Public Finance Matters

Updates on recent public finance and municipal bond developments

Enactment Imminent for Section 529A Tax-Exempt Savings Programs for Disabled Beneficiaries

Posted in Section 529 plans

By LEN WEISER-VARON

On December 16, 2014 the U.S. Senate approved the Achieving a Better Life Experience (“ABLE”) legislation previously approved by the House, authorizing state-sponsored tax-exempt savings programs for disability-related expenses. President Obama is expected to sign the legislation (which is part of the “tax-extenders” bill) before the year is out. Pursuant to the legislation, states may establish ABLE programs under which individuals can set up ABLE accounts in which earnings can accumulate and be distributed on a tax-free basis to pay for the expenses of a disabled beneficiary.

The new Section 529A of the Internal Revenue Code, into which the ABLE provisions will be codified, is modeled on the immediately preceding section, pursuant to which “Section 529” college savings programs have been launched nationwide. The perceived inequity of the existence of tax-favored savings accounts permitting parents and others to save for children’s higher education costs but not for the future expenses of children with disabilities produced an increasingly rare consensus in Congress on the enactment of this new tax benefit for individuals.  As stated by one of the legislation’s co-sponsors: “No longer would individuals with disabilities have to stand aside and watch others use IRS-sanctioned tools to lay the groundwork for a brighter future.”

Although the desire to level the playing field, taxwise, for families saving for individuals with disabilities propelled the ABLE statute through a difficult legislative environment, Section 529A is being enacted under budget-neutral requirements requiring offsetting budget cuts to balance out the projected new tax expenditures. This explains various constraints on the funding of Section 529A ABLE accounts that are not present in the case of Section 529 college savings accounts, which were originally authorized as tax-deferred accounts in 1996 and made tax-exempt in 2001.

The substantive provisions of the ABLE legislation, similarities and differences between ABLE programs and Section 529 programs, and additional steps that will be required at the state level before ABLE accounts become available to those anxious to provide for the future of disabled beneficiaries are outlined below.

I.  ABLE Programs and Accounts

a. Residency Requirement

Although the legislation authorizes the federal tax benefits associated with ABLE accounts effective January 1, 2015, such accounts only can be accessed through a state-administered program authorized under state legislation. Unlike Section 529 programs, which have no residency limits and therefore can operate as nationwide programs in which states compete with each other based on state tax incentives and the attractiveness of the investment managers and investment options provided by each program, an ABLE account only may be opened in the program established by the state in which the disabled beneficiary resides, or, if such state has not established an ABLE program, in the program of another state with which the beneficiary’s state of residence has contracted for the purposes of providing its residents access to an ABLE program.

b. Single Account Requirement

Also in contrast to Section 529, only one ABLE account per beneficiary is permitted. Accordingly, once an ABLE account is established for a particular beneficiary, a subsequent ABLE account established by the same or a different person for the same beneficiary will not qualify for the ABLE tax benefits. An exception is contemplated for account rollovers to a different state’s program if a beneficiary changes his or her state of residence, if the beneficiary is changed to another beneficiary residing in a different state or, presumably, if the state of the beneficiary’s residence establishes its own ABLE program after having initially contracted out its ABLE program to another state.

c.  Contribution Limits

The maximum amount that can be contributed to an ABLE account is the same generous maximum contribution limit applicable to Section 529 college savings accounts; in fact, the statute specifies that the ABLE account limit is the limit established by the applicable state for its Section 529 program. Although Section 529 precludes excessive contributions, it does not provide a specific dollar limit, and the formulas used by each state to determine contribution limits to that state’s program vary; many states currently have per beneficiary limits in the range between $300,000 and $400,000.

There are two significant aspects, however, in which the funding of ABLE accounts is restricted relative to the funding of college savings accounts.  First, unlike Section 529, Section 529A imposes an annual per account funding limit equal to the annual gift tax exclusion (currently $14,000 per year), which means that it would take several decades of steady annual contributions to build up to the permissible per beneficiary limit.

Second, the per beneficiary limit imposed under Section 529 is measured against accounts opened in a particular state’s programs; because Section 529 does not restrict the number of states in which accounts for a particular beneficiary can be established, as a practical matter there is no limit on the amount that can be contributed to Section 529 accounts for a single beneficiary. Because Section 529A limits ABLE accounts for a particular beneficiary to a single account in a single state, both the annual and the lifetime contribution limits for an ABLE account beneficiary are meaningful limits.

Because these limits, particularly the annual limit, put ABLE accounts at a disadvantage relative to Section 529 accounts, and ABLE programs at a disadvantage relative to Section 529 programs due to the likelihood of a smaller asset base against which program administrative expenses can be spread, future pressure on Congress to loosen the annual limit on ABLE account contributions can be anticipated.

d. Account Ownership Requirements

Another structural difference between ABLE accounts and Section 529 college savings accounts is that the ABLE legislation defines “designated beneficiary” as “the eligible individual who established an ABLE account and is the owner of the account”, whereas Section  529 permits the account owner to be a different individual (or entity) than the beneficiary. One of the psychologically attractive features of Section  529 accounts is that a parent or other individual can be the account owner, set aside money for the beneficiary and treat the money as transferred to the beneficiary for gift and estate tax purposes, while maintaining total control of the account, including the right, if necessary, to apply the money for the account owner’s purposes, rather than the beneficiary’s (subject to payment of income taxes and a 10% tax penalty on the withdrawn account earnings.) This unique deemed gift arrangement under Section 529 has given the IRS headaches due to concerns about potential circumvention of transfer taxes.

Perhaps in response to such concerns, the ABLE legislation eliminates for ABLE accounts the distinction between the account owner and the beneficiary, and thus requires an irrevocable transfer to the beneficiary by the funder(s) of the ABLE account. In addition, ABLE accounts are ineligible for the 5-year accelerated gifting provision applicable to 529 accounts.

The requirement that an ABLE beneficiary be the account owner is puzzling, particularly given that  many beneficiaries are likely to be minors, and that some of the beneficiaries may not have contracting capacity even when they are adults. This suggests that ABLE accounts may need to be established as UTMA or UGMA accounts or in other forms of individual or corporate custodianship for the account owner/beneficiary.

