the possible ability to isolate bad loans,


(ii) the ability to allow for multiple $15 million limitations to apply to a single pool issue, and (iii) the ability to receive the full 10% private use under the private activity bond rules.



14. LEASES & OTHER NON-TRADITIONAL FINANCINGS


What We Will Cover

• Overview of General Obligation Bonds• Leases and Installment Payment Contracts• Other Common Non-Traditional Financings• Pooled Financings


General Obligation Bond Overview

• Common Elements• Backed by full faith and credit• Payable from taxes• May require voter approval

• Benefits• Low default risk for investors• Simpler documentation

• Limitations and Disadvantages• Uses of proceeds • Amounts may be limited by constitution or statute• May not want to use property taxes for repayment



Leases/Installment Payment Contracts• Common Elements

• Lessee is state or local governmental entity• Installment payments with a specified interest

component• Acquiring the use of, and, in many cases, title to,

real or personal property• In most jurisdictions does not constitute “debt” for

state law purposes

• Benefits• Do not constitute “debt” for state law purposes• No encumbrance of revenues


Leases/Installment Payment Contracts (cont.)

• Two types of Leases• Capital Leases-- involves the transfer of title to the

real or personal property to the state or political subdivision at the end of the lease; or

• True Leases or Tax-exempt Use Leases--involves no transfer of title to the property to the state or political subdivision at the end of the term.


Forms of Leases• Annual Quid Pro Quo Leases

• Current Liability• Fair Rental Value

• Annual Appropriation Leases• Legal Liability• Compulsion to Appropriate

• Abatement Leases • Vesting of Title at End of Term • Rents Subject to Abatement



Forms of Leases (cont.)• Limited Tax Full Faith and Credit Leases

• The Oregon Example

• Special Fund Leases and Related Variants

• Special Fund Leases• Annual Appropriation Tax-Supported Leases

• “Asset Transfer” Lease Financing Transactions

• State Law Issues• Potential Advantages


Categories of Lessors• Private entities, financial institutions and

insurance companies• Certificates of Participation (“COPs”)

• “On Behalf Of” Lessors• Constituted Authorities• 63-20 Corporations


Basic Lease Concerns• Is the Lease Valid?

• Statutory Authority Analysis• Valid Provisions Analysis• Valid Procurement Analysis• Debt Analysis• Usury Law Analysis• Proper Authorization Analysis• Tax Levy Analysis



Forms of Leases (cont.)• Limited Tax Full Faith and Credit Leases

• The Oregon Example

• Special Fund Leases and Related Variants

• Special Fund Leases• Annual Appropriation Tax-Supported Leases

• “Asset Transfer” Lease Financing Transactions

• State Law Issues• Potential Advantages


Categories of Lessors• Private entities, financial institutions and

insurance companies• Certificates of Participation (“COPs”)

• “On Behalf Of” Lessors• Constituted Authorities• 63-20 Corporations


Basic Lease Concerns• Is the Lease Valid?

• Statutory Authority Analysis• Valid Provisions Analysis• Valid Procurement Analysis• Debt Analysis• Usury Law Analysis• Proper Authorization Analysis• Tax Levy Analysis


Basic Lease Concerns (cont.)• Are the Owners’/Investors’ Interests Adequately Protected?

• Essentiality Analysis• Title Analysis• Lease Ownership Analysis• Perfection of Security Interest Analysis• Credit Enhancement Analysis• Payment/Budget Analysis• Abatement Analysis


Basic Lease Concerns (cont.)• Does the lease trigger unexpected state or local taxes?

• Ad Valorem Tax Analysis• Sales and Use Tax Analysis• Franchise Tax Analysis• Covenant Regarding Payment of Taxes

• Has the lessee formally accepted the equipment financed by a lease?


Basic Lease Concerns (cont.)

• Federal or State Securities Laws Issues• Securities/Exempt Securities Analysis• Initial/Continuing Disclosure Analysis• Dodd-Frank Act Analysis



Basic Lease Concerns (cont.)• Federal Income Tax Issues

• State or Political Subdivision Analysis• Capital Lease/True Lease Analysis• Interest Component Analysis• Registered Form Analysis• Private Activity Bond Analysis


Basic Lease Concerns (cont.)• Federal Income Tax Issues (cont.)

• Federal Guarantee Analysis• Arbitrage/Rebate Analysis• Investment Trust Analysis• Form 8038 Reporting• “Qualified Tax-Exempt Obligation” Analysis


Basic Lease Concerns (cont.)

• COP Transaction Issues• Lessee as a Party to the Trust Agreement• Specific Legislation Analysis• COP Opinions


Provisions Normally Included in Leases

• Lease payments reflecting the expected completion date of the construction and the expected remaining useful life of the leased property

• Leased property consisting of multiple assets or assets that are more valuable than the total principal portion of the rental payments (thereby reducing the practical risk of nonappropriation); may not be legally possible or feasible


Provisions Normally Included in Leases (cont.)

• Protections against completion/acquisition risk• Entering into the lease after final design and cost estimates are

complete and only slightly before commencement of construction or acquisition

• Requirements for construction contract which include builder’s “all risk” insurance during construction, performance and payment bonds and liquidated damages for delay

• Capitalized interest through completion of construction/acquisition and acceptance by lessee



• Owner’s and Loan Title Insurance Policies• Appraisals on the property• Limitations on condemnation powers with respect to the

property--1996 Sheridan, Colorado situation• Irrevocable assignment by a lessor to a bank trustee

representing COP Investors



Provisions Normally Included in Leases

• Lease payments reflecting the expected completion date of the construction and the expected remaining useful life of the leased property

• Leased property consisting of multiple assets or assets that are more valuable than the total principal portion of the rental payments (thereby reducing the practical risk of nonappropriation); may not be legally possible or feasible



• Protections against completion/acquisition risk• Entering into the lease after final design and cost estimates are

complete and only slightly before commencement of construction or acquisition

• Requirements for construction contract which include builder’s “all risk” insurance during construction, performance and payment bonds and liquidated damages for delay

• Capitalized interest through completion of construction/acquisition and acceptance by lessee



• Owner’s and Loan Title Insurance Policies• Appraisals on the property• Limitations on condemnation powers with respect to the

property--1996 Sheridan, Colorado situation• Irrevocable assignment by a lessor to a bank trustee

representing COP Investors




• Remoteness of risk of bankruptcy of lessor to the COP Investors

• Casualty and rental interruption insurance (particularly for “abatement” leases)

• Reserve fund relating to failure to pay or appropriate rental payments



• For purposes of the UCC and in light of the prevalence of electronic searches requiring precise names, incorporation of a provision confirming the lessee’s/debtor’s legal name may be a prudent course of action (especially where the lessee/debtor does not file articles of incorporation with any particular secretary of state)

• Lessee’s restrictions on further assignments and/or servicing



• For installment contracts or leases dependent upon savings (such as energy savings), provision for sufficient time to realize such savings in relation to the first lease payment through capitalized interest

• Provisions for a lease subject to continuous renewal (absent nonappropriation), annual termination or affirmative renewal




• Remoteness of risk of bankruptcy of lessor to the COP Investors

• Casualty and rental interruption insurance (particularly for “abatement” leases)

• Reserve fund relating to failure to pay or appropriate rental payments



• For purposes of the UCC and in light of the prevalence of electronic searches requiring precise names, incorporation of a provision confirming the lessee’s/debtor’s legal name may be a prudent course of action (especially where the lessee/debtor does not file articles of incorporation with any particular secretary of state)

• Lessee’s restrictions on further assignments and/or servicing



• For installment contracts or leases dependent upon savings (such as energy savings), provision for sufficient time to realize such savings in relation to the first lease payment through capitalized interest

• Provisions for a lease subject to continuous renewal (absent nonappropriation), annual termination or affirmative renewal


Other Common Non-Traditional Financings

• Revenue Bonds—obligations payable solely from one or more sources of specific revenues

• Double-Barreled Obligations—obligations secured both by full faith and credit and revenues from a particular project or a specified source

• Bond Anticipation Notes (“BANS”)—short-term obligations used as a means of interim financing until a long-term bond can be issued

• Revenue and Tax Anticipation Notes (“RANS” and “TANS”)—short-term obligations used to level cash flows to match revenue and expenditure patterns during the fiscal year

• Grant Anticipation Revenue Bonds (“GARVEES”)—bonds issued in anticipation of federal highway or other grants used as a source of repayment for the bonds


Other Common Non-Traditional Financings (cont.)

• Assessment Financings—obligations secured by assessments against the individuals or properties receiving the benefits from the improvements

• Tax Increment Financings—obligations secured by incremental increases in tax revenues paid by users of developed property or by general increases in taxable valuations within the tax increment area

• Special District Financings—obligations issued by a special statutory entity that provides both governmental services and financing and secured by special tax levies within the district separate from the municipality


Applicable Debt Limitation Exceptions for Common Non-Traditional Financings

• Special Fund Doctrine and Revenue Obligations• Contingent Obligation Exception• Service Contracts• Moral Obligations• Short-Term Borrowings• Involuntary Obligations• Nonrecourse Obligations



Pooled Financings• Definition

• Section 149(f)(6)(A) of the Code states, in general, the term “pooled financing bond” means any bond issued as part of an issue more than $5,000,000 of the proceeds of which is reasonably expected to be used to make or finance loans to two or more ultimate (conduit) borrows.

• Types• Tax-exempt issues—the proceeds are used to make loans that themselves

may or may not be tax-exempt; (known as a “basic pooled financing”) these issues derive their tax-exemption from the top down, i.e., the overall issue fails the private activity bond and loan tests and may or may not qualify for a rebate exception


Pooled Financings (cont.)• Types (cont.)

• Bond Bank issues—the proceeds are used to make loans to, and purchase the tax-exempt obligations of, local government issuers; these issues derive their tax-exemption and rebate liability or exception from the bottom up, i.e., these obligations are equal to the sum of their parts in that each local government issuer is responsible for its own stand-alone tax-exemption and rebate liability or exception

• COPs in grantor trusts—the corpus is funded with tax-exempt notes of local government issuers; these issues derive their tax-exemption and rebate liability or exception from the bottom up, i.e., these obligations are equal to the sum of their parts in that each local government issuer is responsible for its own stand-alone tax-exemption and rebate liability or exception.


Pooled Financings (cont.)• History

• Tax Reform Act of 1984• Tax Reform Act of 1985• Post-Tax Reform Act of 1986• Canada• United States



Pooled Financings (cont.)

• Advantages of Pooled Financings• Economies of Scale• Diversification of Credit Risk


Pooled Financings (cont.)• Disadvantages of Pooled Financings

• “Weakest Link” Theory• Competition with Other Pool Issuers• Additional Federal Tax Issues• “Qualified Tax-Exempt Obligation” Elimination• Additional Disclosure Issues





15. Demystifying DTC

Faculty:David J. Fernandez Buchanan Ingersoll & Rooney PC – New York, NY Matthew O. Gray Butler Snow LLP – Denver, CO Lois Radisch The Depository Trust & Clearing Corporation, New York, NY

I. INTRODUCTION AND OVERVIEW OF KEY TERMS USED IN THIS SESSION.

A. Cede & Co. - the nominee of DTC.

B. DTC - The Depository Trust Company.

C. Participant – banks, broker-dealers, clearing corporations, and other financial organizations that maintain accounts at DTC.

D. Certificated Form – a security, bond or other evidence of debt represented by one or more physical certificates.

E. Uncertificated Form – a security, bond or other evidence of debt that is held electronically; e.g. holders of the security do not receive physical certificates representing their interests in the securities.

F. FAST – Fast Automated Securities Transfer Program.

G. FRAC – Fast Rejection and Confirmation.

H. DWAC – Deposit or Withdrawal at Custodian.

II. WHAT IS DTC?

A. DTC is a U.S. registered clearing agency for securities.

B. DTC provides depository, custody, book-entry transfer, and related asset servicing for securities that satisfy the eligibility requirements provided in the DTC rules and procedures.

C. DTC is a wholly-owned subsidiary of The Depository Trust & Clearing Corporation (“DTCC”).


1. DTCC is the holding company for DTC, National Securities Clearing Corporation (“NSCC”), and Fixed Income Clearing Corporation, all of which are registered clearing agencies.

2. DTCC is owned by the users of its clearing agency subsidiaries. DTC rules and procedures (the “Rules”) are required to be filed with, and approved by the Securities and Exchange Commission, and are publicly available on DTC’s website located at http://www.dtcc.com.

III. WHY WAS DTC CREATED?

A. Before the creation of DTC and NSCC, all securities were held in Certificated Form.

B. DTC was created in 1973 to address inefficiencies of the then-current system, to lower the costs of trading securities in the primary and secondary market, and to reduce the overall risk in the clearance and settlement of securities transactions.

C. With the exception of direct purchase transaction, in which DTC is typically not involved, most securities are certificated and held in some manner by DTC making it the largest securities depository in the world.

IV. WHAT DOES DTC DO AND HOW DOES IT WORK?

A. DTC accepts deposits of eligible securities from its Participants which maintain accounts at DTC.

B. Participants may deposit and hold interests in securities at DTC for their own account or for the account of others, and those for whose account they hold may in turn be holding for their own account or acting as intermediaries, holding for the accounts of others.

