On December 8, 2016, the Treasury Department and the Internal Revenue Service released Treasury Decision 9801, which sets forth final regulations providing a revamped definition of the “issue price” of tax-exempt bonds under the arbitrage bond rules of Section 148 of the Internal Revenue Code of 1986. These new regulations, which come after two rounds of proposed issue price regulations, in 2013 and 2015, represent a substantial departure from the issue price standard that has been in place since the early 1990s. The new definition of “issue price” will apply to tax-exempt bonds sold on or after June 7, 2017.

The new regulations mark a notable shift insofar as they look to the actual prices at which bonds are sold to the public to establish their issue price. Unlike the issue price guidance that has been in place for decades, the new definition generally no longer permits issuers to establish issue price on the basis of expectations at the time bonds are sold to underwriters.

All of this is fundamental for tax-exempt bond issuers, conduit borrowers, underwriters and other market participants because the calculation of the “arbitrage yield” of tax-exempt bonds turns on their issue price, and accurately computing the arbitrage yield of bonds is the key to compliance with all of the yield restriction and arbitrage rebate restrictions that ensure that such bonds are indeed tax-exempt.

The following is a brief summary of the main elements of the final regulations:

1. General Rule—Actual Sales of Publicly Offered Bonds

Under the new regulations, the issue price of publicly offered bonds issued for money generally is the first price at which a substantial amount (i.e., 10%) of such bonds is actually sold to the public, unless, on or before the bond issuance date, the issuer of such bonds selects one of the two special rules described immediately below.

2. Special Rule—Initial Offering Price of Publicly Offered Bonds

For publicly offered bonds, issuers may choose to treat the “initial offering price” of the bonds to the public as of their sale date (i.e., the first date on which there is a binding commitment in writing for the sale of the bonds, which typically is the date on which the issuer executes a bond purchase agreement with the underwriters of the bonds) as the issue price, if the following conditions are satisfied:

• The underwriters offered the bonds to the public at a specified initial offering price on or before the sale date;
• The lead underwriter in the underwriting syndicate or selling group (or, if applicable, the sole underwriter) provides a certification to the issuer by the bond issuance date to that effect, together with supporting documentation (such as a pricing wire or comparable communication); and
• Each underwriter of the bonds agrees in writing that it will neither offer nor sell the bonds to any person at a price that is higher than the specified initial offering price to the public during a “hold firm” period starting on the sale date and ending on the earlier of (1) the close of the 5th business day after the sale date or (2) the date on which the underwriters have sold a substantial amount (i.e., 10%) of the bonds to the public at a price that is no higher than the specified initial offering price to the public.

An observation about this special rule—issuers and underwriters often may be uncertain on the sale date (i.e., the date of execution of the bond purchase agreement) whether 10% or more of each maturity of the bonds of an issue actually will be sold by their issue date (usually a week or two later). This means there could be some risk that issuers will not be able to compute the arbitrage yield on their bonds on the bond issuance date. As a result, the special rule may create a natural incentive for issuers and underwriters always to “hedge their bets” by including language, likely in the bond purchase agreement or perhaps in an “agreement among underwriters” for selling groups or syndicates, to commit to the “hold firm” requirement described above, so that the special rule can be selected if needed. In all events, it seems quite clear that this special rule will have a broad impact on the way bond purchase agreements and agreements among underwriters are drafted, perhaps even before the June 7, 2017 effective date of the regulations.

3. Special Rule—Competitive Sales of Publicly Offered Bonds

The final regulations also include a special rule for bonds that are sold pursuant to a competitive bidding process. Under this special rule, issuers may rely on a certification of the underwriter submitting the winning bid of its reasonable expectations on the sale date regarding the initial offering price to the public for the bonds. This special rule is available for bonds that are offered for sale to underwriters on specified written terms (typically in a notice of sale) in a bidding process in which:

• The issuer disseminates the notice of sale to potential underwriters in a manner reasonably designed to reach them (for example, by means of an electronic communication that is widely circulated to underwriters by a recognized publisher of municipal bond offering documents or by posting the notice of sale on a website that is regularly used for such purposes and is widely available to potential underwriters);
• All bidders have an equal opportunity to bid;
• The issuer receives bids from at least three underwriters who have established industry reputations for underwriting new issuances of tax-exempt bonds; and
• The issuer awards the sale of the bonds to the bidder who offers the highest price (or lowest interest cost) for the bonds.

4. Selection of Rule for Determining Issue Price

If more than one of the foregoing rules (e.g., the general actual sales rule and the special competitive sales rule) is available to an issuer with respect to a bond, the issuer is permitted to select the rule it will apply to establish the issue price of the bond. To make the selection, the issuer must, on or before the bond issuance date, identify the rule it is selecting in its books and records maintained for the bond. The issuer need not select the same rule to establish the issue price for all of the bonds of an issue. Thus, for example, it appears that an issuer may apply the general actual sales rule to one maturity of bonds of an issue and one of the special rules, if applicable, to another maturity of bonds of the same issue.

5. Privately Placed Bonds

The final regulations also confirm that for a bond issued for money in a private placement to a single buyer that is not an underwriter or a related party to an underwriter, the issue price of the bond is the price paid by that buyer.

6. Definitions

The final regulations define the “public” to mean any person other than an underwriter or related party to an underwriter. The final regulations define “underwriter” to mean (1) any person that agrees pursuant to a written contract with the issuer (or with the lead underwriter to form an underwriting syndicate) to participate in the initial sale of bonds to the public and (2) any person that agrees pursuant to a written contract directly or indirectly with a person described in (1) to participate in the initial sale of the bonds to the public (including, for example, a retail bond distribution agreement between a national underwriter and a regional trading firm under which the regional firm agrees to participate in or support the initial distribution of the bonds).

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The preceding is a summary of the newly released issue price regulations. As noted above, these regulations are likely to have an impact on how bond purchase agreements and agreements among underwriters are documented; the regulations are also likely to have an impact on the manner in which competitive sales of bonds are conducted. Issuers and borrowers of tax-exempt bonds should consider discussing the implications of these new regulations with their bond counsel and financial advisors in order to be prepared for changes in market practices that may develop in coming months.

Please contact Antonio Martini at (617) 378-4136 or any other member of Hinckley Allen’s Public Finance Group if you would like more information about the issue price regulations, or if you have any other tax-exempt bond compliance matter you would like to discuss.