A related peculiarity is that, as is the case with Section 529 accounts, the ABLE statute permits changes in an account’s designated beneficiary to another “member of the family”, although for ABLE accounts that term is limited to siblings and step-siblings of the beneficiary, whereas for Section 529 accounts the term includes a much wider menu of relatives. Given that an ABLE beneficiary is also required to be the account owner, it appears that a change in account beneficiary also would require a change in account ownership. Moreover, given that such a change would require direction from the account owner, any such change would seem to require direction by the original account owner/beneficiary or by some other individual with power of attorney for the original account owner/beneficiary. This is an area in which regulatory or other guidance is likely to be required.

An additional peculiarity is that the ABLE legislation attempts to provide some bankruptcy protection to ABLE accounts, as is provided for Section 529 accounts.  However, the language protecting ABLE accounts protects ABLE account assets “only if the designated beneficiary of such account was a child, stepchild, grandchild, or stepgrandchild of the debtor.” This language makes sense in the context of Section 529, where the “debtor”/account owner typically is a different individual than the beneficiary. In the case of an ABLE account, where the beneficiary is required to be the account owner, the language offers no protection for a bankruptcy by the account owner/beneficiary, as, notwithstanding some well-known song lyrics, the beneficiary cannot be his or her own child or grandchild.

e. Eligibility Requirements

Under the ABLE legislation, the beneficiary of an ABLE account must be an “eligible individual” at the time the account is established, at the time of any contribution to the account and at the time of a distribution for qualified disability expenses. Eligibility is required to be redetermined for each tax year. To be eligible, an individual must have been determined to be disabled prior to age 26.

There are two ways of satisfying the disability determination. First, an individual meets the eligibility requirement if during the applicable tax year the individual is entitled to Social Security Act benefits based on blindness or disability that occurred before the individual reached age 26. Alternatively, the eligibility requirement can be satisfied if (i) a certification is filed on behalf of the individual for the applicable tax year with the Treasury Secretary, certifying that the individual is blind or has a physical or mental impairment which results in severe functional limitations and which has lasted or is expected to last for a continuous period of at least 12 months or can be expected to result in death, (ii) the certification attests that such blindness or disability occurred prior to age 26 and (iii) the certification includes a diagnosis of the relevant impairment signed by a qualified physician.

The ABLE legislation does not specify what happens if an individual is eligible at the time an account is established and at the time of contributions and distributions, but there are intervening years in which the annual eligibility determination was not made or documented. Regulatory guidance will be needed on whether there is a deemed termination of the ABLE account in the first year in which eligibility is not determined, or a less draconian result.

f. Qualified Disability Expenses

As with Section 529 accounts, earnings in an ABLE account build up on a federally tax-free basis, and distributed earnings remain tax-free to the extent they do not exceed the beneficiary’s qualified expenses in the applicable tax year. For an ABLE account, “qualified disability expenses” is defined broadly as “any expenses related to the eligible individual’s blindness or disability which are made for the benefit of an eligible individual” and includes expenses for education, housing, transportation, employment training and support, assistive technology and personal support services, health, prevention and wellness, financial management and administrative services, legal fees, oversight and monitoring, funeral and burial and other expenses approved by the Treasury Secretary.

The earnings portion of distributions from an ABLE account that exceed an eligible beneficiary’s qualified disability expenses is subject to federal income tax and, unless the distribution follows the beneficiary’s death, a 10% additional tax.

g.  Investment Direction

The ABLE legislation permits an account beneficiary to direct the investment of contributions to the account twice a year.  (The ABLE legislation also amends Section 529 to permit such twice a year investment direction for Section 529 college savings accounts.) Assuming that the IRS interprets the ABLE statute in a manner similar to its interpretation of the investment direction provisions in Section 529, ABLE account beneficiaries will be able to redirect existing account balances among the ABLE program’s investment options twice per year, and will be able to direct the investment of any new contributions at the time the applicable contribution is made. Again, because the ABLE beneficiary may be a minor or have a disability that precludes investment decisions, a person with power of attorney to make such investment decisions on the beneficiary’s behalf may be required.

h. Effect on Eligibility for Means-Tested Programs

Aside from availability of funds for savings purposes, a frequent impediment to saving for a dedicated purpose such as higher education expenses or disability expenses is the perception that such savings may reduce the amount of available funding from other sources, such as financial aid in the case of college savings accounts and federal or state disability assistance in the case of disability savings accounts. The ABLE legislation addresses this issue by generally excluding ABLE account balances and distributions from being counted for purposes of means-tested federal programs.

There are two exceptions relating to the Supplemental Security Income (SSI) program: distributions from an ABLE account for housing expenses are not excluded, and the excess of an ABLE account balance over $100,000 is counted and may result in the suspension of SSI benefits during any period in which such excess amount remains in the ABLE account. Even if SSI benefits are suspended due to an ABLE account balance in excess of $100,000, the beneficiary’s Medicaid eligibility is not impacted by such suspension.

i. State Reimbursement Claim upon Beneficiary’s Death

Upon the death of an ABLE account beneficiary, a state that has paid for the beneficiary’s medical costs incurred after the account was established may claim reimbursement from any balance in the ABLE account for such payments, net of any premiums paid on the beneficiary’s behalf to a Medicaid Buy-In program. The 10% income tax surcharge is inapplicable to any such distribution to a state.

j. ABLE Program Verification and Reporting Requirements

Under Section 529A, a state establishing an ABLE program is not required to verify the eligibility of a beneficiary for whom an ABLE account is opened; that appears to be between the beneficiary and the IRS, subject to any regulations that may be promulgated by the Treasury Secretary. Similarly, as is the case with Section 529 programs, an ABLE program is not required to determine whether distributions are qualified for tax-exemption or taxable. However, an ABLE program must report to the Treasury Secretary, at the time an ABLE account is established, the name and state of residence of the beneficiary, and must report on a monthly basis to the Commissioner of Social Security distributions from and account balances for each ABLE account.

Section 529A permits the Treasury Secretary to adopt regulations “providing for the information to be presented to open an ABLE account”, among other topics. The Treasury Secretary may also require the state sponsor of an ABLE program to report to the Treasury Secretary and account beneficiaries “with respect to contributions, distributions, the return of excess contributions, and such other matters as the Secretary may require.”