C. When eligible securities are deposited to DTC, DTC credits the accounts of appropriate Participants with an interest in those securities.

D. Securities are identified by their CUSIP number.

E. When such interests are transferred among Participants, DTC debits the account of a delivering Participant and credits the account of a receiving Participant.

F. Each CUSIP held by DTC is allocated among those Participants holding an interest in the security in accordance with the number/value of the securities of the CUSIP held by each Participant.

G. Transfers of securities must be made through Participants. Because securities held under the DTC system may (frequently) change ownership without physical delivery, the DTC system in effect “immobilizes” any securities that are still represented by physical certificates.


H. Eligible securities held at DTC may be certificated (that is, represented by one or more physical certificates) or uncertificated, so long as the registered owner on the books of the issuer, or its transfer agent, is Cede & Co., the nominee of DTC.

I. Only Participants have a legal relationship with DTC.

J. If the Participant is acting on behalf of its customers, the interest acquired by the customer as an actual purchaser of the securities (a “Beneficial Owner”) must be credited to an account on the Participant’s records. If, however, the customer of the Participant is itself a securities intermediary holding for its customer, the customer of the Participant would credit an interest in the securities to an account it maintains for its own customer.

K. Payments of principal and interest are made by the issuer to the paying agent/trustee, which in turn makes the payments to DTC. Such payments flow to the Participants and to the party ultimately entitled to receive such payments.

V. WHAT IS FAST?

A. The FAST Program and the FAST Agent.

1. Fast Automated Securities Transfer (“FAST”) Program.

2. Eliminates the necessity of physically transferring securities to DTC.

3. Allows a trustee/paying agent or transfer agent properly registered with DTC as a “FAST Agent” to act as custodian for DTC, and in that capacity to take delivery of the Certificated Form of the securities registered to Cede & Co., for and on behalf of DTC.

B. Frequently referred to as a “FAST closing.” A FAST closing results in a more efficient and economical delivery and settlement of the securities by avoiding delivery of the securities directly to DTC.

VI. OTHER DTC FEATURES AND FUNCTIONS.

A. Deposit or Withdrawal at Custodian (“DWAC”) Transactions. Deposits or withdrawals under the FAST program initiated by a Participant for purposes of transferring a position in the applicable security credited to that Participant’s DTC account.

B. FAST Rejection and Confirmation (“FRAC”).

1. FRAC is a function within the FAST program by which the FAST Agent, using an internal DTC system, may monitor the balance held by a Participant or any transferees of securities.

2. “Updating the FRAC”. This is the step in the closing process when the FAST Agent agrees with the underwriter regarding the aggregate original


principal amounts and CUSIPs posted on the FRAC function for the securities.

VII. DTC’S ROLE IN A BOND FINANCING.

A. DTC Eligibility Requirements.

1. Securities must be DTC eligible to use the DTC system.

2. Only Participants can request eligibility (e.g. the underwriter).

3. Online submission process: Securities Origination, Underwriting and Reliable Corporate Action Environment.

See http://www.dtcc.com/leadership/issues/reengineering/underwriting/registration.ph

4. Note that certain deadlines apply requiring ample lead time before the bond closing.

5. Letter of Representations.

a) A “Blanket Issuer Letter of Representations” allows all of the issuer’s eligible securities to be held at DTC. In public finance transactions, it is common for issuers to have executed a Blanket Issuer Letter of Representation covering both past and future issues, but this should be verified prior to submission of issue information to DTC. (A form is attached in Appendix A.)

b) Penalties may be assessed if the incorrect letter is used.

B. Disclosure and Documentation.

1. Language regarding DTC and its book-entry system is frequently included in underlying bond documents and disclosure.

2. Standard DTC disclosure is included in Schedule A to the attached Blanket Issuer Letter of Representations.

C. The Bond Closing.

1. After the appropriate documents have been submitted to make the securities DTC eligible, the underwriter will give relevant information to DTC regarding the new issuance in anticipation of the closing date.

2. DTC Closing Requirements that must be met include:

a) DTC must have received the certificated securities or DTC must have received confirmation that the trustee or bond registrar, as FAST Agent, has received such certificates as posted on the FRAC function.


b) No later than 1:15 PM Eastern time on the closing date, DTC’s closing department must receive a closing call from the underwriter and the trustee/bond registrar confirming the issue is closed. Extensions may be permitted in some situations.

D. Post-Closing.

1. Payments. Upon receipt of a payment of principal and/or interest on the securities, DTC allocates the aggregate amount received among Participants holding an interest in the applicable security and credits these ratable amounts to those Participant accounts, depending on (i) whether a single Participant holds the entire position, or several Participants hold partial positions, in the securities, and (ii) whether the payment in question is allocable among all Participants, as in the case of a scheduled interest payment, or only among certain Participants selected by DTC’s lottery system, as in the case of a partial redemption. Each Participant is then responsible for transmitting those payments to its customer or customers; and to the extent that those recipients are acting as intermediaries, they must likewise do the same to their underlying customers, and so on.

2. Investor communications and notices. Upon receipt of a notice, DTC posts the notice where it can be accessed electronically by Participants. Each Participant is then responsible for transmitting those notices to its customer(s); and to the extent that those recipients are acting as intermediaries, they must likewise do the same to their underlying customer(s).


Appendix A – Blanket Issuer Letter of Representations






15. Demystifying DTC


Topics to be discussed:

• What is DTC? • The History of DTC• What does DTC do and how does it work?• DTC’s Role in a Municipal Bond Financing• After Closing: Interacting with DTC and Investors• Frequently Asked Questions


What is DTC?

• DTC is a U.S. registered clearing agency for securities• Why was DTC created?



Certain Key Elements of DTC – what does DTC do and how does it work?• FAST• Book-entry system• Administration and transfers:

• FAST• DWAC• FRAC


DTC’s Role in a Bond Financing

• Security Eligibility Requirements• The anatomy of the Blanket Issuer Letter of Representation• Documents and Disclosure

• DTC language in the disclosure document• The Bond Closing

• FAST Rejection and Confirmation (“FRAC”)• What the FRAC?


After Closing: Interacting with DTC and Investors

• Record Ownership vs. Beneficial Ownership• Payments and Communications Generally• Omnibus Proxy Service• Record Dates• Notices to Investors• Payments to Investors• Maturities• Redemptions• Other Events: Change of Trustee; “Holds” and “Suspensions”• Transfer Restrictions



Frequently Asked DTC Questions

• How do I help the issuer "sign up" for DTC in connection with the new issue?• What provisions pertaining to DTC should an issuer incorporate into its

financing documents?• What should an issuer disclose about DTC in the issuer's offering statements?• What is DTC's cutoff time for closing a new issue? • What is FRAC and why does it always need to be updated?• How is DTC notified of a new issue closing?


Frequently Asked DTC Questions (cont.)

• What is the sequence of events for a bondholder to be paid?• What does DTC require with respect to redemptions and advance refundings?• How is DTC compensated?• Can an Issuer request withdrawal of its securities from DTC?


Questions?



Frequently Asked DTC Questions

• How do I help the issuer "sign up" for DTC in connection with the new issue?• What provisions pertaining to DTC should an issuer incorporate into its

financing documents?• What should an issuer disclose about DTC in the issuer's offering statements?• What is DTC's cutoff time for closing a new issue? • What is FRAC and why does it always need to be updated?• How is DTC notified of a new issue closing?


Frequently Asked DTC Questions (cont.)

• What is the sequence of events for a bondholder to be paid?• What does DTC require with respect to redemptions and advance refundings?• How is DTC compensated?• Can an Issuer request withdrawal of its securities from DTC?


Questions?

Ethics Training Sessions Materials





16. Engagement Letters & Opinions (Ethics Credit)

Faculty:Angela W. Adolph Kean Miller LLP – Baton Rouge, LA S. Doug Williams Maynard, Cooper & Gale – Birmingham, AL David J. Fernández Buchanan Ingersoll & Rooney PC – New York, NY

Engagement Letters

I. GENERAL

A. The Model Rules of Professional Conduct (adopted by the ABA in 1983, as amended, the “Model Rules”) have been adopted in most jurisdictions (although the rules adopted in many states have not adhered, verbatim in all respects, to the Model Rules). The Model Rules are applicable to Bond Counsel. See generally The Function and Professional Responsibilities of Bond Counsel, NABL 2011 Edition (available at www.nabl.org/uploads/cms/documents/nabl_function_and_professional_responsibilities_of_bond_counsel.pdf)

B. Model Rule 1.5(b) provides that the terms of an engagement shall be communicated to the client, preferably in writing, before or within a reasonable time after commencing the representation.

C. Benefits to Bond Counsel and the issuer if engagement letters are consistently used may include:

1. Minimizing disagreements or misunderstandings 2. Focusing attention on the conditions and guidelines that will govern the

proposed attorney-client relationship 3. Addressing conflicts before they occur 4. Calling attention to areas where additional representation may be required

D. The purpose of Model Engagement Letters, National Association of Bond Lawyers (“NABL”), 1998 Edition (“Model Engagement Letters”) is to provide guidance subject to varying state rules and practices.

E. Key components of engagement letters:

1. Identification of the client


2. Scope of bond counsel services 3. Compensation arrangements 4. Conflicts of interest and waivers of such conflicts 5. Other provisions (optional)

II. IDENTIFICATION OF CLIENT

A. Mandatory under Model Rules - Model Rule 1.1 requires that an attorney provide competent representation to a client. Prior to adoption of the Model Rules, Bond Counsel was deemed “counsel to the transaction” or “counsel to the bondholders”.The Model Rules do not allow this position. See B.L.M. v. Sabo & Deitsch et al., 64 Cal. Rptr. 2d 335 (Cal. App. 4th, 1997) where the court specifically rejected the theory that Bond Counsel was counsel to the transaction.

B. Once client is identified, only then can Bond Counsel analyze:

1. Duties of loyalty 2. Confidentiality 3. Privilege 4. Communications5. Conflict/consents

C. Bond Counsel is not acting as an intermediary (see Comment to Model Rule 1.7) where all parties become a client and confidentiality and privilege are lost.

D. General legal principles impose duties on Bond Counsel running to non-clients that might have severe consequences if breached:

1. Agency2. Representation and reliance 3. Statutory rules – civil and criminal relating to securities transactions

E. Governmental Bonds

1. Address to governmental entity, with an attention line to the person to whom the authority has been lawfully delegated to:

a. engage Bond Counsel b. receive communications c. give consent, if necessary

2. Reserve right to communicate directly with the governing body. See ModelRule 1.13.

3. Implications of Sarbanes/Oxley.


F. Conduit Bonds:

1. Engagement letter to issuer, which the NABL Model Engagement Letters generally assume is the Client.

2. Fee letter to the Conduit Borrower – if responsible for fee as is typical 3. Payment of the issuer’s fees by Conduit Borrower does not create multiple

representations. Opinion of the Virginia State Bar Standing Committee on Legal Ethics No. 546 (March 1, 1984).

G. Memorandum to other parties stating that the issuer is the Bond Counsel’s client (applicable to both governmental and conduit bond engagements), addressing:

1. Scope of Bond Counsel’s representation. 2. Limitation of Bond Counsel’s representation. 3. Co-counsel.4. Reliance on other counsel. 5. Bond Counsel may contact other parties directly (i.e., not through their counsel), unless otherwise advised in writing. 6. Attach engagement letter to issuer if it doesn’t include confidential information.

Bond Counsel’s obligation to render an objective legal opinion in a public finance transaction is very frequently a responsibility owed to more than one party but this fact does not mean that each party relying on the Bond Counsel’s opinion is a client.

III. STRUCTURE OF TRANSACTION

A. Specify:

1. Parts of the transaction 2. Nature of transaction: competitive vs. negotiated public offering; private

placement; bank purchase 3. Security, including use of credit enhancement

B. Amend engagement letter if structure changes.

IV. SCOPE OF ENGAGEMENT

A. Model Rule 1.2 provides that a lawyer shall abide by decisions of a client concerning objectives of representation.

B. Model Rule 1.2 allows a lawyer to limit the scope of representation if limitation is reasonable and client gives informed consent.


C. Model Rule 2.3 provides that a lawyer may provide an evaluation of a matter affecting a client for use by others, however, if the evaluation will materially and adversely affect the client’s interest, the client must give consent.

D. Specific language to address Bond Counsel rules with respect to disclosure matters.

E. Reliance on other counsel as to matters other than validity:

1. Pending litigation 2. Opinion of counsel of credit enhancers 3. 501(c)(3) status of conduit borrower

F. Modification if Co-Bond Counsel – See Model Rule 1.5(e). See also TheSelection and Evaluation of Bond Counsel, NABL 1998.

G. Advice client – what representation is not assumed by Bond Counsel due to reliance on other opinions.

H. “The Engagement Letter should clearly set forth when the attorney-client relationship between bond counsel and the issuer will be concluded. In most transactions, the relationship terminates upon delivery of the opinion.” Model Engagement Letters at page 28. (Note: some duties – filing 8038’s and preparing transcripts - may still exist.)

1. Disengagement letters 2. Separate engagement letter for post-closing advice

V. COMPENSATION

A. The issuer may be asked to countersign fee letter for a governmental issue.

B. Many Bond Counsel fees are contingent (or effectively contingent) on closing. A contingent fee is permitted, but under Model Rule 1.5 a contingent fee must be in writing (unless a state’s particular language in adopting such rule provides otherwise).

