Public Finance Matters

Updates on recent public finance and municipal bond developments

Puerto Rico’s Recovery Act Ruled Preempted: What Now?

Posted in Bankruptcy, State Law

By LEN WEISER-VARON and BILL KANNEL

At the end of “The Candidate”, Robert Redford’s title character, having won, famously asks, “What do we do now?”

A similar question can be asked now that the federal district court in Puerto Rico has struck down the Puerto Rico Public Corporation Debt Enforcement and Recovery Act.

In a February 6, 2015 opinion, Judge Besosa rejected enough of Puerto Rico’s ripeness and standing arguments to reach the merits of the plaintiffs’  challenges to the validity of the Recovery Act.  As we had anticipated, Judge Besosa held that the Recovery Act is preempted by Section 903(1) of the federal Bankruptcy Code, which 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 Recovery Act contains provisions that purport to permit changes to the debt obligations of eligible Puerto Rico public corporations without the consent of all affected debtholders. The court held that Section 903(1) applies to Puerto Rico, and that it not only invalidates those provisions of the Recovery Act that purport to bind non-consenting creditors, but preempts the Recovery Act entirely.

Puerto Rico enacted the Recovery Act because the federal Bankruptcy Code precludes Puerto Rico’s public corporations from availing themselves of Chapter 9 of the federal Bankruptcy Code to restructure their debts. Puerto Rico’s public officers are now asking themselves the Spanish version of Redford’s question: “Y ahora que hacemos?” Certain creditors of PREPA and other overleveraged Puerto Rico issuers may be asking variations of that question.

Some potential answers:

1)      The Recovery Act may yet recover. In addition to the ripeness and standing issues, Judge Besosa’s opinion rests on a textual analysis of Section 903(1), including the definition of the word “creditor” as used therein and elsewhere in the Bankruptcy Code and its applicability to creditors of an entity that is not a debtor in a federal proceeding. Puerto Rico is likely to appeal the federal district court’s ruling, both as to the ripeness and standing analysis and as to the applicability of Section 903 to Puerto Rico and the Recovery Act. The ruling is certainly a victory for the plaintiff bondholders and takes the Recovery Act off the table for the near future. In addition, Judge Besosa’s discussions of the contract clause and taking clause issues with the Recovery Act highlight the obstacles the Recovery Act has faced from the beginning as legislation that does not benefit from the federal bankruptcy power’s override of the contracts clause. Accordingly, a resurrected version of the Recovery Act, if any, would continue to face substantial legal challenges. But the Recovery Act, or something like it, will remain hovering in the background of any restructuring discussions during the pendency of the likely appeal.

2)      The invalidation of the Recovery Act, whether or not it proves permanent, eliminates the only existing process under which those public entities that would have been eligible to restructure under that legislation could do so over the objections of holdouts.  Both for Puerto Rico and for those creditors who believe that PREPA and/or certain other Puerto Rico issuers are incapable of sustaining their existing debt and must restructure, the invalidation of the Recovery Act may provide additional impetus to try to persuade the U.S. Congress to amend the Bankruptcy Code to authorize Puerto Rico to authorize its public corporations, or certain of its public corporations, to file for bankruptcy under Chapter 9. Such legislation was filed in the prior session of Congress and its viability may be somewhat enhanced by Judge Besosa’s ruling.

3)      While any Recovery Act appeal wends its way through the higher courts, and while any  legislation to amend the federal Bankruptcy Code seeks to wend its way through Congress, PREPA and PREPA’s creditors, and any other Puerto Rico issuers who seek debt relief and their creditors, will need to negotiate without a forum, without a final arbiter, and without the ability to impose a majority or supermajority consensus on holdouts. That process can be a messy and difficult one, but not necessarily an impossible one. In contrast to Robert Redford’s most recent movie, the working title for the as-yet-unfinished movie about Puerto Rico and its creditors remains All Is Not Lost.

 

 

 

Off-Key BABs: IRS Hits Wrong Note in Reissuance Analysis

Posted in Tax/arbitrage

By LEN WEISER-VARON

The IRS recently published a December 9, 2014 Chief Counsel Advice Memorandum to the effect that the defeasance of taxable Build America Bonds (BABs) causes a tax reissuance of the bonds, with the consequence that the municipal issuer ceases to be eligible for federal government interest subsidies for the period from the defeasance date to the redemption date.  (A “reissuance” means that from a tax perspective existing bonds are deemed exchanged for new bonds issued on the reissuance date.)  The BABs subsidy was available for bonds issued in 2009 and 2010; bonds issued or deemed issued in 2014 are ineligible.