II. Getting ABLE Programs Off the Ground

a. State ABLE Legislation

The enactment of Section 529A will authorize the establishment of ABLE programs effective January 1, 2015, but ABLE accounts will not be available to families anxious to take advantage of tax-exempt savings for disabled beneficiaries until the beneficiary’s state of residence launches an ABLE program or enters into a contract with another state permitting its residents to use an ABLE program launched by the other state. A state is likely to require legislation authorizing a particular state agency or instrumentality to establish and administer an ABLE program, and it is also likely that legislative authorization would be required for a state to contract with another state for resident access to the other state’s ABLE program. Some states have already passed ABLE legislation in anticipation of the enactment of the federal tax benefit, but many states still need to do so before their residents can access the new tax benefit.

States that have not yet enacted ABLE legislation will need to determine whether the authority to launch and operate the state’s ABLE program should be granted to the state agency or instrumentality responsible for the state’s 529 college savings program, or to a different entity. Given the similarities between Section 529A and Section 529, there appear to be obvious efficiencies in consolidated administration of such programs. On the other hand, disability advocates may prefer administration of ABLE programs by state officials or boards with expertise in disability matters, even though the duties of ABLE program administrators are primarily investment-oriented.  Some states may elect to provide their Section 529 and Section 529A programs under the same roof, but include individuals with disability expertise on the applicable board or advisory council.

b. Program Managers and Investment Options

The consensus around the desirability of ABLE programs suggests the existence of substantial pent-up demand for investing in such programs. However, the current $14,000 per year contribution limit, and an ABLE program’s inability, with the limited exception of the “contracting state” provision, to attract out of state residents, are likely to result in a much longer ramp-up period for ABLE programs than for the more successful 529 programs, and smaller amounts of assets under management. States establishing ABLE programs will need to evaluate the pros and cons of lumping their 529 and 529A programs together for purposes of program management contracts and other potential administrative cost efficiencies inherent in combining the two asset pools operationally, while segregating them for legal and tax purposes.

Similarly, states establishing ABLE programs and their investment managers will need to consider the efficiency of offering similar investment options and underlying investments in their ABLE programs and college savings programs. One obvious adjustment that will need to be made is in age-based options, the most popular options under 529 programs, in which investments follow an increasingly conservative investment glide path as the account beneficiary approaches presumed college age. Age-based options may also be useful in ABLE programs, but considerable financial tinkering will be required to make them appropriate for expenditures over a disabled beneficiary’s lifetime versus the much narrower higher education window. The fact that many ABLE accounts are likely to be fiduciary or custodial accounts rather than accounts in which the account owner owes no fiduciary duty to the account beneficiary may also influence the investment line-up offered by ABLE programs.

 

 

 

SEC Introduces “Control Person” Liability as Enforcement Action Weapon in Claim Against Municipal Officer for Misleading Bond Offering Document

Posted in Disclosure

By Len Weiser-Varon

The U.S. Securities and Exchange Commission recently settled the first securities fraud charges brought against a municipal official alleging “control person” status under the federal securities laws.  The SEC’s settlement with the former mayor of the city of Allen Park, Michigan bars him from participating in future securities offerings and imposes a $10,000 penalty. A city administrator also was charged and barred from participation in future securities offerings

The SEC’s enforcement actions, brought against the city and the two city officials, alleged that the offering documents for a “double-barreled” general obligation bond issue contained false and misleading statements.  In particular, the SEC alleged that the offering documents failed to disclose adverse developments relating to a proposed public-private transaction for a film studio project to be located on land purchased with the bond proceeds; the project was not consummated, leading to financial difficulties that caused the state of Michigan to appoint an emergency manager for the city.  The bonds issued for the project were rated A by S&P and subsequently downgraded to BB+, and recent audited financial statements for the city have carried a going concern qualification.

The enforcement action against the city was brought under  Section 17(a)(2) of the Securities Act of 1933, which permits administrative action by the SEC for negligent conduct, and under SEC Rule 10b-5, which permits administrative action by the SEC as well as a private right of action by affected investors, but requires proof of “scienter”, or an intent to deceive (which has been interpreted to include highly unreasonable conduct or recklessness.)

More notably, the SEC charged the mayor as a “control person” under Section 20(a) of the Securities Exchange Act, under which any person who directly or indirectly “controls” another person found liable for a violation of the Securities Exchange Act or any regulation thereunder is jointly and severally liable, to the same extent as the controlled person, to any person to whom the controlled person is liable.  Liability as a “control person” can be avoided if the “control person” establishes that he or she acted in good faith and did not directly or indirectly induce the act or acts constituting the violation.

Liability under Section 20(a) generally requires two elements: a primary violation of the federal securities laws by the “controlled person”, and proof that the person charged with the Section 20(a) “controlled” the primary violator.  It is unclear whether there are any circumstances under which a municipal official sitting on a multi-person board or council could be held to “control” an issuer, or issuer personnel, found to be a primary violator responsible for fraudulent statements in an offering document for municipal securities.  But in the Allen Park enforcement action the SEC appears to have alleged that the mayor controlled the city, the alleged primary violator.

If a primary violation and “control” of the person or entity that made the misleading statement is established, the burden shifts to the “control person” to establish good faith, which, unsurprisingly, means the absence of bad faith, which is akin to the absence of scienter.  In theory, even if an accused official does not establish good faith, he or she can avoid liability upon proof that he or she did not “induce” the primary violation.  The courts have not conclusively adjudicated whether to “induce” requires active encouragement, or whether in some circumstances the failure to exercise efforts to prevent a violation can be deemed to induce the violation.

The Allen Park enforcement action was settled by the issuer and the officials without admitting or denying liability, and sets no precedent on what type of conduct by an issuer official constitutes “control” over a primary violator of the securities laws or induces the violation.  But it suggests that in the aftermath of U.S. Supreme Court decisions that have eliminated aiding and abetting liability in private actions under Section 10(b) of the Securities Exchange Act and narrowed the circle of potential primary violators that the SEC can allege “make”, within the meaning of Section 10(b), a fraudulent statement in a securities offering document, the SEC intends, when feasible, to use a “control person” theory to go after actors it deems culpable for securities fraud in municipal offerings but cannot reach as primary violators.