C. Fee letter sent to Conduit Borrower for a conduit transaction.

D. Co-Bond Counsel – Model Rule 1.5(e) discusses parameter for division of a fee between lawyers who are not in the same firm.

VI. CONFLICTS

A. Directly adverse – Model Rule 1.7(a)(1) B. Material limitation – Model Rule 1.7(a)(2)


C. Former clients – Model Rule 1.9 D. Consent - certain jurisdictions will not permit consent by governmental issuers to

a conflict. See Freivogel Conflicts: A Guide to Conflicts of Interest for Lawyers, citing authorities in various states including Gallagher v. Atlantic City Bd. Of Ed.,2010 U.S. Dist. LEXIS 13509 (D.N.J. Feb, 17, 2010).

E. ABA Formal Opinion 93-372 and 05-436 addresses ethical permissibility and effectiveness of obtaining advance consent for a conflict arising in the future.

F. Recent case: The law firm is not disqualified from representing creditors pressing claims in bankruptcy against the conduit bond indenture trustee just because the firm in a separate matter has provided legal representation to the trustee. In re Muma Services, Inc. 286 B.R. 583 (2002).

VII. OTHER PROVISIONS

A. Retention of records – benefits of having a consistent policy

B. Practice pointer – potentially include statement in responding to request for proposal that the attorney-client relationship is created only upon selection of Bond Counsel and receipt of signed engagement letter

C. Indemnification provisions should be avoided: - negligence standard applies - makes Bond Counsel a guarantor - cause of action against Bond Counsel arising out of contract, rather than

negligence might not be covered by Bond Counsel’s professional liability policy. See Ethics–Conflicts of Interest and Engagement Letters, Bond Attorneys Workshop, 2007.

D. Arbitration clauses. ABA Formal Opinion 02-425 held that arbitration clauses can be inserted into retainer agreements. However, certain states may prohibit such agreements. S.C. Stat. Ann. §15-48-10 purports to bar arbitration clauses in “[a] pre-agreement entered into when the relationship of the contracting parties is such that [sic] of lawyer-client. Id. §15-48-10(b)(3). However, agreements involving interstate commerce are subject to arbitration under the Federal Arbitration Act, 9 U.S.C. §2 (2002), which serves to pre-empt state limits on arbitrability. See Munoz v. Green Tree Financial Corporation, 343 S.C. 531, 542 SE2d 360 (2001). “A great many (but by no means all) projects undertaken by lawyers for their clients involve dealing with Commerce sufficient to invoke the FAA’s reach.” John Freeman, Lawyers and Corporate Disgrace, South Carolina Lawyer, page 11, January 2003.

E. Consider disclaiming responsibility for providing financial advice (and may not be covered by malpractice insurance). See Ethics–Conflicts of Interest and Engagement Letters, Bond Attorneys Workshop, 2007.


F. Consider drafting a Termination Letter in the private activity setting for deals which have a sustained period of absolute inactivity. See Ethics–Conflicts of Interest and Engagement Letters, Bond Attorneys Workshop, 2008.

G. Consider disclaiming responsibility for post-closing matters such as IRS or SEC investigations.

Opinions

I. BOND COUNSEL OPINION

A. Historical Evolution of Bond Counsel Opinion

1. Bonds sold entirely on strength of the issuer’s representation and/or local counsel.

2. Discuss a. ultra vires

b. lack of public purpose c. debt limit violation d. absence of voter approval

3. Underwriters/purchasers obtained opinions from experts that would not act as advocate for the issuer and examine transcript of proceedings.

4. Bond issue accompanied by an opinion of recognized Bond Counsel could have better market acceptance.

B. Primary Opinion

Bond counsel “may render an ‘unqualified’ opinion regarding the validity and tax exemption of bonds if it is firmly convinced (also characterized as having a ‘high degree of confidence’) that, under the law in effect on the date of the opinion, the highest court of the relevant jurisdiction, acting reasonably and properly briefed on the issues, would reach the legal conclusions stated in the opinion.” ModelBond Opinion Report, NABL Committee on Opinions and Documents, 2003 Edition (“2003 Report”), page 7. The 2003 Report purports to supercede portions of The Function and Responsibilities of Bond Counsel, NABL 1995 Edition, and Statement Concerning Standard Applied in Rendering the Federal Income Tax Portion of Bond Opinions adopted by the NABL Board on November 29, 1993. Prior standard was “it would be unreasonable for a court to hold to the contrary”, Model Bond Opinion Report, NABL, 1997 Edition (“1997 Report”).

C. Reliance Letters of Bond Counsel may be addressed to:

Trustee Underwriter Conduit Borrower


Credit Enhancer

D. The Bond Counsel opinion must be printed on or attached to certificated bonds (“good delivery” under Municipal Securities Rulemaking Board Rules G‐12 and G‐15).

E. Ethics Considerations in Opinion Practice

1. Model Rule 1.1 – Competencea. state and local governmental law b. tax law c. securities law

2. Model Rule 1.2 – Scope of Representationa. Lawyers shall abide by a client’s decisions concerning the

objectives of the representation. b. Issues concerning objectivity in rendering the opinion and

counsel’s duties to parties who are not clients may impose limits on the client’s ability to direct the activities of counsel.

3. Model Rule 1.3 – Diligence requires reasonable diligence and promptness in representing a client.

4. Model Rule 2.3 – This rule concerns evaluation by a lawyer of a matter affecting a client for the use of someone other than the client. This rule is the closest recognition in Model Rules to bond opinion practice.

5. Model Rule 4.3 – Dealing with Unrepresented Person

6. The 2003 Report provides model opinions for: General obligation bonds, revenue bonds (not private activity bonds), and private activity bonds that are conduit financing bonds

F. Key Elements of the Opinion

1. Date of the Opinion

a. Dated as of date of original issuance date of original delivery of and payment for the bonds

b. Speaks only as of its date and no undertaking to update c. Reflects law and facts on such date.

2. Addressees of the Opinion

a. Issuer


b. Underwriter or designated managing underwriter if acting for a syndicate (or reliance letter)

c. Trustee (or reliance letter) d. Conduit borrower (or reliance letter) e. “Bond opinion, by its very nature, is intended to be relied on by

non-clients, such as underwriters, bondholders, and any trustee for the bondholders”. 2003 Report at page 5. See also Model Rule 2.3.

f. The bond purchase agreement often specifies that Bond Counsel’s client has directed Bond Counsel to deliver its opinion to specified parties.

3. Salutation a. Not necessary b. Can follow local practice

4. Identification of Client The client should be clearly identified in the opinion

5. Description of Bond Issue and Transaction Providing a brief summary of the transaction, but avoid detailed description of, including, but not limited to maturities, interest rates, registration privileges, terms of redemption.

6. Scope of Examination a. Describe, generally what Bond Counsel has examined. In such

capacity (Bond Counsel), we have examined such law and such certified proceedings, certifications (added in 2003 Report), and other documents as we have deemed necessary to render this opinion.

b. Reliance on certified proceedings

c. Without undertaking independent investigation to verify the same

7. “Unqualified Opinion” a. This opinion should be subject only to customary assumptions,

limitations and qualifications.

b. It is important to remember standard in Section I(B) of this outline:

i. for issues of state law – relevant court is highest court of that state; and

ii. for issues of federal law – U.S. Supreme Court

c. The standard for federal income tax matters is that you are “firmly convinced that, upon due consideration of the material facts and all


of the relevant sources of applicable law on federal income tax matters described below, the Supreme Court would reach the federal income tax conclusions stated in the opinion or the IRS would concur or acquiesce in the federal income tax conclusions stated in the opinion”. 2003 Report at page 8.

d. Materials you may need to review and analyze include:

i. Internal Revenue Code, including temporary and final regulations

ii. Statutes

iii. Congressional intent as expressed in committee reports

iv. Joint explanatory statements of managers included in Congressional Conference Committee reports

v. Congressional floor statements made prior to enactment by one of a bill’s managers

vi. IRS and Treasury administrative pronouncements (revenue rulings, revenue procedures, notices and “written determinations”) which may be relied on formally as precedent

e. Appropriate consideration may also need to be given to more precedential IRS administrative guidance such as:

i. proposed regulations

ii. IRS private letter rulings

iii. IRS technical advice memoranda

iv. IRS general counsel memoranda

v. IRS Actions on Decision

8. An opinion is not a guaranty of an outcome, but rather an expression of professional judgment. Third-Party Closing Opinions: A Report of the TriBar Opinion Committee, 53; Business Lawyer, 591, 596, cited in 2003 Report at page 8. See Circular 230 (31 CFR Part 10), which governs practice before the IRS; proposed regulations under Circular 230 (proposing standards for practice before the IRS relating to state or local bond opinions); and the interim definition of State or Local Bond Opinion under §10.35(b)(9), which is applicable to opinions rendered after June 20, 2005 (2005-26 I.R.B. 1373, June 27, 2005).


G. Basic Opinions

1. The Bonds have been duly authorized and executed by the issuer.

2. The Bonds are valid and binding [general] obligations of the issuer. (The 2003 Report does not use “enforceable”).

3. Describe the security and/or source of repayment for the bonds.

4. Discuss the Federal income tax status of the bonds

a. excludable (2003 Report) vs. excluded (1997 Report)

b. definition of Code as Internal Revenue Code of 1986, as amended

c. conditions to federal tax opinion

i. Issuer has covenanted to comply with Code

ii. Failure to comply causes interest to be included retroactively to date of issuance

iii. Issuer covenants to comply with all requirements of the Code – implies ongoing compliance, not just on dated date

iv. Failure to comply can result in loss of tax exemption retroactively

d. opinion only addresses excludability of interest from gross income (as defined in Code Section 61)

e. address applicability of alternative minimum tax imposed on individuals and corporations by Code Section 55

f. other tax consequences, such has tax treatment of Social Security, Railroad Retirement benefits, deductibility of interest by financial institutions

i. better practice could be to address in disclosure document

g. Code Section 265(b)(3) – “qualified tax-exempt obligation”

h. original issue discount

i. no reference to arbitrage bonds since consumed by tax exemption opinion

j. taxable bonds – affirmatively state

5. The 2003 Report recommends not listing: “neither necessary or desirable”. 2003 Report at page 12.

6. State Tax Exemption

a. Discuss opinion is on a state-by-state basis


7. Bankruptcy and Equitable Principles

a. Discuss generally applicable to creditor’s rights

8. Credit Enhancement

a. can refer to bond insurance, letter of credit

b. can take exception in bond opinions with respect to excludability of interest on the bonds after such change

9. Unnecessary Provisions:

a. Disclaimer of responsibility regarding creditworthiness – unnecessary because bond opinions should not be construed to render such matter. 2003 Report at page 17.

b. Contingent fees – does not impact ethical responsibilities.

c. Litigation: can still render unqualified opinion if “bond counsel is satisfied that a material adverse outcome is remote and if terms of the sale permit delivery of the bonds in these circumstances”. 2003 Report at page 18.

i. Bond Counsel can rely upon “no merit” opinion of other counsel if Bond Counsel satisfied as to competence

ii. Describe in disclosure document

H. Supplemental Bond Counsel Opinions Regarding Disclosure Document

1. Securities laws – federal

a. Securities Act of 1933 – offering and sale of bonds exempt from registration

b. Trust Indenture Act of 1939 – exemption of trust indenture from qualification under the Trust Indenture Act of 1939

2. Securities laws – state

a. No opinion rendered

b. Reference to police powers – inherent in governmental statutes of issuer

I. Bond Counsel Opinions unique to Revenue Bonds

1. No opinion regarding the perfection or priority of the lien on revenues or other funds. “We note that, unless perfected, the lien on Revenues may not be effective.” 2003 Report at page 21.

2. Provide enforceable opinion regarding the revenue pledge.


J. Bond Counsel Opinions unique to Private Activity Bonds

1. Describe Trust Indenture and Loan Agreement

2. Reference to, and reliance on, Opinions of Other Counsel

a. Reliance – such as opinion as to 501(c)(3) status of conduit Borrower

b. Reference – such as opinion of bank counsel as to enforceability of letter of credit

3. Special language for:

a. Small issue bonds – Code Section 144(a)

b. Exempt facility bonds – Code Section 142

c. Mortgage revenue bonds – Code Section 123

d. Qualified student loan bonds – Code Section 144(b)

e. Qualified redevelopment bonds – Code Section 144(c)

K. Exploding Opinions – opinions that cease to be applicable under certain circumstances

L. Reasoned Opinions

M. Qualified Opinions

II. DISCLOSURE COUNSEL OPINION

A. Typically addressed to issuer

B. Deals with disclosure document – Rule 10b(5)

III. UNDERWRITER’S COUNSEL LETTER

A. Addressed to the underwriter(s)

B. Deals with disclosure document and bond purchase agreement

C. See Model Letter of Underwriter’s Counsel, NABL, 1999.



16. Engagement Letters & Opinions (Ethics Credit)


Engagement Letters


• Benefits of Engagement Letters• Minimize disagreements or misunderstandings• Focus attention of conditions that govern the attorney-client

relationship• Define scope of services



• Benefits of Engagement Letter (cont.)• Identify any consents and disclosures upon which consents are based • Specify client's obligations• Call attention to areas requiring additional representation or necessity

for other professionals


• Key Components of engagement letters:• Addressee• Identification of the client• Scope of engagement/services (nature and purpose of the transaction)• Compensation arrangements• Conflicts of interest (and waivers thereof)• Other provisions (optional)


Opinions



• Benefits of Engagement Letter (cont.)• Identify any consents and disclosures upon which consents are based • Specify client's obligations• Call attention to areas requiring additional representation or necessity

for other professionals


• Key Components of engagement letters:• Addressee• Identification of the client• Scope of engagement/services (nature and purpose of the transaction)• Compensation arrangements• Conflicts of interest (and waivers thereof)• Other provisions (optional)


Opinions


• Background• What is an opinion?• Third party opinion practices in business transactions generally• Origin of bond counsel and the bond opinion


• Municipal bond opinion practice• Municipal market custom and practice – the “approving opinion”• NABL opinion standard• Circular 230


• Opinions in municipal bond transactions• Bond counsel approving opinion• Bond counsel supplemental opinion• Issuer counsel opinion• Borrower counsel opinion• Underwriter counsel opinion



• Opinions in municipal bond transactions (cont.)• Disclosure counsel opinion• Trustee counsel opinion• Other – opinions of counsel to credit enhancer/liquidity provider, etc.