This internal counsel advice is not particularly consequential in the specific context to which it applies.  As noted in a Bond Buyer article on the advice memorandum, defeasance escrows for taxable bonds tend to be established for short periods, usually the thirty day period between the date a redemption notice is mailed and the redemption date.  Accordingly, any loss of BABs subsidy to the issuer resulting from a purported reissuance is minor.  Similarly, though a reissuance of taxable bonds may accelerate realization of gain or loss by a bondholder, if the reissuance occurs 30 days before the redemption date, it is unlikely to change the tax year in which such gain or loss occurs.

The larger point is that the advice memorandum reflects a troubling approach by the IRS to the interpretation of its rules.  A legal defeasance of taxable bonds generally causes a reissuance (which is why taxable bond indentures provide for “covenant defeasance”, which permits the creation of a defeasance escrow that economically defeases the bonds while the issuer retains theoretical liability for any escrow shortfall.)  However, the reissuance regulations provide an exception for municipal bonds.  The reissuance exception applies to “tax-exempt bonds”, which IRS Regulation 1.1001-3(f)(5)(iii) defines as “a state or local bond that satisfies the requirements of § 103(a).”  Section 103(a) of the Internal Revenue Code sets forth the requirements that must be satisfied by tax-exempt municipal bonds.

BABs are required to meet the requirements of Section 103(a) in order to be eligible for the federal subsidy.  This is because the BABs subsidy, which is paid by the Treasury to the issuer and offsets the issuer’s interest cost, is merely an alternative mechanism for lowering the interest costs to a municipal issuer of issuing bonds that satisfy the criteria for a federal subsidy.  Instead of exempting the bondholder from income tax on the bond interest, thereby lowering the rate the issuer must pay to attract bond purchasers, the BABs mechanism pays a subsidy directly to the issuer, which some believe to be a more cost-effective form of federal subsidy.  But in order to be eligible for either form of subsidy – tax-exemption of interest, or direct subsidy payments to the issuer by the federal government – the applicable bonds must comply with the same Section 103(a) requirements.

So why does the IRS advice memorandum conclude that the reissuance exception for defeasance of bonds that satisfy the requirements of Section 103(a) is inapplicable to BABs?  The memorandum acknowledges that the legislation creating BABs was enacted subsequent to the promulgation of the relevant reissuance exception, and that the regulatory exception was not revised at that time to exclude BABs from  the exception.  But the memorandum asserts that the concerns that gave rise to the reissuance exception for such defeasances focused on preserving the tax-exemption of interest to bondholders, and that taxable BABs do not present the same concerns for bondholders.  Respected bond counsel dispute the advice memorandum’s characterization of the regulatory history of the reissuance exception.

But the more troubling feature of the IRS analysis is that BABs satisfy the literal requirements of the reissuance exception for defeasance.  Regulatory history and speculation as to whether the rulemakers would or wouldn’t have included BABs if they had focused on the question should only be relevant if there is ambiguity in the regulation.  In this instance, there is none.

Issuers should be entitled to rely on the plain meaning of IRS regulations in structuring their bond issues and/or refinancing their bond issues.  If circumstances change and the IRS does not wish a rule that literally applies to such changed circumstances to be applicable, the burden should be on the IRS to change the rule, versus expecting issuers and practitioners to pre-clear with the IRS whether some unwritten carveout to the rule exists in the minds of individuals at the IRS.  A more famous (and tonally adept) Babs once sang “If You Could Read My Mind,” but that is no way to run a tax system.

Municipal Bond Interest Paid By a Bond Insurer After an Issuer’s Bankruptcy Discharge Can Remain Tax-Exempt

Posted in Bankruptcy, Bond Insurance, Tax/arbitrage

By LEN WEISER-VARON and MAXWELL D. SOLET

In the aftermath of recent municipal bankruptcies in which issuers proposed and/or implemented bankruptcy plans involving partial discharges of the issuer’s payment obligation on insured bonds, there has been increased focus on whether municipal bond interest paid by a bond insurer after the bankruptcy plan’s effective date continues to be tax-exempt.