Initial reaction to the SEC’s introduction of “control person” charges to municipal securities enforcement actions has included concern that public officials involved with municipal entities that issue bonds or other securities may now face charges and potential vicarious liability for disclosure malfeasance by other issuer officers or employees.  However, the SEC will face an uphill battle proving allegations of “control”, bad faith and “inducement” of a primary violation by an issuer board member or official who may have approved the distribution of an official statement but was not actively involved in its preparation, did not sign the official statement, and did not urge another official to exclude or include particular disclosure. The extent to which the SEC will include “control person” charges in future enforcement actions alleging primary securities law violations by an issuer or another issuer official remains to be seen, but such charges are most likely to be brought where there is evidence of active complicity in deceptive disclosure.

 

Pennsylvania Amends Act 47 to Give the Commonwealth More Oversight and its Municipalities Less Time to Reorganize

Posted in Bankruptcy

By William Kannel and Adrienne Walker

Pennsylvania’s legislature recently approved House Bill No. 1773, an overhaul to its Municipalities Financial Recovery Act, commonly known as “Act 47.”  HB 1773 was signed into law by Governor Tom Corbett on October 31, 2014.

Act 47 was established in 1987 to provide the Commonwealth, largely through the Governor’s office, greater oversight over financially troubled municipalities.  Under Act 47 (currently and after the amendments go into effect), if a municipality is found to be in financial distress the Commonwealth is authorized to pursue a series of escalating steps to address the municipality’s financial problems, ranging from a coordinator to a receiver selected by the Governor.  At each level of state oversight, municipalities are required to adopt or abide by recovery plans to address their respective financial distress.  No Act 47 plan may unilaterally alter the rights of bondholders.

The primary changes to Act 47 include the following:

  • Termination Date:  The amendments establish a maximum 5 year exit strategy.  While the amendment does not stop a municipality from returning to Act 47, its intent is to move municipalities more quickly through an Act 47 rehabilitation.  This change will impact municipalities, such as Pittsburgh, which is presently under Act 47 oversight.  The amendment will require all current Act 47 municipalities to exit Act 47 oversight within 5 years from the date of their most recently enacted recovery plan.
  • Early Intervention Program:  With the goal of preventing municipalities from experiencing significant financial distress, the Commonwealth will establish an early intervention program to provide resources to municipalities to manage potential financial distress.  This early intervention program may provide financial support to municipalities through grants (subject to partial matching by the municipality) to develop plans for fiscal stability.
  • Ability to Raise Certain Taxes:  The amendment will allow a municipality under certain circumstances to petition to triple the applicable local services tax.  However, the amendments exempt Pittsburgh from this potential opportunity.
  • Disincorporation:  While it is unlikely to be a common occurrence, the amendments outline a process for disincorporation of “nonviable municipalities.”  For purposes of the disincorporation provisions, the definition of municipality excludes any city of the first class – which only includes Philadelphia. The process of disincorporation involves both state court and gubenatorial oversight. Upon disincorporation, the municipality is established as an unincorporated services district and the municipality’s assets (including bondholder collateral) would vest in the Commonwealth and be held in trust for the residents, property owners and other parties in interest.  While the amendments appear to preserve bondholder rights to collateral and payments of debt obligations, bondholders involved with a municipality that may disincorporate must be vigilant in preserving their rights to both their collateral and future debt service payments.

IRS Provides Increased Flexibility on Management Contracts for Tax-Exempt Bond-Financed Property

Posted in Tax/arbitrage

By Maxwell D. Solet

On October 24, 2014, the Internal Revenue Service issued Notice 2014-67 (the “Notice”), which provides important guidance and increased flexibility for issuers and conduit borrowers of tax-exempt bonds regarding contracting with private parties in a manner that avoids “private use” by such parties of bond-financed facilities. The Internal Revenue Code restricts private use of facilities financed by certain categories of tax-exempt bonds, including governmental bonds and bonds issued for the benefit of hospitals and other organizations that are tax exempt under Section 501(c)(3) of the Internal Revenue Code. The Notice addresses so-called “management contracts,” i.e., contracts (other than leases) with private parties that provide services with respect to bond-financed property, and, as discussed below, states that no private use will be deemed to arise from such contracts provided their term does not exceed 5 years and the compensation methodologies adhere to an expanded menu of permissible arrangements.

The Notice also addresses the treatment, for private use purposes, of Accountable Care Organizations (ACOs) established under the Affordable Care Act, and provides helpful guidance for participation in such organizations without creating “private use.”

The New 5-Year Safe Harbor

The Notice “amplifies” Revenue Procedure 97-13, which provides various safe harbors under which management contracts will not be treated as causing private use of bond-financed facilities. Both the National Association of Bond Lawyers and the American Bar Association have urged that this 1997 Revenue Procedure be updated to reflect substantial changes since its publication in the sorts of arrangements being proposed or used in connection with bond-financed facilities, including the use of ACOs.

The Notice’s new safe harbor for contracts with a term not exceeding five years improves on the existing safe harbor for contracts of similar length in several respects:

  • The new 5-year safe harbor permits a binding contract for the full 5-year term. The existing one required that the contract be terminable without penalty by the issuer or conduit borrower at any earlier date than their full term.
  • The existing 5-year safe harbor required that at least 50% of the compensation payable to the private party under the contract be fixed. The new 5-year safe harbor, as confirmed by informal conversations with the IRS, permits any combination of the permissible compensation methods outlined in the 1997 Revenue Procedure, including a 100% variable compensation methodology based on a percentage of revenues or a percentage of expenses (but not both, since that would be considered a proxy for participation by the private party in the bond-financed facility’s net profits, which is a third rail for “private use” purposes.)
  • While Revenue Procedure 97-13 allowed an annual “productivity award” based on achievement of revenue or expense goals, the Notice permits a new type of annual incentive payment keyed to satisfying quality performance standards.

IRS private letter rulings approving management contracts outside the safe harbors for some time have focused principally on the absence of an interest in net profits. The new safe harbor established under the Notice does the same, eliminating most of the detailed compensation rules under the existing 5-year and shorter safe harbors. The IRS can be expected at some point to promulgate a new Revenue Procedure which will eliminate those no longer necessary provisions.

While the Notice has a January 22, 2015 effective date, it specifically allows application to earlier bonds or contracts. Accordingly, the enhanced flexibility in compensation methodologies can be built into new contracts, and existing contracts can be amended if desired to take advantage of the new flexibility without jeopardizing tax-exemption of outstanding bonds.