• Bond Counsel Approving Opinion• Validity• Tax Exemption (Federal, State, other)• Reliance aspects• NABL Opinion Report• Ethics considerations


• Bond Counsel Supplemental Opinion• Negotiated context• Description of bonds and security and document summaries• Registration of bonds (and “separate securities”)



• Opinions in municipal bond transactions (cont.)• Disclosure counsel opinion• Trustee counsel opinion• Other – opinions of counsel to credit enhancer/liquidity provider, etc.


• Bond Counsel Approving Opinion• Validity• Tax Exemption (Federal, State, other)• Reliance aspects• NABL Opinion Report• Ethics considerations


• Bond Counsel Supplemental Opinion• Negotiated context• Description of bonds and security and document summaries• Registration of bonds (and “separate securities”)


• Issuer counsel opinion• Sale context: competitive or negotiated• Historical context (“no litigation”)• Similarity to borrower counsel opinion


• Borrower counsel opinion• Similarity to third party closing opinions in debt transactions• “Negative assurances” regarding disclosure • 501(c)(3) opinions• Title/security matters


• Underwriter’s counsel opinion• Context of sale: negotiated/competitive• Addressee – Underwriter(s)• Negative assurance regarding disclosure• Registration of bonds• NABL’s Model Letter of Underwriter’s Counsel



• Disclosure counsel opinion• Differences with and similarities to underwriter counsel opinionAddresseeNegative assurances regarding disclosure


• Other opinions• Trustee counsel opinion• Opinions of counsel to credit enhancement or liquidity provider



• Disclosure counsel opinion• Differences with and similarities to underwriter counsel opinionAddresseeNegative assurances regarding disclosure


• Other opinions• Trustee counsel opinion• Opinions of counsel to credit enhancement or liquidity provider


May 4 – May 6, 2016 – Chicago, Illinois

17. Conflicts of Interest & Ethical Issues (Ethics Credit)

Faculty:Kimberly J. Min Whiteford, Taylor & Preston, LLP – Baltimore, MD Hal Patrick Harris Beach PLLC – Albany, NY

I) EVOLUTION, PURPOSE AND ROLE OF BOND COUNSEL

A) Historical role was to review transcript and provide underwriters or investors with objective opinion of independent counsel that bonds were valid and enforceable obligations of the issuer. Bond counsel was not viewed as an advocate for the issuer.

B) Today, bond counsel are lawyers engaged to provide an expert and objective legal opinion with respect to validity and other subjects, including tax treatment of interest on bonds. The opinion is an objective judgment rather than a partisan position or “advocacy”.

C) Evolution from representation of “the transaction” to representation of at least one party to the transaction.

1) Important to identify client in order to determine how to analyze and deal appropriately under Model Rules with situations involving duties of loyalty, confidentiality, privilege, communication and consent.

2) Client must be an entity capable of receiving communications and, if necessary, giving consent.

3) Some portion of the representation may involve more of an “advocacy” role than the purely objective function inherent in the rendering of a bond counsel opinion.

D) Who is the client may vary depending on the circumstances.

E) Even if bond counsel identifies a client, it may owe duties to third parties, including bondholders, based on common law and statutory concepts such as misrepresentation, reliance and agency. See also Model Rule 2.3: Evaluation For Use By a Third Person.

II) RULES GOVERNING LAWYERS

A) Model Rules of Professional Conduct (adopted in 1983) form the basis for state rules in forty-seven states and the District of Columbia.


B) Model Code of Professional Responsibility (adopted in 1970 to replace the outdated Canons of Professional Ethics originally adopted in 1908) - still the basis for state rules in New York.

C) Securities and Exchange Commission Rules of Practice - Rule 102(e).

D) Internal Revenue Code and rules regulating participants in various transactions (e.g.,Section 6700, “Circular 230,” [31 CFR Part 10]).

E) Various state laws regulating, inter alia, criminal and tortious actions; California and Maine established their own ethics rules.

III) RULES GOVERNING THE CLIENT-LAWYER RELATIONSHIP

{Not all of the Model Rules and/or Comments are included in this outline, only those that are proposed for discussion at this seminar. The complete text of the Model Rules and applicable Comments may be found on the web at www.americanbar.org. Seminar participants are urged, in any event, to consult the applicable ethical and related rules adopted in such participant’s respective jurisdiction.}

A) Model Rule 1.1 Competence

A lawyer shall provide competent representation to a client. Competent representation requires the legal knowledge, skill, thoroughness and preparation reasonably necessary for the representation.

Comment

Legal Knowledge and Skill

[1] In determining whether a lawyer employs the requisite knowledge and skill in a particular matter, relevant factors include the relative complexity and specialized nature of the matter, the lawyer’s general experience, the lawyer’s training and experience in the field in question, the preparation and study the lawyer is able to give the matter and whether it is feasible to refer the matter to, or associate or consult with, a lawyer of established competence in the field in question. In many instances, the required proficiency is that of a general practitioner. Expertise in a particular field of law may be required in some circumstances.

[2] A lawyer need not necessarily have special training or prior experience to handle legal problems of a type with which the lawyer is unfamiliar. A newly admitted lawyer can be as competent as a practitioner with long experience. Some important legal skills, such as the analysis of precedent, the evaluation of evidence and legal drafting, are required in all legal problems. Perhaps the most fundamental legal skill consists of determining what kind of legal problems a situation may involve, a skill that necessarily transcends any particular specialized knowledge. A lawyer can provide adequate representation in a wholly novel field through necessary study. Competent representation can also be


provided through the association of a lawyer of established competence in the field in question.

{Parts [3] through [8] of Comment are omitted from this outline intentionally.}

Observations for Seminar Discussion (Not in Model Rules or Comment)

1) The role of bond counsel involves particularly specialized knowledge, including that of federal tax legislation and regulation, federal and state securities laws and principles of law affecting state and local government.

2) Issues may arise that require knowledge of other practice areas (e.g., regulatory, property, utility, healthcare, etc.). Key is understanding what legal issues are raised and answering them or finding someone to participate who knows how to answer them.

3) See also Canon 6, A Lawyer Should Represent a Client Competently.

While the licensing of a lawyer is evidence that he has met the standards then prevailing for admission to the bar, a lawyer generally should not accept employment in any area of the law in which he is not qualified. However, he may accept such employment if in good faith he expects to become qualified through study and investigation, as long as such preparation would not result in unreasonable delay or expense to his clients. Proper preparation and representation may require the association by the lawyer of professionals in other disciplines. A lawyer offered employment in a matter in which he is not and does not expect to become so qualified should either decline the employment or, with the consent of his client, accept the employment and associate a lawyer who is competent in the matter. EC 6-3.

4) DR 6-101 prohibits a lawyer from handling a matter “which he knows or should know he is not competent to handle, without associating with him a lawyer who is competent to handle it.”

B) Model Rule 1.2 Scope of Representation and Allocation of Authority Between Client and Lawyer

(a) Subject to paragraphs (c) and (d), a lawyer shall abide by a client’s decisions concerning the objectives of representation and, as required by Rule 1.4, shall consult with the client as to the means by which they are to be pursued. A lawyer may take such action on behalf of the client as is impliedly authorized to carry out the representation. A lawyer shall abide by a client’s decision whether to settle a matter. In a criminal case, the lawyer shall abide by the client’s decision, after consultation with the lawyer, as to a plea to be entered, whether to waive jury trial and whether the client will testify.


(b) A lawyer’s representation of a client, including representation by appointment, does not constitute an endorsement of the client’s political, economic, social or moral views or activities.

(c) A lawyer may limit the scope of the representation if the limitation is reasonable under the circumstances and the client gives informed consent.

(d) A lawyer shall not counsel a client to engage, or assist a client, in conduct that the lawyer knows is criminal or fraudulent, but a lawyer may discuss the legal consequences of any proposed course of conduct with a client and may counsel or assist a client to make a good faith effort to determine the validity, scope, meaning or application of the law.

{Comment omitted from this outline intentionally.}


1) Consider whether the requirement of objectivity of bond counsel in rendering his or her opinion and bond counsel’s duties to non-clients limit the ability of the client to direct the scope of the engagement.

2) Desirability of engagement letters to set forth scope of engagement.

3) Under certain circumstances, bond counsel’s role may be more precisely limited (e.g., special tax counsel). This is permitted under Rule 1.2(c) provided that the client gives informed consent. “Informed Consent” is defined in Rule 1.0(e) and requires the attorney to adequately communicate to the client information and explanation about the risks of and alternatives to a proposed course of conduct.

4) Rule 1.2(d) and SEC Rule 205.3 may affect bond counsel’s ability to participate knowingly in a transaction involving inadequate disclosure to bondholders if that inadequacy amounts to a securities law violation.

(a) Prohibits a lawyer from counseling a client “to engage, or assist a client, in conduct that the lawyer knows is criminal or fraudulent, but a lawyer may discuss the legal consequences of any proposed course of conduct with a client and may counsel or assist a client to make a good faith effort to determine the validity, scope, meaning or application of the law” (emphasis supplied).

(b) The comments suggest that if a lawyer discovers that conduct that the lawyer originally thought was proper is, in fact, criminal or fraudulent, the lawyer must withdraw and, in some cases, “[i]t may be necessary for the lawyer to give notice of the fact of withdrawal and to disaffirm any opinion, document, affirmation or the like.”


(c) Also review SEC Rule 205, establishing standards of practice before the SEC.

5) See also DR 7-102, which provides that a lawyer shall not, among other things:

(a) Conceal or knowingly fail to disclose that which he is required by law to reveal;

(b) Knowingly make a false statement of law or fact;

(c) Counsel or assist his client in conduct that the lawyer knows to be illegal or fraudulent; or

(d) Knowingly engage in other illegal conduct or conduct contrary to a Disciplinary Rule

C) Model Rule 1.3 Diligence

A lawyer shall act with reasonable diligence and promptness in representing a client.

Comment

{Parts [1] through [3] and [5] of Comment are omitted from this outline intentionally.}

[4] Unless the relationship is terminated as provided in Rule 1.16, a lawyer should carry through to conclusion all matters undertaken for a client. If a lawyer’s employment is limited to a specific matter, the relationship terminates when the matter has been resolved. If a lawyer has served a client over a substantial period in a variety of matters, the client sometimes may assume that the lawyer will continue to serve on a continuing basis unless the lawyer gives notice of withdrawal. Doubt about whether a client-lawyer relationship still exists should be clarified by the lawyer, preferably in writing, so that the client will not mistakenly suppose the lawyer is looking after the client’s affairs when the lawyer has ceased to do so. For example, if a lawyer has handled a judicial or administrative proceeding that produced a result adverse to the client and the lawyer and the client have not agreed that the lawyer will handle the matter on appeal, the lawyer must consult with the client about the possibility of appeal before relinquishing responsibility for the matter. See Rule 1.4(a)(2). Whether the lawyer is obligated to prosecute the appeal for the client depends on the scope of the representation the lawyer has agreed to provide to the client. See Rule 1.2.



1) Consider when the lawyer/client relationship ends in a bond counsel relationship; should bond counsel send a letter evidencing the termination of the representation? Should bond counsel notify the investing public?

D) Model Rule 1.4 Communication

a) A lawyer shall:

(1) promptly inform the client of any decision or circumstance with respect to which the client’s informed consent, as defined in Rule 1.0(e), is required by these Rules;

(2) reasonably consult with the client about the means by which the client’s objectives are to be accomplished;

(3) keep the client reasonably informed about the status of the matter;

(4) promptly comply with reasonable requests for information; and

(5) consult with the client about any relevant limitation on the lawyer’s conduct when the lawyer knows that the client expects assistance not permitted by the Rules of Professional Conduct or other law.

(b) A lawyer shall explain a matter to the extent reasonably necessary to permit the client to make informed decisions regarding the representation.

Comment

{Parts [1] through [5] and [7] of Comment are omitted from this outline intentionally.}

[6] Ordinarily, the information to be provided is that appropriate for a client who is a comprehending and responsible adult. However, fully informing the client according to this standard may be impracticable, for example, where the client is a child or suffers from diminished capacity. See Rule 1.14. When the client is an organization or group, it is often impossible or inappropriate to inform every one of its members about its legal affairs; ordinarily, the lawyer should address communications to the appropriate officials of the organization. See Rule 1.13. Where many routine matters are involved, a system of limited or occasional reporting may be arranged with the client.