Market confusion as to the treatment of bond insurance payments in the discharged issuer context is at least partially attributable to an incomplete understanding of why bond insurer payments of municipal bond interest are deemed tax-exempt in other contexts. Although the IRS has not specifically addressed the tax status of bond insurer payments following the issuer’s partial (or full) discharge in bankruptcy, review of IRS rulings on bond insurance suggests that, in ordinary circumstances, interest on the insured bond continues to be tax-exempt notwithstanding that the only source of payment is the bond insurance.

The technical basis for the continued tax-exemption of post-discharge interest is discussed in detail below.  The analysis is rooted in one simple concept articulated in an IRS revenue ruling: in ordinary circumstances, a payment by a bond insurer is deemed, for tax purposes, to have been made by the issuer of the bonds.  For this reason, although a bankruptcy may, for non-tax purposes, discharge an issuer from further liability on all or a portion of bond payments, for tax purposes the bond payments made by the bond insurer continue to be treated as being made by the issuer.  All else is detail, for those with an interest in such detail.

And so, on to the technical discussion.

The tax-exempt treatment of interest paid by a municipal bond insurer is founded on a trio of favorable IRS revenue rulings, which, unlike private letter rulings, are statements of IRS policy on which the market can rely.

The first such ruling, Revenue Ruling 72-134, dealt with the situation where the issuer pays for bond insurance when the bonds are issued, and concluded that “defaulted interest paid by the independent insurance company is excludable from the gross income of the bondholders.”

Revenue Ruling 72-575 extended such favorable treatment to a bond insurance policy purchased by the underwriter, and Revenue Ruling 76-78 went a substantial step further, upholding the tax-exemption of interest payments received under secondary market bond insurance purchased by a bondholder.

These three rulings state a favorable result without discussing the rationale. The technical basis for the tax-exemption of bond insurance payments is illuminated in Revenue Ruling 94-42, an adverse ruling involving a bondholder that purchased secondary market bond insurance on zero coupon bonds, rerated the bonds AAA and resold the bonds.  The bond insurance premium for the secondary market insurance was an amount sufficient to fund the bond insurer’s purchase of a high-yielding portfolio of Treasury securities that economically defeased most of its insurance obligation. In the ruling, the IRS expressed concern that treating such bond insurance interest payments as tax-exempt would effectively permit a secondary market arbitrage bond, and set about distinguishing the scenario under review from “customary” bond insurance payments treated as tax-exempt in the earlier rulings.

In the 1994 ruling, the IRS noted that customarily bond insurance enhances marketability and reduces interest rates, which is consistent with the IRS’s objective of preventing overburdening of the market with tax-exempt interest. The ruling stated that such tax-exempt treatment is accomplished by “integrating the insurance contract with the obligation of a political subdivision” instead of treating the bond insurer’s obligation as a separate debt instrument.

According to this key ruling, “an insurance contract or similar agreement is treated as both incidental to bonds and not a separate debt instrument … only if, at the time it is purchased, the amount paid is reasonable, customary, and consistent with the reasonable expectation that the issuer of the bonds, rather than the insurer, will pay debt service on the bonds.” The ruling concluded that at the time the bond insurance policy under review was purchased, the insurance premium was not reasonable and customary and reflected an expectation of default by the issuer.  The IRS ruled that because the insurance purchaser looked primarily to the insurer for payment of the debt service on the bonds, the bond insurance was not incidental and should be treated as a separate non-municipal obligation rather than integrated with the insured bonds.  The conclusion that the interest payments by the bond insurer were taxable followed from the treatment of the bond insurance as a non-municipal obligation.

Two significant concepts are articulated in Revenue Ruling 94-42. First, the technical basis for treating bond insurance interest payments as tax-exempt is that, for customary bond insurance transactions, the bond insurance is integrated with and treated as the same debt instrument as the insured municipal bond. Second, the treatment of bond insurance as integrated with the insured bond versus as a separate debt instrument that is not a municipal bond is determined based on reasonable expectations at the time the bond insurance is purchased.

In other words, provided the bond insurance is “customary” at the time it is purchased, it becomes another source of payment by the issuer of the insured bonds, albeit one that, at the time the insurance is purchased, is not expected to be needed. If circumstances change and defaulted interest is paid from the bond insurance, it is deemed a payment by the municipal issuer on the insured bond, not a separate payment by the bond insurer.