Treatment of ACOs

The Notice also clarifies that hospitals or other health care organizations will not be treated as creating private use of bond-financed facilities through their participation in ACOs mandated by the Medicare Shared Savings Program under the Affordable Care Act.  The United States Treasury and the IRS have been focused on ensuring that federal tax policy not be inconsistent with federal health care policy, which has increasingly encouraged and in some cases mandated collaboration between tax-exempt 501(c)(3) organizations and for-profit entities. ACOs are a prime example. The IRS previously, in Notice 2011-20, provided favorable guidance on the effect of ACO participation on the tax-exempt status of such charitable organizations.

While an argument could be made that ACO arrangements are just a variation on third-party payment arrangements, and third-party payers have never been treated by bond counsel as “users” of bond-financed facilities, the need for this guidance arises, first, from the fact that ACOs must be distinct legal entities, frequently partnerships, which are separate from the health care provider and separate from insurers, and, second, from the fact that these arrangements provide for financial sharing between the exempt and non-exempt participants which might be viewed as problematic for the private use analysis. Under the Notice, upon satisfying multiple stated requirements, ACOs will not be treated as creating an impermissible net profits interest by the ACO or its private participants (such as doctors’ organizations) and therefore will not be treated as private use. This guidance is consistent with recommendations made by industry groups, including the National Association of Bond Lawyers. The major shortcoming of those recommendations and this guidance is the failure to deal with ACOs other than those which are created under the Affordable Care Act. In fact, health care providers are under increasing pressure to participate in ACOs to deal with other third-party payers, and such ACOs may include features which are not blessed under the Notice.

 

Court Rules on Applicability of Make-Whole Premiums Upon Debt Acceleration

Posted in Bankruptcy, Financing Structures

BY LEN WEISER-VARON

The linked Mintz Levin client advisory, which discusses a recent bankruptcy court ruling regarding the applicability of a make-whole premium upon a refinancing of corporate debt following such debt’s automatic acceleration upon bankruptcy under the terms of the governing documents, may also be of interest to holders of municipal bonds with call protection and/or early redemption premiums.  In  the context of make-whole premiums, court decisions suggest that the applicability of the premium upon a refinancing in bankruptcy will be governed by the wording of the debt documents, and that if an automatic acceleration  is triggered by the documents and the documents do not expressly provide for a prepayment premium in such circumstances, no prepayment premium will be payable by the issuer.  Municipal bonds typically feature fixed percentage optional redemption premiums rather than make-whole premiums, but courts may also be inclined to apply to municipal bonds the principle that such early redemption premiums are inapplicable upon an acceleration absent express contract language applying the premium in that context (or, as some courts have suggested, absent evidence that the issuer deliberately defaulted for the purpose of circumventing the call protection provisions.)

PREPA Bondholders Seek Summary Judgment Invalidating Puerto Rico’s Public Corporation Bankruptcy Legislation

Posted in Bankruptcy

By LEN WEISER-VARON and BILL KANNEL

On August 11, Franklin Funds and Oppenheimer Rochester Funds filed a second amended complaint, opposition to motion to dismiss and cross-motion for summary judgment in the litigation they previously filed in the United States District Court for Puerto Rico challenging the constitutionality and validity of Puerto Rico’s so-called Recovery Act.  The second amended complaint reiterates that a PREPA filing under the Recovery Act, which establishes debt adjustment procedures for most of Puerto Rico’s public corporations, is both “probable and imminent.”  The motion seeks summary judgment on two of the plaintiffs’ claims: that the Recovery Act is constitutionally and statutorily preempted, and that the Recovery Act’s automatic stay provisions are illegal to the extent they purport to preclude a federal court action.  The motion asserts that these two claims are “purely legal, and will not be clarified by further factual development.”

The summary judgment motion re-enforces our prior assessment that, once the court is persuaded to address the merits, one of the plaintiffs’ strongest arguments is that Section 903 of the federal Bankruptcy Code precludes enforcement of any Recovery Act debt adjustment against non-consenting bondholders.

The motion, referencing legislative history and prior case law,  effectively dispenses with Puerto Rico’s relatively weak arguments that Section 903 cannot or should not be read as applicable to Puerto Rico’s public corporations.   Puerto Rico has argued that Congress could not have intended to leave its public instrumentalities without access to any debt adjustment process, which, given Puerto Rico’s express exclusion from eligibility under Chapter 9 of the Bankruptcy Code, would be the effect of  applying Section 903 to Puerto Rico’s own public corporation insolvency legislation.  Whether Congress indeed intended to leave Puerto Rico in such a predicament is unclear.  The plaintiff’s brief suggests that because Puerto Rico’s bonds, unlike any state’s bonds,  benefit from nationwide triple tax-exemption (which accounts for Puerto Rico’s status as the third highest volume issuer of tax-exempt bonds after California and New York), “Congress did not want Puerto Rico to restructure its municipal debt through either its own laws or Chapter 9.”  Whether this or any other rationale for Puerto Rico’s statutory treatment under the Bankruptcy Code exists, the plaintiffs’ motion argues that the statutory language in Chapter 9 is explicit, and that if Puerto Rico is unhappy with its position, “Puerto Rico’s remedy lies … with Congress.”

Although Section 903 does not technically preempt or prohibit all of the Recovery Act, if a court agrees that Section 903 is applicable, any debt adjustment produced by the Recovery Act’s procedures could not be enforced against non-consenting creditors, thereby rendering the Recovery Act largely ineffective as a debt adjustment mechanism.

For an adjudication of the plaintioffs’ challenge to take place in federal court, plaintiffs must establish standing and ripeness.  The Commonwealth and PREPA have asserted the obvious argument that PREPA has not filed under the Recovery Act, and that therefore there is no case or controversy to adjudicate. The plaintiffs’ summary judgment motion, like the original complaint, argues that the plaintiff PREPA bondholders have suffered a devaluation of their bonds as a result of the Recovery Act’s enactment, and that they are forced to litigate before a filing because the automatic stay provisions of the Recovery Act would preclude them from pursuing federal court litigation after a PREPA filing under the Recovery Act.  (As noted, the plaintiffs simultaneously seek summary judgment on the unconstitutionality of any such application of the Recovery Act’s automatic stay to preclude or freeze a federal court action.) Whether these arguments that the case is ripe for adjudication will find traction with the court remains to be seen.