1) Providing sufficient information may better permit the client to make an informed decision as to the representation. To what extent does the education vary with the nature of the decision?


2) Lawyers should consider who is the appropriate person to be making the decision in the context of a governmental issuer. See, e.g., School District of the City of Pontiac, Michigan v. Miller, Canfield, Paddock & Stone, 563 N.W.2d 693 (Mich. Ct. App. 1997).

E) Model Rule 1.5 Fees

(a) A lawyer shall not make an agreement for, charge, or collect an unreasonable fee or an unreasonable amount for expenses. The factors to be considered in determining the reasonableness of a fee include the following:

(1) the time and labor required, the novelty and difficulty of the questions involved, and the skill requisite to perform the legal service properly;

(2) the likelihood, if apparent to the client, that the acceptance of the particular employment will preclude other employment by the lawyer;

(3) the fee customarily charged in the locality for similar legal services;

(4) the amount involved and the results obtained;

(5) the time limitations imposed by the client or by the circumstances;

(6) the nature and length of the professional relationship with the client;

(7) the experience, reputation, and ability of the lawyer or lawyers performing the services; and

(8) whether the fee is fixed or contingent.

(b) The scope of the representation and the basis or rate of the fee and expenses for which the client will be responsible shall be communicated to the client, preferably in writing, before or within a reasonable time after commencing the representation, except when the lawyer will charge a regularly represented client on the same basis or rate. Any changes in the basis or rate of the fee or expenses shall also be communicated to the client.

(c) A fee may be contingent on the outcome of the matter for which the service is rendered, except in a matter in which a contingent fee is prohibited by paragraph (d) or other law. A contingent fee agreement shall be in a writing signed by the client and shall state the method by which the fee is to be determined, including the percentage or percentages that shall accrue to the lawyer in the event of settlement, trial or appeal; litigation and other expenses to be deducted from the recovery; and whether such expenses are to be deducted before or after the contingent fee is calculated. The agreement must clearly notify the client of any expenses for which the client will be liable whether or not the client is the prevailing party. Upon


conclusion of a contingent fee matter, the lawyer shall provide the client with a written statement stating the outcome of the matter and, if there is a recovery, showing the remittance to the client and the method of its determination.

(d) A lawyer shall not enter into an arrangement for, charge, or collect:

(1) any fee in a domestic relations matter, the payment or amount of which is contingent upon the securing of a divorce or upon the amount of alimony or support, or property settlement in lieu thereof; or

(2) a contingent fee for representing a defendant in a criminal case.

(e) A division of a fee between lawyers who are not in the same firm may be made only if:

(1) the division is in proportion to the services performed by each lawyer or each lawyer assumes joint responsibility for the representation;

(2) the client agrees to the arrangement, including the share each lawyer will receive, and the agreement is confirmed in writing; and

(3) the total fee is reasonable.

Comment

{Parts [1] - [4] and [6] – [9] of Comment are omitted from this outline intentionally.}

[5] An agreement may not be made whose terms might induce the lawyer improperly to curtail services for the client or perform them in a way contrary to the client’s interest. For example, a lawyer should not enter into an agreement whereby services are to be provided only up to a stated amount when it is foreseeable that more extensive services probably will be required, unless the situation is adequately explained to the client. Otherwise, the client might have to bargain for further assistance in the midst of a proceeding or transaction. However, it is proper to define the extent of services in light of the client’s ability to pay. A lawyer should not exploit a fee arrangement based primarily on hourly charges by using wasteful procedures.


1) Integrally related to scope of engagement?

2) The comments note that the factors listed in the Rule as relevant to the reasonableness of the fee are not exclusive. What other factors could be considered in connection with the bond counsel engagement? See also EC 2-17 and EC 2-8 and DR 2-106 of the Model Code.


3) What issues are raised with a fixed fee that is competitively determined? See, e.g., EC 2-16 of the Model Code of Professional Responsibility.

4) The Model Rules provide essentially that both fees and expenses should be clearly communicated to client, with enough information to permit the client to make an informed decision concerning the representation. See also EC 2-19 of the Model Code. Both fees and expenses should be reasonable.

5) Many bond counsel fees are contingent upon successful issuance and delivery of the bonds. Special issues relating to contingent fees:

(a) Must be in a writing signed by the client.

(b) Does it compromise objectivity?

(c) Should a contingent arrangement be disclosed to potential bondholders?

6) Fee sharing arrangements - relationships with co-bond counsel may implicate these rules. See also EC 2-22 and DR 2-107 of the Model Code. Is joint responsibility for representation possible if counsel opine on different matters?

7) Counsel should keep in mind that some states have adopted versions of Rule 1.5 that depart in material respects from Model Rule 1.5 as shown above concerning matters, for example, covering the extent to which details as to fees and expenses must be set forth in a written engagement.

F) Model Rule 1.6 Confidentiality of Information

a) A lawyer shall not reveal information relating to the representation of a client unless the client gives informed consent, the disclosure is impliedly authorized in order to carry out the representation or the disclosure is permitted by paragraph (b).

(b) A lawyer may reveal information relating to the representation of a client to the extent the lawyer reasonably believes necessary:

(1) to prevent reasonably certain death or substantial bodily harm;

(2) to prevent the client from committing a crime or fraud that is reasonably certain to result in substantial injury to the financial interests or property of another and in furtherance of which the client has used or is using the lawyer’s services;

(3) to prevent, mitigate or rectify substantial injury to the financial interests or property of another that is reasonably certain to result or has resulted from the client’s commission of a crime or fraud in furtherance of which the client has used the lawyer’s services;


(4) to secure legal advice about the lawyer’s compliance with these Rules;

(5) to establish a claim or defense on behalf of the lawyer in a controversy between the lawyer and the client, to establish a defense to a criminal charge or civil claim against the lawyer based upon conduct in which the client was involved, or to respond to allegations in any proceeding concerning the lawyer’s representation of the client; or

(6) to comply with other law or a court order; or

(7) to detect and resolve conflicts of interest arising from the lawyer’s change of employment or from changes in the composition or ownership of a firm, but only if the revealed information would not compromise the attorney-client privilege or otherwise prejudice the client.

(c) A lawyer shall make reasonable efforts to prevent the inadvertent or unauthorized disclosure of, or unauthorized access to, information relating to the representation of a client.



1) Prior to 2003, the Model Rule version permitted disclosure of confidential client information in very limited circumstances - “to prevent reasonably certain death or substantial bodily harm,” in defense of the lawyer’s own interests, or to comply with other law or a court order. This rule was amended in 2003 to “more effectively protect the interests of the corporate client and to protect the professional integrity of the buyer from a client using his or her services to further a crime as fraud.” Report of the ABA Corporate Responsibility Task Force.

2) The rules applicable in most states tend to permit broader disclosure - as of 2004, 43 states permitted a lawyer to disclose confidential information to prevent a client’s criminal fraud; eighteen states permitted such disclosure to rectify substantial loss resulting from client crime or fraud, using the lawyer’s services; four of those states required a lawyer to make such a disclosure, and only nine states and the District of Columbia forbade a lawyer from revealing such information. See also “The Functions and Responsibilities of Bond Counsel”, 2011 Edition, at FN 68.

3) Query: Does the lawyer’s duty change with a public entity as a client, in light of open records and sunshine laws?

4) Note Comment 7 to Model Rule 1.6 which provides in part:

Although paragraph (b)(2) does not require the lawyer to reveal the client’s misconduct, the lawyer may not counsel or assist the client in conduct the lawyer


knows is criminal or fraudulent. See Rule 1.2(d). See also Rule 1.16 with respect to the lawyer’s obligation or right to withdraw from the representation of the client in such circumstances, and Rule 1.13(c), which permits the lawyer, where the client is an organization, to reveal information relating to the representation in limited circumstances.

5) Cf. EC 4-2 and DR 4-101 of the Model Code, which generally permit disclosure of client confidences or secrets only after the client consents after full disclosure, when permitted by the Disciplinary Rules or required by law or a court order, when the client intends to commit a crime and the information necessary to prevent the crime, or when necessary to collect a fee or defend himself.

6) See also EC 8-5 which provides:

Fraudulent, deceptive or otherwise illegal conduct by a participant in a proceeding before a tribunal or legislative body is inconsistent with fair administration of justice, and it should never be participated in or condoned by lawyers. Unless constrained by his obligation to preserve the confidences and secrets of his client, a lawyer should reveal to appropriate authorities any knowledge he may have of such improper conduct.

G) Model Rule 1.7 Conflict of Interest: Current Clients

(a) Except as provided in paragraph (b), a lawyer shall not represent a client if the representation involves a concurrent conflict of interest. A concurrent conflict of interest exists if:

(1) the representation of one client will be directly adverse to another client; or

(2) there is a significant risk that the representation of one or more clients will be materially limited by the lawyer’s responsibilities to another client, aformer client or a third person or by a personal interest of the lawyer.

(b) Notwithstanding the existence of a concurrent conflict of interest under paragraph (a), a lawyer may represent a client if:

(1) the lawyer reasonably believes that the lawyer will be able to provide competent and diligent representation to each affected client;

(2) the representation is not prohibited by law;

(3) the representation does not involve the assertion of a claim by one client against another client represented by the lawyer in the same litigation or other proceeding before a tribunal; and


(4) each affected client gives informed consent, confirmed in writing.



1) See Brown and Williamson Tobacco Corporation v. Pataki, 152 F. Supp. 2d 276 (S.D.N.Y. 2001) (Must know who client is in order to accurately identify actual or potential conflicts.).

2) It may be important to assess, in certain representations, the likelihood that a difference in interests will arise and if it does, whether it will materially interfere with the lawyer’s independent professional judgment in considering alternatives or foreclose courses of action that reasonably should be pursued on behalf of the client. This issue naturally depends on the applicable facts and circumstances.

(a) See In re Supreme Court Advisory Committee on Professional Ethics Opinion No. 697 (December 8, 2006), in which the New Jersey Supreme Court held that an attorney and his or her law firm are not per se prohibited from serving simultaneously as bond counsel and representing a private client before one of the boards, agencies or municipal court of the municipality.

3) Narrow rule of bond counsel [“mere scrivener”] may mitigate conflict issues.

4) Factors to consider may include, among potential others:

(a) Duration and intimacy of lawyer’s relationship with the client(s) involved.

(b) Functions being performed by the lawyer.

(c) Likelihood that disagreements will arise.

(d) Likely prejudice to the client from the conflict if it does arise.

5) Consider particularly dual representation of issuer as bond counsel and underwriter as underwriter’s counsel, in a negotiated as well as a competitive situation. Are the two roles “fundamentally antagonistic”?

(a) In Iowa, it previously appeared that consent would not cure the conflict. See Iowa Supreme Court, Board of Ethics and Conduct, Formal Ethics Opinion 95-20, dated February 22, 1996, and rendered under Iowa’s version of the Model Code; however, after Iowa adopted new standards based on the revised Model Rules, the same Board rendered Opinion 06-03 (November 6, 2006), which provides that a law firm may represent an issuer when it is already representing the underwriter in other, unrelated transaction, provided waivers are obtained after proper disclosure and those signing the waivers are sophisticated and experienced users of the legal


services involved. The question of dual representation in the same transaction remains unresolved in Iowa.

6) What conflict issues are raised if a lawyer’s fee is being paid by someone other than the client? Note Model Rule 1.8(f) which specifically prohibits an attorney from accepting compensation from a person other than the client unless:

(a) the client gives informed consent;

(b) there is no interference with the lawyer’s independence of professional judgment or with the client-lawyer relationship; and

(c) information relating to representation of a client is protected as required by Rule 1.6.

See also EC 2-21 of the Model Code.

7) If multiple representation is undertaken, the lawyer should fulfill any duty to explain the implications of the common representation and the advantages and risks involved. Examples of such considerations may include:

(a) Reduced cost and increased time efficiencies,

(b) Loss of confidentiality - see Rule 1.6 - communications from either client to the lawyer are neither confidential nor privileged with respect to the other client, and

(c) Inability to represent in adversarial situation. See West Contra Costa Unified School District v. RDS Architects, 2004 Cal. App. Unpub. LEXIS 11726 (Cal. App. Dec. 27, 2004).

8) Who can consent?

(a) See, e.g., State ex rel. Morgan Stanley & Co., Inc. v. MacQueen, 416 S.E. 2d 55 (W. Va. 1992).

9) Can a client consent to a future conflict? See Comment 22 to Model Rule 1.7; seealso ABA Op. 05-436 (March 11, 2005).

10) Cf. DR 5-101 and DR 5-105. Also see Section 10.29 of Treasury Department Circular 230, recognizing on inherent conflict between the issuer and its bond counsel in case of an IRS examination of a bond issue.

11) Also note Rule 1.18, which imposes duties on a lawyer’s relationship with prospective clients and potentially affects a lawyer’s ability to represent other parties if the lawyer receives information from the prospective client that could be significantly harmful to the prospective client in the matter.