Nothing in the revenue rulings on the tax-exemption of interest payments sourced to a bond insurer makes the integration of the bond insurance with the bond dependent on the continuing legal obligation of the issuer to make the insured debt service payment. The above-summarized favorable revenue rulings describe customary bond insurance as including provisions under which a bond insurer’s payment to a bondholder does not discharge the bondholder’s payment claim against the issuer, to which the insurer becomes subrogated. But such revenue rulings do not suggest that if a bondholder has no claim against the issuer because the issuer has received a bankruptcy discharge, the worthlessness of the bond insurer’s subrogation claim alters the character of the bond insurance payment as an integrated tax-exempt payment on the municipal bond constructively made by the issuer, notwithstanding the issuer’s discharge as a source of payment for non-tax purposes.

The utility of bond insurance, and the reduction in bond interest rates and the aggregate amount of tax-exempt bond interest that have justified its tax treatment, would be substantially eroded if the IRS were to rule (which it never has) that the tax-exempt nature of bond insurance payments hinges on abstract distinctions between whether non-payment from other sources is due to the issuer’s financial condition or to the legal discharge in bankruptcy of the issuer’s duty to make such payments. Bond insurance is purchased for the precise purpose of insuring against default by the issuer, foreseeably and prominently including the possibility of the issuer’s bankruptcy and the potential legal discharge of part or all of its legal obligation to pay debt service.

The cause of non-payment of the bonds from sources other than the bond insurance is immaterial for tax-exemption purposes once the bond insurance payment is recognized as integrated with and indistinguishable from the other sources of payment of the bond.  Moreover, the line between an issuer’s lack of a legal obligation to pay and factual insolvency is often vague, and if such a distinction affected tax-exemption of bond insurer payments, uncertainty would prevail.  For example, a conduit bond issuer whose obligation to pay is limited to loan or lease payments from a conduit obligor that is not making any payments could be characterized as lacking a legal obligation to pay and/or the financial ability to pay.  Similarly, an issuer that ceases to operate and is dissolved without assumption of its liabilities by another party could be characterized as legally non-existent and/or factually unable to pay.

The tax treatment of bond insurance should not, and the relevant revenue rulings support the view that it does not, depend on distinctions that are esoteric, unpredictable and impractical. Notably, in a slightly different context, the market does not doubt the continued tax-exemption of interest on innumerable “legally defeased” bonds payable solely from portfolios of Treasury securities, although the issuer is contractually discharged from making payments from other sources.

The tax impact of bankruptcy plan modifications of an issuer’s rights and duties on insured bonds are often an afterthought not adequately focused on in the plan or the plan disclosure. Documentation and characterizations of what is technically occurring to the insured bonds under the plan may be imprecise. A bankruptcy plan may suggest that portions of insured bonds that the issuer will be discharged from paying are being extinguished, when what is actually meant is that such bonds will remain outstanding and payable from bond insurance that for tax purposes is attributed as an issuer payment.

To be sure, some bankruptcy plans may purport to make changes to insured bonds beyond the full or partial discharge of the issuer’s liability.  Presumptively, a modification of the issuer’s contractual duties under a bankruptcy plan does not change the payment obligations insured by the bond insurer. Nonetheless, to avoid muddying the waters plan language should be crafted in a manner that ensures that any portion of the original insured bond from which the issuer is discharged remains outstanding for tax purposes as well as for purposes of claiming against the bond insurer.

Any purported changes by a bankruptcy plan to the terms of the bonds beyond a reduction or elimination of the issuer’s liability require separate tax analysis. The devil is frequently in the details, and the debtor and its representatives may not be focused on or impacted by the tax treatment of insured future bond payments from which the issuer has been discharged. Holders of insured tax-exempt bonds that are being modified in any manner by a bankruptcy plan may wish to obtain input from tax counsel experienced in bankruptcy-related tax-exemption issues in time to impact the plan wording and structure relating to such bonds. But, although the IRS has not directly addressed the topic, there is no reason to presume that interest paid by a bond insurer on an outstanding municipal bond will be taxable simply because the issuer will have no remaining legal obligation to make the insured payment from another source.

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 gubernatorial 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 plaintiffs’ 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.