The filing also previews arguments that will be further litigated if the Recovery Act survives the plaintiffs’ preemption claim.  The plaintiffs assert that the Recovery Act’s provisions effect an unconstitutional impairment of contracts.   As we have previously discussed, courts have interpreted the “Contracts clause” not as an absolute bar to impairment of contracts by state action, but rather as a balancing test in which the state’s interests and needs and the extent of the contractual impairment are weighed against each other.  This makes contract impairment claims highly fact-sensitive and unlikely candidates for summary judgment.  For example, the plaintiffs’ brief argues that PREPA has the following alternatives to impairing its bonds through debt adjustment:

(1)    PREPA can raise rates.

(2)    The Commonwealth of Puerto Rico could repay over $640,000,000 it owes to PREPA.

(3)    The Commonwealth could reduce PREPA’s taxes and subsidies which the brief asserts amount to over $1 billion from 2014 through 2018.

(4)    PREPA should collect its full accounts receivable and pay subsidies after debt service instead of permitting customers to offset subsidies from their payments.

(5)    PREPA should cut costs and address inefficiencies.

(6)    PREPA should strengthen its capital markets reputation by hiring an investment banker and making public presentations.

If PREPA, or any other public corporation, eventually seeks protection and debt adjustment under the Recovery Act, these types of arguments about whether the applicable issuer requires any debt adjustment in order to maintain financial and operational viability (and, if so, whether the proposed amount of debt adjustment is necessary for such viability) will be front and center in such proceedings.

Puerto Rico and PREPA Seek Dismissal of Bondholder Challenge to Territory’s Bankruptcy Statute

Posted in Bankruptcy

 

By LEN WEISER-VARON and BILL KANNEL

The Commonwealth of Puerto Rico and the Puerto Rico Electric Power Authority (PREPA) yesterday filed separate motions to dismiss the federal court complaint filed last month by some PREPA bondholders seeking to invalidate the recently-enacted Puerto Rico Public Corporation Debt Enforcement and Recovery Act.  As anticipated, the motions to dismiss assert that the plaintiffs lack standing and the claims lack ripeness because PREPA has not, to date, sought relief under the challenged legislation.

PREPA’s motion is limited to standing and ripeness arguments; the Commonwealth’s motion to dismiss also engages the bondholders’ substantive claims, arguing that the bondholders have failed to state claims on which relief can be granted.  In our prior analysis of the bondholders’ complaint, our assessment was that the bondholders’ strongest argument is the statutory argument that Section 903 of the federal Bankruptcy Code preempts Puerto Rico’s bankruptcy legislation.   The Commonwealth’s motion to dismiss confirms that assessment, as its attempts to rebut the preemption argument consist principally of an argument that Congress cannot have intended to leave Puerto Rico’s public corporations without recourse to a bankruptcy process, even though that is exactly what Section 903 appears to do as a literal matter.

Section 903 provides that “a State law prescribing a method of composition of indebtedness of [a] municipality may not bind any creditor that does not consent to such composition.”   The Commonwealth’s motion argues that “because Puerto Rico’s public corporations may not avail themselves of Chapter 9, Section 903—which, by its own terms, applies only when Chapter 9 is invoked—is wholly inapplicable to the Commonwealth.” (emphasis added)  The Commonwealth’s motion to dismiss does not corroborate its assertion that Section 903 “by its own terms … applies only when Chapter 9 is invoked” with any identification of the “terms” of Section 903 that allegedly limit its application to jurisdictions that are eligible to adopt Chapter 9.

Apparently recognizing that its textual analysis of what Section 903 literally says may be unpersuasive, the Commonwealth’s motion next asserts that Section 903 cannot possibly mean what it apparently says.  According to the motion: “That Congress would have denied Puerto Rico and its public corporations [the] ability to escape financial ruin in a brief statutory provision unrelated to Puerto Rico strains credulity.”   Finally, the Commonwealth argues that if Section 903 says what it appears to say, Section 903 of the Bankruptcy Code may be unconstitutional because it discriminates against Puerto Rico: “In any event, even if Section 903 could plausibly be read to pre-empt the Act—and it cannot—Plaintiffs’ construction of Section 903—under which Puerto Rico would not only be excluded from Chapter 9, but also barred from enacting a nearly identical restructuring mechanism of its own—would force this Court to confront constitutional concerns about whether Congress properly exercised its power to establish ‘uniform laws on the subject of bankruptcies through the United States.’”

With regard to the Commonwealth’s suggestion that it might be unconstitutional for Congress to exclude Puerto Rico from access to a bankruptcy process that binds non-consenting creditors, it should be noted that the federal courts have held that “Congress, which is empowered under the Territory Clause of the Constitution, U.S.Const., Art. IV, § 3, cl. 2, to ‘make all needful Rules and Regulations respecting the Territory . . . belonging to the United States,’ may treat Puerto Rico differently from States so long as there is a rational basis for its actions.” New Progressive Party v. Hernandez Colon, 779 F. Supp. 646, 661 (D.P.R. 1991)(citing Harris v. Rosario, 446 U.S. 651 (1980)).

In sum, the motions to dismiss seek to defer adjudication of the validity of Puerto Rico’s bankruptcy legislation until one or more of Puerto Rico’s public corporations seek protection under the legislation.  As to the merits of the challenge, the Commonwealth’s motion to dismiss raises predictable counter-arguments to the constitutional challenges, but contains little firepower on what is likely to be the central issue, the federal Bankruptcy Code’s statutory prohibition on non-federal debt composition statutes that purport to bind nonconsenting creditors.  The motion’s arguments that Section 903 doesn’t say what it appears to say, can’t say what it appears to say, and is unconstitutional if it says what it appears to say, do little to dispel our perception that this legislation faces a battle under Section 903.

Be PREPAred: PREPA Bondholders Greet Puerto Rico’s Bankruptcy Legislation With Federal Lawsuit

Posted in Uncategorized

By LEN WEISER-VARON and BILL KANNEL

On Saturday, June 28, Puerto Rico’s Governor Padilla signed into effect Puerto Rico’s new bankruptcy law for certain revenue bond issuers.  Within 24 hours of the statute’s enactment, two mutual fund complexes owning approximately $1.7 billion in bonds of the Puerto Rico Electric Power Authority (PREPA) filed a complaint in the federal district court for Puerto Rico, seeking a declaratory judgment invalidating the fledgling legislation.