H) Model Rule 1.9 Duties to Former Clients

a) A lawyer who has formerly represented a client in a matter shall not thereafter represent another person in the same or a substantially related matter in which that person’s interests are materially adverse to the interests of the former client unless the former client gives informed consent, confirmed in writing.

(b) A lawyer shall not knowingly represent a person in the same or a substantially related matter in which a firm with which the lawyer formerly was associated had previously represented a client

(1) whose interests are materially adverse to that person; and

(2) about whom the lawyer had acquired information protected by Rules 1.6 and 1.9(c) that is material to the matter;

unless the former client gives informed consent, confirmed in writing.

(c) A lawyer who has formerly represented a client in a matter or whose present or former firm has formerly represented a client in a matter shall not thereafter:

(1) use information relating to the representation to the disadvantage of the former client except as these Rules would permit or require with respect to a client, or when the information has become generally known; or

(2) reveal information relating to the representation except as these Rules would permit or require with respect to a client.



1) This issue may arise, for example, where a firm acts as underwriter’s counsel to a particular investment bank on some matters and also acts as bond counsel to an issuer in a transaction with that investment banking firm. Ask whether a subsequent bond issue is “the same or a substantially related matter.”

2) Comment to Rule 1.9 makes clear that a lawyer who has recurrently handled one type of matter for a client is not precluded from later representing another client in a wholly different problem of that type, even if the lawyer’s position is adverse to the former client’s position.

3) The client may waive the disqualification after consultation and with consent. Does the issuer’s “recommendation” of a particular firm as underwriter’s counsel where that firm had previously served as bond counsel to the issuer serve as “consent”?


I) Model Rule 1.13 Organization as Client

(a) A lawyer employed or retained by an organization represents the organization acting through its duly authorized constituents.

(b) If a lawyer for an organization knows facts from which a reasonable lawyer, under the circumstances, would conclude that an officer, employee or other person associated with the organization is engaged in action, intends to act or refuses to act in a matter related to the representation that is a violation of a legal obligation to the organization, or a violation of law that reasonably might be imputed to the organization, and that is likely to result in substantial injury to the organization, then the lawyer shall proceed as is reasonably necessary in the best interest of the organization. Unless the lawyer reasonably believes that it is not necessary in the best interest of the organization to do so, the lawyer shall refer the matter to higher authority in the organization, including, if warranted by the circumstances, to the highest authority that can act on behalf of the organization as determined by applicable law.

(c) Except as provided in paragraph (d), if

(1) despite the lawyer’s efforts in accordance with paragraph (b) the highest authority that can act on behalf of the organization insists upon or fails to address in a timely and appropriate manner an action or a refusal to act, that is clearly a violation of law, and

(2) the lawyer reasonably believes that the violation is reasonably certain to result in substantial injury to the organization,

then the lawyer may reveal information relating to the representation whether or not Rule 1.6 permits such disclosure, but only if and to the extent the lawyer reasonably believes necessary to prevent substantial injury to the organization.

(d) Paragraph (c) shall not apply with respect to information relating to a lawyer’s representation of an organization to investigate an alleged violation of law, or to defend the organization or an officer, employee or other constituent associated with the organization against a claim arising out of an alleged violation of law.

(e) A lawyer who reasonably believes that he or she has been discharged because of the lawyer’s actions taken pursuant to paragraphs (b) or (c), or who withdraws under circumstances that require or permit the lawyer to take action under either of those paragraphs, shall proceed as the lawyer reasonably believes necessary to assure that the organization’s highest authority is informed of the lawyer’s discharge or withdrawal.

(f) In dealing with an organization’s directors, officers, employees, members, shareholders or other constituents, a lawyer shall explain the identity of the client


when the lawyer knows or reasonably should know that the organization’s interests are adverse to those of the constituents with whom the lawyer is dealing.

(g) A lawyer representing an organization may also represent any of its directors, officers, employees, members, shareholders or other constituents, subject to the provisions of Rule 1.7. If the organization’s consent to the dual representation is required by Rule 1.7, the consent shall be given by an appropriate official of the organization other than the individual who is to be represented, or by the shareholders.



1) While the comments to the rule note that the rule specifically applies to a government organization as the client, “defining precisely the identity of the client and prescribing the resulting obligations of such lawyers may be more difficult in the government context.”

2) This rule is similar to the “up the ladder” reporting requirements of SEC Rule 205 (17 CFR Part 205). A potential difficulty for bond lawyers is in determining the chain of command - what level of authorization must be obtained?

3) Note that Paragraph (c) of the rule supplements Rule 1.6(b) by providing an additional basis upon which the lawyer may reveal information about the client.

4) What can the lawyer do to determine who is the responsible party at the client?

(a) Review statutes and other governing law (e.g., ordinances, charters).

(b) Consider having City Council adopt ordinance approving selection of lawyer and designating appropriate constituent to speak on behalf of the client.

J) Model Rule 1.16 Declining or Terminating Representation

(a) Except as stated in paragraph (c), a lawyer shall not represent a client or, where representation has commenced, shall withdraw from the representation of a client if:

(1) the representation will result in violation of the rules of professional conduct or other law;

(2) the lawyer’s physical or mental condition materially impairs the lawyer’s ability to represent the client; or

(3) the lawyer is discharged.


(b) Except as stated in paragraph (c), a lawyer may withdraw from representing a client if:

(1) withdrawal can be accomplished without material adverse effect on the interests of the client;

(2) the client persists in a course of action involving the lawyer’s services that the lawyer reasonably believes is criminal or fraudulent;

(3) the client has used the lawyer’s services to perpetrate a crime or fraud;

(4) the client insists upon taking action that the lawyer considers repugnant or with which the lawyer has a fundamental disagreement;

(5) the client fails substantially to fulfill an obligation to the lawyer regarding the lawyer’s services and has been given reasonable warning that the lawyer will withdraw unless the obligation is fulfilled;

(6) the representation will result in an unreasonable financial burden on the lawyer or has been rendered unreasonably difficult by the client; or

(7) other good cause for withdrawal exists.

(c) A lawyer must comply with applicable law requiring notice to or permission of a tribunal when terminating a representation. When ordered to do so by a tribunal, a lawyer shall continue representation notwithstanding good cause for terminating the representation.

(d) Upon termination of representation, a lawyer shall take steps to the extent reasonably practicable to protect a client’s interests, such as giving reasonable notice to the client, allowing time for employment of other counsel, surrendering papers and property to which the client is entitled and refunding any advance payment of fee or expense that has not been earned or incurred. The lawyer may retain papers relating to the client to the extent permitted by other law.



1) Mandatory withdrawal where the representation will result in a violation of the Rules or other law (See also DR 2-110(B) of the Model Code).

2) Withdrawal is permitted where, among other things:

(a) the attorney reasonably believes that the client is perpetrating a crime or fraud involving the attorney’s services;


(b) the client has used the attorney’s services to perpetrate a crime or fraud;

(c) the representation will result in an unreasonable financial burden on the attorney or has been rendered unreasonably difficult by the client. Query: how does this Rule fit in with fixed fee engagements where the scope of the underlying transaction changes substantially?

(d) Contrast DR 2-110(C) of the Model Code which permits withdrawal in only limited circumstances.

3) After withdrawal, the attorney is still bound to maintain client confidences, as required by Rule 1.6, unless disclosure is otherwise permitted by Rule 1.6. However, the attorney may give notice of the fact of withdrawal and may disaffirm any opinion, document, affirmation or the like.

4) Cf. proposed Rules under Sarbanes-Oxley where a counsel who has reported evidence of a material violation “up the ladder” and has not received an appropriate response would be required to withdraw as counsel and to notify the SEC of the fact of withdrawal and that the withdrawal was undertaken for “professional considerations.” Although this provision has not been adopted by the SEC, it is still under consideration. Under the general provisions of Rule 205, the requirements of the rule would effectively pre-empt inconsistent state law, although it would permit state enforcement of more stringent rules.

5) Cf. also EC 2-32 of the Model Rules (“A decision by a lawyer to withdraw should be made only on the basis of compelling circumstances. A lawyer should not withdraw without considering carefully and endeavoring to minimize the possible adverse effect on the rights of his client and the possibility of prejudice to his client as a result of his withdrawal...”).

IV) RULES GOVERNING THE LAWYER AS COUNSELOR

A) Model Rule 2.1 Advisor

In representing a client, a lawyer shall exercise independent professional judgment and render candid advice. In rendering advice, a lawyer may refer not only to law but to other considerations such as moral, economic, social and political factors, that may be relevant to the client’s situation.




1) Although a lawyer may be asked for both legal and non-legal advice, the lawyer does not have an affirmative duty to provide substantive, non-legal advice.

2) Comment indicates that when a lawyer knows that a client’s course of conduct is likely to result in substantial adverse legal consequences for the client, the lawyer may have a duty under Rule 1.4 to act if the client’s course of action is related to the representation. Even though the lawyer has no duty to provide “unwanted” advice, the lawyer may initiate advice to a client when it is in the best interests of the client to do so. E.g., the lawyer reads in the local newspaper that the client intends to lease out half of the City Hall complex, which the lawyer knows to be in contravention of the private activity bond rules of the Internal Revenue Code.

3) Note that the client’s reliance on non-legal advice of a lawyer may not be a good defense to a claim against the client for negligence. Draney v. Wilson, Morton, Assaf & McElligott (D. Ariz. 1984), CCH Fed. Sec. L. Rep. 1984 Transfer Binder ¶ 91,463.

B) Model Rule 2.3 Evaluation for Use by Third Persons

(a) A lawyer may provide an evaluation of a matter affecting a client for the use of someone other than the client if the lawyer reasonably believes that making the evaluation is compatible with other aspects of the lawyer’s relationship with the client.

(b) When the lawyer knows or reasonably should know that the evaluation is likely to affect the client’s interests materially and adversely, the lawyer shall not provide the evaluation unless the client gives informed consent.

(c) Except as disclosure is authorized in connection with a report of an evaluation, information relating to the evaluation is otherwise protected by Rule 1.6.



1) An evaluation of a legal matter may be performed by a lawyer at the request of a client for the benefit of a third party. Although normally legal advice rendered to a client is to be kept confidential, in this case, the client has requested that such advice be given to third persons. Because the lawyer is disclosing confidential information, it is important that the client be carefully identified so that the lawyer can determine whether, in fact, the client requested disclosure of the information.

2) The lawyer may need to determine whether a legal duty to the intended beneficiary arises and the extent to which the duty is compatible with the lawyer’s other responsibilities to client.


3) The lawyer may need to disclose in his report any limitations on the scope of the investigation (e.g. “We express no opinion on any matters related to the federal tax treatment of the interest earned on the obligations.”).

V) RULES GOVERNING TRANSACTIONS WITH PERSONS OTHER THAN CLIENTS

A) Model Rule 4.1 Truthfulness in Statements to Others

In the course of representing a client a lawyer shall not knowingly:

(a) make a false statement of material fact or law to a third person; or

(b) fail to disclose a material fact to a third person when disclosure is necessary to avoid assisting a criminal or fraudulent act by a client, unless disclosure is prohibited by Rule 1.6.



1) The Rule provides that a lawyer may be prohibited from disclosing even an impending criminal or fraudulent act by Rule 1.6; however, Rule 1.6 has since been amended to permit disclosure to prevent the client from committing a crime or fraud that is reasonably certain to result in a substantial injury to the financial interest or property of another and in the furtherance of which the client has used or is using the lawyers services. This exception to the confidentiality rule may help clarify the responsibility of counsel in securities transactions regarding disclosure of potentially fraudulent acts.

2) Note that a client’s failure to follow her lawyer’s advice to disclose relevant information might be neither criminal nor fraudulent and thus the Rule would not be implicated.

3) Further, the Comment states that generally a lawyer has no affirmative duty to inform an opposing party of relevant facts. But cf. affirmative duties under securities or antifraud laws to inform other participants of relevant facts. Note that a partial, incomplete statement of fact may be enough to trigger the Rule.

4) What are the lawyer’s obligations to effect a “noisy withdrawal”?

5) Cf. DR1-102 (“a lawyer shall not...engage in conduct involving dishonesty, fraud, deceit, or misrepresentation”).

B) Model Rule 4.2 Communications with Person Represented by Counsel

In representing a client, a lawyer shall not communicate about the subject of the representation with a person the lawyer knows to be represented by another lawyer


in the matter, unless the lawyer has the consent of the other lawyer or is authorized to do so by law or a court order.

{Parts [1] – [2] and [4] – [9] of Comment omitted from this outline intentionally.}

[3] The Rule applies even though the represented person initiates or consents to the communication. A lawyer must immediately terminate communication with a person if, after commencing communication, the lawyer learns that the person is one with whom communication is not permitted by this Rule.


1) Is the consent of the other parties’ attorneys implied based on the “universal practice in the municipal finance area of attorneys talking directly to other participants”?

2) Note that the participant loses any claim to privilege with respect to information disclosed to parties other than his attorney.

3) Does it matter if the information requested is a public record?

4) See also DR 7-104 (A)(1).

VI) RULES GOVERNING LAW FIRMS AND ASSOCIATIONS

A) Model Rule 5.1 Responsibilities of Partners, Managers and Supervisory Lawyers

(a) A partner in a law firm, and a lawyer who individually or together with other lawyers possesses comparable managerial authority in a law firm, shall make reasonable efforts to ensure that the firm has in effect measures giving reasonable assurance that all lawyers in the firm conform to the Rules of Professional Conduct.

(b) A lawyer having direct supervisory authority over another lawyer shall make reasonable efforts to ensure that the other lawyer conforms to the Rules of Professional Conduct.

(c) A lawyer shall be responsible for another lawyer’s violation of the Rules of Professional Conduct if:

(1) the lawyer orders or, with knowledge of the specific conduct, ratifies the conduct involved; or

(2) the lawyer is a partner or has comparable managerial authority in the law firm in which the other lawyer practices, or has direct supervisory authority over the other lawyer, and knows of the conduct at a time when its consequences can be avoided or mitigated but fails to take reasonable remedial action.




1) What “supervisory authority” does a partner have over a co-counsel?

2) Compare to SEC Rule 205.5(c), where a subordinate attorney is deemed to have complied with the “up the ladder” reporting requirements of the rule if he or she reports the evidence of a material violation to his or her supervisory attorney, unless the subordinate attorney reasonably believes that the supervisory attorney had failed to comply with the Rule.

B) Model Rule 5.3 Responsibilities Regarding Nonlawyer Assistants

With respect to a nonlawyer employed or retained by or associated with a lawyer:

(a) a partner, and a lawyer who individually or together with other lawyers possesses comparable managerial authority in a law firm shall make reasonable efforts to ensure that the firm has in effect measures giving reasonable assurance that the person’s conduct is compatible with the professional obligations of the lawyer;

(b) a lawyer having direct supervisory authority over the nonlawyer shall make reasonable efforts to ensure that the person’s conduct is compatible with the professional obligations of the lawyer; and

(c) a lawyer shall be responsible for conduct of such a person that would be a violation of the Rules of Professional Conduct if engaged in by a lawyer if:

(1) the lawyer orders or, with the knowledge of the specific conduct, ratifies the conduct involved; or

(2) the lawyer is a partner or has comparable managerial authority in the law firm in which the person is employed, or has direct supervisory authority over the person, and knows of the conduct at a time when its consequences can be avoided or mitigated but fails to take reasonable remedial action.



1) Generally, the nonlawyer assistant (e.g., secretaries, law clerks, paralegals and others) must be familiar with and comply with the rules of conduct applicable to the lawyer as described above.


2) See also DR 4-101(D) (“A lawyer shall exercise reasonable care to prevent his employees, associates and others whose services are utilized by him from disclosing or using confidences or secrets of a client....”).

C) Model Rule 5.5 Unauthorized Practice of Law; Multijurisdictional Practice of Law

(a) A lawyer shall not practice law in a jurisdiction in violation of the regulation of the legal profession in that jurisdiction, or assist another in doing so.

(b) A lawyer who is not admitted to practice in this jurisdiction shall not:

(1) except as authorized by these Rules or other law, establish an office or other systematic and continuous presence in this jurisdiction for the practice of law; or

(2) hold out to the public or otherwise represent that the lawyer is admitted to practice law in this jurisdiction.

(c) A lawyer admitted in another United States jurisdiction, and not disbarred or suspended from practice in any jurisdiction, may provide legal services on a temporary basis in this jurisdiction that:

(1) are undertaken in association with a lawyer who is admitted to practice in this jurisdiction and who actively participates in the matter;

(2) are in or reasonably related to a pending or potential proceeding before a tribunal in this or another jurisdiction, if the lawyer, or a person the lawyer is assisting, is authorized by law or order to appear in such proceeding or reasonably expects to be so authorized;

(3) are in or reasonably related to a pending or potential arbitration, mediation, or other alternative dispute resolution proceeding in this or another jurisdiction, if the services arise out of or are reasonably related to the lawyer’s practice in a jurisdiction in which the lawyer is admitted to practice and are not services for which the forum requires pro hac vice admission; or

(4) are not within paragraphs (c)(2) or (c)(3) and arise out of or are reasonably related to the lawyer’s practice in a jurisdiction in which the lawyer is admitted to practice.

(d) A lawyer admitted in another United States jurisdiction, and not disbarred or suspended from practice in any jurisdiction, may provide legal services in this jurisdiction that:


(1) are provided to the lawyer’s employer or its organizational affiliates and are not services for which the forum requires pro hac vice admission; and, when performed by a foreign lawyer and requires advice on the law of this or another jurisdiction or of the United States, such advice shall be based upon the advice of a lawyer who is duly licensed and authorized by the jurisdiction to provide such advice; or

(2) are services that the lawyer is authorized to provide by federal law or other law of this jurisdiction.

(e) For purposes of paragraph (d), the foreign lawyer must be a member in good standing of a recognized legal profession in a foreign jurisdiction, the members of which are admitted to practice as lawyers or counselors at law or the equivalent, and are subject to effective regulation and discipline by a duly constituted professional body or a public authority.



1) How does this rule apply to bond counsel rendering an approving opinion in a transaction in a state in which the attorney is not licensed to practice? Is rendering a bond counsel opinion “practicing law” in the foreign jurisdiction?

2) The recent revisions to Model Rule 5.5 reflect the trend in the legal profession towards specialization and authorizes the multijurisdictional practice of law in certain instances. The Rule now permits bond counsel to engage in the practice of law across state lines so long as the attorney:

(a) is admitted in another United States jurisdiction and is not disbarred or suspended from practice in any jurisdiction; and

(b) provides legal services in a jurisdiction in which he or she is not licensed only on a temporary basis; and

(c) provides such legal services in association with an attorney admitted to practice in the subject jurisdiction who actively participates in the matter; and

(d) otherwise complies with the applicable ethical rules.

3) See, e.g., In The Matter Of Opinion 33 Of The Committee On The Unauthorized Practice Of Law, 160 N.J. 63, 733 A.2d 478 (1999), in which the New Jersey Supreme Court (acting prior to the adoption of the Model Rules in New Jersey) discussed two instances in which the public interest is served by allowing counsel from outside the state to serve as bond counsel for New Jersey issuers.


4) See also DR 3-101(B) of the Model Code relating to unauthorized practice.

VII) MISCELLANEOUS RULES

A) Model Rule 7.3 Direct Contact with Prospective Clients

(a) A lawyer shall not by in-person, live telephone or real-time electronic contact solicit professional employment from a prospective client when a significant motive for the lawyer’s doing so is the lawyer’s pecuniary gain, unless the person contacted:

(1) is a lawyer; or

(2) has a family, close personal, or prior professional relationship with the lawyer.

(b) A lawyer shall not solicit professional employment from a prospective client by written, recorded or electronic communication or by in-person, telephone or real-time electronic contact even when not otherwise prohibited by paragraph (a), if:

(1) the prospective client has made known to the lawyer a desire not to be solicited by the lawyer; or

(2) the solicitation involves coercion, duress or harassment.

(c) Every written, recorded or electronic communication from a lawyer soliciting professional employment from a prospective client known to be in need of legal services in a particular matter shall include the words “Advertising Material” on the outside envelope, if any, and at the beginning and ending of any recorded or electronic communication, unless the recipient of the communication is a person specified in paragraphs (a)(1) or (a)(2).

(d) Notwithstanding the prohibitions in paragraph (a), a lawyer may participate with a prepaid or group legal service plan operated by an organization not owned or directed by the lawyer that uses in-person or telephone contact to solicit memberships or subscriptions for the plan from persons who are not known to need legal services in a particular matter covered by the plan.



1) Generally applies to solicitation of individuals, not to the solicitation of organizations.


B) Model Rule 8.3 Reporting Professional Misconduct

a) A lawyer who knows that another lawyer has committed a violation of the Rules of Professional Conduct that raises a substantial question as to that lawyer’s honesty, trustworthiness or fitness as a lawyer in other respects, shall inform the appropriate professional authority.

(b) A lawyer who knows that a judge has committed a violation of applicable rules of judicial conduct that raises a substantial question as to the judge’s fitness for office shall inform the appropriate authority.

(c) This Rule does not require disclosure of information otherwise protected by Rule 1.6 or information gained by a lawyer or judge while participating in an approved lawyers assistance program.



1) How certain must the lawyer be that a violation has, in fact, occurred? The standard in Model Rule 8.3 is “actual knowledge.”

2) Does a bond counsel who is concerned about the competence of co-counsel have to report those concerns? The answer depends on the extent to which co-counsel makes a reasonable attempt to learn the substantive law or limits their responsibilities to matters as to which they are competent.

3) Any obligation to report is subject to Rule 1.6 relating to confidential information.

4) Cf. DR 1-103 of the Model Code of Professional Responsibility.

VIII) SPECIAL PROBLEMS FOR BOND COUNSEL

A) Post-issuance obligations and disengagement letters. When does the bond counsel’s representation end? Many attorneys have used the post-issuance review process to cultivate a continuing relationship with their issuer clients. Note how this approach can continue a client relationship but yet create confusion about the level of representation being offered.

B) Unrepresented parties.

C) Concurrent or intermittent representation of multiple parties in the same or different transactions – AKA “Musical Chairs”.

D) Fee arrangements, including contingency fees.


HYPOTHETICALS

Hypothetical No. 1

A. Michael A. Goodliving, a partner in the law firm of Keep, Diehl, Cummings & Howe, has served as bond counsel to Strapt County for many years. The County officials attended a seminar sponsored by Maka Buck investment banking firm, which recommended that counties consider paying early retirement payments by issuing tax-exempt bonds and thereby converting such payments from current operating expenses to a long-term debt obligations. Maka Buck’s managing director, Helen Wheels, indicated that a number of counties were considering such a transaction.

Strapt County asked Mike whether he would be willing to render an unqualified approving legal opinion on such a transaction. Mike knew from a friend at the law firm of Goode & Co. that one of Goode’s bond counsel clients, another county, had submitted a request to the IRS for a private letter ruling on an identical transaction, although Mike knew that it was unlikely that the IRS would rule for a number of months. Mike’s friend gave Mike a copy of the draft of the private letter ruling request and Mike thought that the arguments presented in support of issuing tax-exempt bonds for the buy-out were pretty sound. Strapt County was proposing a large transaction and the fees from the deal would be significant to Keep, Diehl in an otherwise mediocre year.

Maka Buck had significant number of counties in the state as customers and referred most of its business to the out-of-state bond counsel firm of Notwell Thawedout, but Helen Wheels told Strapt County that she would work with Mike’s firm if it would be willing to render the unqualified opinion on the proposed bond issue. Helen also told the Strapt County officials that they could let Mike know that there were a number of other counties looking at the same transaction and that she would be willing to refer those issues to Mike as well if he were able to render the opinion.

Mike knew that a number of reputable firms, including Goode & Co., were not willing to render the approving legal opinion on the transaction. Strapt County was really pressuring Mike for his opinion and wanted to hear from him by Friday so that it could put the final touches on the early retirement plan.

What is Mike’s responsibility to his client? To his law firm?

Can Mike render an approving legal opinion under the NABL standard? What should he advise his client?

B. Mike begins researching the issues presented and finds a state statute specifically limiting a county’s power to borrow for operating expenses, unless required to comply with a court order or judgment. Mike also learns that a bill has been introduced in the last legislative session at the request of the County Commissioners’ Association, which would have added an exception for payment of early retirement benefits. The bill died in committee when the


legislature adjourned. There was no discussion of this bill in the draft of the private letter ruling request that Mike saw.

Does Mike have an ethical obligation to Strapt County to inform them of this bill? Does Mike have an ethical obligation to disclose the bill to any other party? If Mike doesn’t disclose the existence of this bill, is Mike meeting the applicable standards of professionalism?

C. Mike determines that his firm cannot render the approving legal opinion consistent with the NABL opinion standard. Strapt County asks Maka Buck whether there are any other bond counsel firms who would render the opinion. Helen Wheels advises that it is likely that Notwell Thawedout would be willing to render an approving opinion on this transaction. Strapt County advises Mike that it would work with Notwell on this transaction, but that the next time the county had a “plain vanilla” issue it would retain Mike’s services - “After all,” the President of the Board of County Commissioners told Mike, “you’re our bond counsel.” Mike is not certain whether Notwell knows of the pending IRS ruling or the proposed legislation.In the state where Notwell is located, a number of issuers have issued bonds to pay for retirement buy-outs after a lower court validated the bonds.

What obligations, if any, does Mike have to inform Notwell about the ruling or the legislative proposal?

D. The President of the Strapt County Board of County Commissioners feels a little badly that Mike’s firm was left out of the deal - after all, the Keep, Diehl lawyers had been very generous to her campaign. She asks Helen Wheels to hire Mike as underwriters’ counsel for this transaction. Helen agrees. Helen asks Mike to serve as underwriters’ counsel and tells him that it should be a good deal for Keep, Diehl, since they will earn a big fee even though Notwell will prepare the official statement and bond purchase agreement for the transactions.

Can Mike accept the engagement? What ethical issues are raised?

E. First National Bank had often purchased Strapt County bond issues, so the bankers at Maka Buck sent the Bank President, Dell R. Mann, a copy of the preliminary official statement for the issue. Dell knew that Mike had always served as Strapt County’s bond counsel, so when Dell saw that Notwell was bond counsel on this issue, he called Mike to find out why the County had a different bond counsel.

What should Mike’s answer be? Would Mike’s answer be different if First National Bank’s investment banking subsidiary were a co-manager of the deal?