The complaint is efficient and straightforward.  It asserts that the legislation is preempted by Section 903 of the United States Bankruptcy Code, which precludes “States” from enacting laws for the composition of debt of “municipalities” that purport to bind non-consenting creditors.  The complaint additionally alleges that, even if not preempted, certain provisions of the legislation effect unconstitutional impairments of contract and/or takings of property of secured creditors.

Puerto Rico has yet to file a response to the complaint, but the Section 903 argument is compelling and, subject to likely objections by Puerto Rico to adjudication of the statute’s validity before a specific issuer seeks its protection, has the potential to make short shrift of Puerto Rico’s attempt to create a bankruptcy process applicable to its financially challenged revenue bond issuers.

 

 

Puerto Rico Poised to Enact Bankruptcy-Like Legislation for Certain Revenue Bond Issuers

Posted in Bankruptcy

By LEN WEISER-VARON and BILL KANNEL

Puerto Rico’s Governor Alejandro Garcia Padilla today introduced debt restructuring legislation which, upon enactment, would provide a judicial debt relief process in Puerto Rico’s courts for certain public corporations, including the Puerto Rico Electric Power Authority (“PREPA”), the Puerto Rico Aqueduct and Sewer Authority (“PRASA”) and the Puerto Rico Highways and Transportation Authority (“PRHTA”).  Despite a semantic effort at today’s press conference by the Governor and in the legislative preamble to distinguish the proposed legislation from “bankruptcy” legislation, the legislation is modeled on Chapter 9 and Chapter 11 of the U.S. Bankruptcy Code (with some significant distinctions) and is in all practical respects a non-federal bankruptcy statute.  The Governor urged Puerto Rico’s legislature to adopt the proposed legislation by June 30, and enactment is considered a virtual certainty.

Under the proposed legislation, entitled “The Puerto Rico Public Corporation Debt Enforcement and Recovery Act,” an eligible public corporation may pursue either or both of two alternatives, simultaneously or sequentially.  The first is a “consensual debt relief transaction” (which can be analogized to a “prepack” and will likely be known as a “Chapter 2″ proceeding.)  To initiate a Chapter 2 proceeding, an eligible entity files a notice of “suspension period” on its website, which notice stays any remedial action by any creditor identified in such notice for a period of up to 360 days if the entity does not seek court approval of specified debt relief, or, if such approval is requested, until the final unappealable approval of such relief or 60 days following denial of such relief.

The applicable consensual debt relief in a Chapter 2 proceeding may only be approved by the court if at least 50% of the amount of debt within a class of substantially similar debt identified by the issuer participates in a vote or consent solicitation relating to the proposed amendments, modifications, waivers or debt exchanges relating to the applicable debt, and at least 75% of the amount of debt in such class that so participates approves the proposed relief.  If so approved, the applicable debt relief is purportedly binding on all creditors within the applicable class.

The second avenue for debt relief (which will likely be known as a Chapter 3 proceeding) involves the filing of a petition with the court by, or on behalf of, an eligible public corporation, which filing triggers an automatic stay protecting  the applicable public corporation from remedial efforts by creditors.  Chapter 3 provides for judicial confirmation of a debt adjustment plan if at least one class of impaired debt has voted to accept the plan by a majority of all votes cast in such class and if two-thirds of the aggregate amount of impaired debt in such class is voted.

Under the proposed legislation, all impaired creditors in a Chapter 3 proceeding must receive payments and/or property having a present value of at least the amount the claims in the applicable class would have received if all creditors had been allowed to enforce their claims on the date the issuer’s petition for relief was filed.  In addition, every such impaired creditor must also receive its pro rata share of 50% of the issuer’s positive free cash flow, if any, after payment of operating expenses, capital expenditures, taxes, debt service, reserves, changes in working capital, cash payments of other liabilities and extraordinary items, during a period of 10 full fiscal years following  the first anniversary of the plan’s effective date.  Such recovery is capped at the amount necessary, together with the present value payment described above, to provide for repayment of the applicable creditor’s full claim on the petition date, with any excess reallocated among remaining impaired creditors.

If enacted, attacks on the legislation’s constitutionality and on the constitutionality of particular provisions are inevitable.  Because the legislation would not be enacted pursuant to the U.S. Constitution’s bankruptcy power, it would have no federal constitutional protection from other provisions of the U.S. Constitution, including those protecting contracts from impairment by state action (which for this purpose would include action by the territory of Puerto Rico.)

The legislative preamble devotes significant attention and argument to the proposition that the legislation is constitutional.  However, the legislation also includes a provision stating that if a contractual creditor demonstrates that its contractual rights are substantially impaired by a Chapter 2 or Chapter 3 proceeding, the impairment shall be allowed only if the issuer (or the Government Development Bank (“GDB”), acting on its behalf) demonstrates that the impairment is a reasonable and necessary means to advance a legitimate government interest, and the creditor “fails to carry the burden of persuasion to the contrary.”  This statutory description, which loosely parallels the federal judiciary’s interpretation of the circumstances under which contract impairments are permitted notwithstanding the “contracts clause” of the U.S. Constitution, fails to mention a key element of that judicial test, namely the requirement that the government establish that no less burdensome alternatives exist for achieving the legitimate government interest.

Another consequence of the legislation being non-federal is that Puerto Rico cannot avail itself of the far-reaching jurisdictional provisions of the federal Bankruptcy Code.  This may permit some creditors to assert jurisdictional challenges to the binding nature of any proceeding conducted in the Court of First Instance, San Juan Part, as the bill requires.  The bill provides for appeals to the Puerto Rico Supreme Court.

Eligibility for the relief provided in the proposed legislation is limited to specific public corporations.  Such corporations may file their own Chapter 3 petitions or GDB, acting at the Governor’s request, may do so on their behalf; any Chapter 2 debt relief must be approved by GDB.  As noted, eligible corporations include (among others) PREPA, PRASA and PRHTA, and the legislative preamble specifically catalogues their financial difficulties in justifying the need for a debt relief mechanism.  In addition, to be eligible to file a Chapter 3 petition, a public corporation must be “insolvent” and must be ineligible for relief under the U.S. Bankruptcy Code because it is not a “municipality” eligible to file under Chapter 9 and is a “government unit” ineligible to file under Chapter 11.