F. After the bonds are issued, the IRS issues the private letter ruling that the bonds similar to Strapt County’s bonds would be taxable.

What are Mike’s ethical obligations?


Hypothetical No. 2

Keep, Diehl, Cummings & Howe is asked to serve as underwriters’ counsel in a negotiated transaction for Flush County in which there are six underwriters, of which the senior, books-running manager is Keep, Diehl’s longstanding client, Staid & Co. One of the co-managers is Harley Honest, another investment banking firm. In litigation unrelated to the Flush County bond issue, Keep Diehl is defending Staid against claims made by Harley Honest.

Can Keep, Diehl serve as underwriters’ counsel? Would the answer be different if Harley Honest were added to the underwriting group the day prior to mailing of the Preliminary Official Statement?

Hypothetical No. 3

Flush County’s Auditor is impressed with Mike Goodliving’s work on behalf of Keep, Diehl in connection with the County’s recent bond issue. The next time that Flush County issues bonds, the Auditor asks Mike to serve as bond counsel. Mike reminds the Auditor that his firm regularly represents Staid & Co., which is likely to negotiate the sale of the new bonds. The Auditor tells Mike that he’ll gladly waive the conflict and allow Mike to serve as both bond counsel and underwriters’ counsel.

Can Mike go ahead and serve as bond counsel? Underwriters’ counsel? Whose consent, if anyone’s, is required?



17. Conflicts of Interest & Ethical Issues (Ethics Credit)


- In the Matter of William R. Carter and Charles J. Johnson, Jr., S.E.C. Release No. 34-17597 (February 28, 1981), CCH 1981 Transfer Binder ¶ 82,847 (fn. 21)

“Very little of a securities lawyer’s work is adversary incharacter. He doesn’t work in courtrooms where thepressure of diligent adversaries and alert judges check him.He works in his office where he prepares prospectuses,proxy statements, opinions of counsel, and other documentsthat … the financial community and the investing public musttake on faith. This is a field where unscrupulous lawyers caninflict irreparable harm to those who rely on the disclosuredocuments that they produce. Hence we are under a duty tohold our bar to appropriately rigorous standards ofprofessional honor.”


HYPOTHETICAL No. 1A

What is Mike's responsibility to his client? To his law firm?

See Model Rule 1.13 - Organization as Client.

Who is Mike's client? Does it matter what the County's organizational documents say about who has the right/obligation to hire counsel?



HYPOTHETICAL No. 1A


See Model Rule 1.4 - Communication

With whom should Mike communicate? See also Comment 6 to Model Rule 1.4.

How much information should Mike provide to the client?


HYPOTHETICAL No. 1A


See Model Rule 2.1 - Advisor

In representing a client, a lawyer shall exercise independent professional judgment and render candid advice. In rendering advice, a lawyer may refer not only to law but to other considerations such as moral, economic, social and political factors, that may be relevant to the client's situation.


HYPOTHETICAL No. 1A


See Model Rule 1.7 - Conflict of Interest: General Rule

Is Mike's interest in protecting his law firm from a malpractice claim or from being precluded from practice before the IRS a "material limitation"?

See Model Rule 1.6 - Confidentiality

Should Mike's friend have given him a copy of the PLR request?



HYPOTHETICAL No. 1A

Can Mike render an approving legal opinion under the NABL standard?Is Mike "firmly convinced" that the highest court, acting reasonably and properly briefed, would reach the legal conclusion that the bonds are validly issued?Can he be "firmly convinced" that, upon due consideration of material facts and all of the relevant sources of applicable law on federal income tax matters, the Supreme Court would reach the federal income tax conclusions stated in the opinion or the IRS would concur or acquiesce in the federal income tax conclusions stated in the opinion?


HYPOTHETICAL No. 1A

Can Mike render an approving legal opinion under the NABL standard?

Note Model Rule 2.3 - Evaluation for Use by a Third Person, which permits Mike to render an approving opinion for the use of someone other than his client, so long as he "reasonably believes that making the evaluation is compatible with other aspects of [his] relationship with the client."


HYPOTHETICAL No. 1B

Does Mike have an ethical obligation to Strapt County to inform them of this bill?

See Model Rule 1.4 - Communication, and Model Rule 2.1 - Advisor

See Model Rule 1.13 - Organization as Client. Who at Strapt County should Mike inform of this bill? What if that person doesn't respond?

Is there any reason to believe that this is confidential information and thus subject to the requirements of Model Rule 1.6?



HYPOTHETICAL No. 1A

Can Mike render an approving legal opinion under the NABL standard?Is Mike "firmly convinced" that the highest court, acting reasonably and properly briefed, would reach the legal conclusion that the bonds are validly issued?Can he be "firmly convinced" that, upon due consideration of material facts and all of the relevant sources of applicable law on federal income tax matters, the Supreme Court would reach the federal income tax conclusions stated in the opinion or the IRS would concur or acquiesce in the federal income tax conclusions stated in the opinion?


HYPOTHETICAL No. 1A

Can Mike render an approving legal opinion under the NABL standard?

Note Model Rule 2.3 - Evaluation for Use by a Third Person, which permits Mike to render an approving opinion for the use of someone other than his client, so long as he "reasonably believes that making the evaluation is compatible with other aspects of [his] relationship with the client."


HYPOTHETICAL No. 1B

Does Mike have an ethical obligation to Strapt County to inform them of this bill?

See Model Rule 1.4 - Communication, and Model Rule 2.1 - Advisor

See Model Rule 1.13 - Organization as Client. Who at Strapt County should Mike inform of this bill? What if that person doesn't respond?

Is there any reason to believe that this is confidential information and thus subject to the requirements of Model Rule 1.6?


HYPOTHETICAL No. 1B

If Mike doesn't disclose the existence of this bill, is Mike meeting the applicable standards of professionalism?

Does failure to disclose the bill constitute "good judgment"? Should Mike disclose the bill to his friend requesting the PLR?


HYPOTHETICAL No. 1C


See Model Rule 1.1 – Competence. Does Notwell Thawedout have the requisite knowledge of and skill in the laws in Strapt County's state?

Does Mike have a client here? See Model Rule 2.3 -Evaluation for Use by a Third Person. Would Mike's disclosure of the information be "compatible with other aspects of [his] relationship with the client"?


HYPOTHETICAL No. 1C


See Model Rule 1.6 - Confidentiality of Information.

If Strapt County is Mike's client, can Mike reveal this information or is it subject to the requirements of Rule 1.6?



HYPOTHETICAL No. 1C


See Model Rule 1.16 - Declining or Terminating Representation.

What duties does Mike have to Strapt County if it is not, or is no longer, his client? Note also Model Rule 4.2 - Communications with Persons Represented by Counsel.


HYPOTHETICAL No. 1C


See Model Rule 4.1 - Truthfulness in Statements to Others. Is disclosure necessary to avoid assisting a criminal or fraudulent act by a client? If so, is disclosure prohibited by Rule 1.6?

Does Model Rule 5.5 relating to the Unauthorized and Multijurisdictional Practice of Law have any bearing on Notwell's engagement by Strapt County?


HYPOTHETICAL No. 1D


Under Model Rule 1.2 - Scope of Representation, the lawyer and the client may agree on the scope of the representation if the limitation is reasonable under the circumstances and the client gives informed consent.



HYPOTHETICAL No. 1D

Can Mike accept the engagement? What ethical issues are raised?Mike should carefully review Model Rules 1.7 and, if applicable, 1.9, relating to Conflicts of Interest and Duties to Former Clients. If Strapt County is a current client, Model Rule 1.7 could prohibit Mike from representing Maka Buck, unless:1. Mike "reasonably believes that [he] will be able to provide competent and diligent representation to each affected client;2. the representation is not prohibited by law;3. the representation does not involve the assertion of a claim by one client against another client in the same litigation or other proceeding before a tribunal; and 4. each affected client gives informed consent, confirmed in writing.”


HYPOTHETICAL No. 1D

Can Mike accept the engagement? What ethical issues are raised?If Strapt County is a former client, Model Rule 1.9 would apply. Mike would have to determine if this is the "same or a substantially related matter" and if Maka Buck's interests are "materially adverse" to Strapt County's, unless the County gives informed consent, confirmed in writing.

Note, too, the confidentiality rules of Model Rule 1.6.


HYPOTHETICAL No. 1D


Can Mike accept the "big fees" promised by Helen? Mike should review carefully the factors set forth in Model Rule 1.5 - Fees to determine if it is a violation of the rules to accept the "big fees" for the scope of work to be undertaken.



HYPOTHETICAL No. 1E

What should Mike's answer be?

Note again the requirements of Model Rule 1.6. Is the fact that Mike's firm was unwilling to render the opinion "confidential information" of Strapt County which Mike is bound to maintain as confidential unless the disclosure meets one of the exceptions?

Note, too, Model Rule 1.9, which prohibits a lawyer from revealing information relating to representation of a former client except as the Rules would permit or require with respect to a client.


HYPOTHETICAL No. 1E

What should Mike's answer be?

If Mike's representation of Strapt County has terminated, he is obligated to "take steps to the extent reasonably practicable to protect a client's interest." Should Mike give notice of the fact of withdrawal? Should he actively "disaffirm" the proposed opinion?


HYPOTHETICAL No. 1E

Would Mike's answer be different if First National Bank's investment banking subsidiary were a co-manager of the deal?

Again, Mike should look to Model Rules 1.7 and 1.9, relating to Conflicts of Interest and Duties to Former Clients, to determine what his duties are if there is a concurrent conflict or a conflict with a former client, and to Model Rule 1.6 relating to whether the fact that Mike's firm would not render the opinion is "confidential information" of Strapt County.



HYPOTHETICAL No. 1E

Would Mike's answer be different if First National Bank's investment banking subsidiary were a co-manager of the deal?

In either event, Mike should be mindful of the provisions of Rule 1.2(d), which prohibit a lawyer from counseling a client to engage, or assisting a client, in conduct that the lawyer knows is criminal or fraudulent. Do Mike's concerns about the validity of the Bonds rise to this level?


HYPOTHETICAL No. 1F

What are Mike's ethical obligations?

Mike should determine if any fraudulent conduct took place. (Consider whether a private letter ruling, which has no precedential value, would affect the Strapt County bonds). The comments to Rule 1.2 suggest that if a lawyer discovers that conduct that he originally thought was proper is, in fact, fraudulent, he must withdraw, and in some cases, the withdrawal must be a "noisy" withdrawal.


HYPOTHETICAL No. 1F

What are Mike's ethical obligations?

May Mike make others, e.g., Strapt County, Notwell Thawedout, Bondholders, etc., aware of the PLR without violating Model Rule 1.6?



HYPOTHETICAL No. 2

Can Keep, Diehl serve as underwriters' counsel? Would the answer be different if Harley Honest were added to the underwriting group the day prior to mailing of the Preliminary Official Statement?

Mike's first question should be whether Harley Honest is Keep, Diehl's client. There are different opinions as to whether underwriters' counsel represents only the senior, books-running manager or all of the co-managers.


HYPOTHETICAL No. 2


If Harley Honest is Keep, Diehl's client, can Mikerepresent Harley Honest when Harley Honest isadverse to Keep, Diehl's client, Staid, in pendinglitigation? Mike should carefully review Model Rule 1.7to determine whether the parties are directly adverseor whether there is a material limitation which wouldpreclude Mike's joint representation.


HYPOTHETICAL No. 3

Can Mike go ahead and serve as bond counsel? Underwriters' counsel? Whose consent, if anyone's, is required?Note again Model Rule 1.7. Will the representation of Flush County be "directly adverse" to Staid? Since Keep, Diehl regularly represents Staid, will Keep, Diehl's representation of Flush County be "materially limited" by the firm's responsibility to Staid? What if Staid's legal billings accounts for 38% of Keep, Diehl's total revenues? 50%? Is Mike's representation of Flush County "materially limited" by his personal interest in maintaining Staid as a client?



HYPOTHETICAL No. 2


Mike's first question should be whether Harley Honest is Keep, Diehl's client. There are different opinions as to whether underwriters' counsel represents only the senior, books-running manager or all of the co-managers.


HYPOTHETICAL No. 2


If Harley Honest is Keep, Diehl's client, can Mikerepresent Harley Honest when Harley Honest isadverse to Keep, Diehl's client, Staid, in pendinglitigation? Mike should carefully review Model Rule 1.7to determine whether the parties are directly adverseor whether there is a material limitation which wouldpreclude Mike's joint representation.


HYPOTHETICAL No. 3

Can Mike go ahead and serve as bond counsel? Underwriters' counsel? Whose consent, if anyone's, is required?Note again Model Rule 1.7. Will the representation of Flush County be "directly adverse" to Staid? Since Keep, Diehl regularly represents Staid, will Keep, Diehl's representation of Flush County be "materially limited" by the firm's responsibility to Staid? What if Staid's legal billings accounts for 38% of Keep, Diehl's total revenues? 50%? Is Mike's representation of Flush County "materially limited" by his personal interest in maintaining Staid as a client?


HYPOTHETICAL No. 3

Can Mike go ahead and serve as bond counsel? Underwriters' counsel? Whose consent, if anyone's, is required?

Can Mike serve as both bond counsel and underwriter's counsel?

Is the Chief Executive Officer's consent sufficient? Should Mike obtain the consent of the President of the County Commissioners? How would he know?