The bill defines “insolvent” as “currently unable to pay valid debts as they mature while continuing to perform public functions” or “at serious risk of being unable, without further legislative acts and without financial assistance from the Commonwealth or GDB, to pay valid debts as they mature while continuing to perform public functions.”

Certain entities are expressly excluded from filing under the proposed statute, including (among others) the Commonwealth of Puerto Rico, Puerto Rico’s municipalities, the GDB and its subsidiaries and affiliates, the Puerto Rico Sales Tax Financing Corporation (COFINA), the Municipal Finance Agency, the Municipal Finance Corporation, the Puerto Rico Industrial, Tourist, Educational, Medical and Environmental Control Facilities Financing Authority and the Puerto Rico Infrastructure Financing Authority.

Certain classes of creditors and claims are expressly protected from impairment under a Chapter 3 plan.  Such protected claims include employee claims for wages, salaries, commissions, vacation, severance and sick leave pay, and similar employment benefits, unless such claims arise under a collective bargaining agreement or retirement or post-employment benefit plan.

Much remains to be said and analyzed on this legislation.  At first blush, however, the legislation (if enacted and determined to be constitutional) would, in some cases, provide more favorable treatment to Puerto Rico’s eligible revenue bond issuers, and less favorable treatment to their creditors, than would Chapter 9 of the United States Bankruptcy Code.  For example, the special revenue provisions of Chapter 9 appear absent from the Puerto Rico legislation, though it is focused on revenue bond issuers.

Municipal Bond Market Absorbs Puerto Rico Supreme Court’s Decision that Teacher Pension Reform Legislation is Unconstitutional Contract Impairment

Posted in State Law

BY LEN WEISER-VARON and BILL KANNEL

The latest swerve in the rollercoaster that is Puerto Rico public finance occurred on April 11 with the release of the Puerto Rico Supreme Court’s ruling striking down as unconstitutional the bulk of the territory’s teacher pension reform legislation.  The outcome of the case creates some disarray in the executive and legislative branches’ efforts to stabilize Puerto Rico’s finances, as well as in the Puerto Rico Supreme Court’s contracts clause jurisprudence.

We have previously discussed both the teacher pension reform litigation and the Puerto Rico Supreme Court’s prior ruling in the Hernandez case upholding the territory’s public employee pension reform legislation.  In the 5-4 Hernandez case, the dissents included strongly worded accusations that the majority had rubber-stamped the legislature’s conclusion that there were no less onerous alternatives to the  challenged impairments of the employee’s pension rights.   In the 5-3 teacher pension case, the majority went to the other extreme and concluded that the legislature and governor had acted unreasonably in enacting the legislation, because (according to the majority) the legislation failed to take into account the high number of accelerated teacher retirements the legislation would provoke, which (according to the majority) would further strain, rather than improve, the teacher pension system’s finances.

In other words, the court majority concluded that the teacher pension reform legislation did not promote the public purpose to which it was addressed.  As we have previously discussed, the “contracts clause” in the U.S. and Puerto Rico constitutions has been interpreted as permitting state action that impairs contracts if such action promotes a necessary public purpose and there are no less onerous means of achieving that public purpose.  Because the Puerto Rico Supreme Court concluded that the teacher pension reform legislation did not serve its stated public purpose of preserving the viability of the teacher pension system, it did not have to address whether there were less onerous means of achieving that purpose than the legislation’s benefit cutbacks and contribution increases.

In particular, the court referenced certain provisions of the legislation that preserved certain benefits for teachers retiring prior to a near-term cutoff date, economic studies presented by the teachers’ union regarding the impact of the early retirement of 7000 teachers, and an actuarial study forecasting the consequences of the early retirement of 5,000, 7000, 10,000 and 15,000 teachers, respectively.  The court also referenced testimony to the effect that approximately 4,100 teachers had contacted the pension system about early retirement since the legislation was enacted, and that 10,000 or more teachers would be eligible for early retirement.  The court interpreted the actuarial studies as showing that if such large-scale early retirements occurred, the pension fund would be depleted at an earlier date than if no legislation were enacted.  The court noted that the legislation had been enacted during a 6-day period and that the legislature had commissioned no studies about the early retirements the legislation might trigger or the impact of such early retirements on the system’s solvency.  The majority concluded that the teachers’ union had met its burden of proof that the challenged legislation, instead of increasing the system’s solvency, would leave it in a more precarious position.

The court upheld the legislation as applicable to teachers who began or begin service subsequent to its enactment, and also upheld certain cutbacks on system contributions to teachers’ health plans and annual Christmas bonuses to retired teachers, concluding that those benefits were not pension rights or contract rights.

It is unusual for a court, in a situation of fiscal crisis,  to hold that the other branches of government are effectively wrong about the financial effect of legislation being positive rather than negative.  There no doubt are genuine distinctions between the evidence presented in the Hernandez case and in the teachers’ pension case; it is also clear that there was a change in the receptiveness of certain of the court’s members to the government’s arguments regarding the necessity of the applicable pension reform.  To understand the difference in analysis and result, one may need to go no further than the majority opinion’s second paragraph, which states that “Teachers are the ones that mold the knowledge of the members of our society.  They are a fundamental piece of the educational system.”   A majority of the court appears to have credited the teachers’ presentation on this difficult public policy matter over the government’s.

Puerto Rico bondholders have been following this case for its credit implications as well as its legal implications.  The result may be a mixed bag from both perspectives.  From a credit perspective, the decision invalidates teacher pension reform that the Puerto Rico government has touted as an important component of its financial stabilization plan; on the other hand, the court invalidated the legislation on the stated grounds that the reform would make things worse, not better.  From a legal perspective, the court’s closer scrutiny of contract impairment may be somewhat heartening to bondholders concerned that Puerto Rico’s debt may be next on the impairment list.  Whether any comfort is warranted remains to be seen, but it seems less likely that the Puerto Rico Supreme Court would second-guess the financial efficacy of any future attempts to legislate debt restructuring.