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Public Finance Matters

Updates on recent public finance and municipal bond developments

First Circuit Hears Oral Arguments on Validity of Puerto Rico’s Recovery Act

Posted in Bankruptcy

By LEN WEISER-VARON and BILL KANNEL

A few reactions to today’s oral arguments before the U.S. Court of Appeals for the First Circuit regarding the validity of Puerto Rico’s Recovery Act:

  • On the three judge panel, Chief Judge Lynch seemed prepared to uphold the lower court decision invalidating the Recovery Act; she suggested  that Congress’s amendment of the Bankruptcy Code to eliminate the Chapter 9 eligibility of Puerto Rico’s instrumentalities could be interpreted as reflecting Congressional intent that Congress, and not Puerto Rico, should determine how to deal with Puerto Rico’s municipal insolvencies.  Judge Torruella seemed more sympathetic to Puerto Rico’s arguments that the statutory language does not articulate any such intent, that there is no legislative history as to the rationale for the removal of Puerto Rico from Chapter 9 eligibility, and that Congressional intent to preempt Puerto Rico’s use of its police power to enact bankruptcy legislation addressing a fiscal crisis cannot be assumed absent affirmative evidence of such intent.  The third judge on the panel, Judge Howard, asked fewer questions, but asked some pointed ones relating to the potential severability of certain provisions of the Recovery Act.  At the end of the arguments, Chief Judge Lynch characterized the case as an important one and pledged that the court would “work hard” on its decision.
  • On the basis of the judges’ questions, it seems more likely that the panel will uphold the lower court’s decision than that it will reverse it, although the decision may be a close one.  It is possible that the court will remand the case back to the District Court with instructions to determine whether provisions of the Recovery Act that do not impact nonconsenting creditors can be salvaged by severing those that do (versus invalidating the entire Recovery Act), but it is questionable that such a statute, and such an exercise, would be of any utility.
  • Either way, there is a good chance that the First Circuit’s opinion will turn out to be a way station on a longer road, the next segment of which will be an appeal to the U.S. Supreme Court.
  • The appellants pressed their arguments that, read literally, Section 903 of the Bankruptcy Code is only applicable in situations involving a Chapter 9 debtor, which Puerto Rico instrumentalities by definition cannot be, and that the lower court therefore misconstrued Section 903 in holding its restrictions on nonfederal bankruptcy statutes applicable to Puerto Rico. The oral arguments then focused primarily on whether a literal interpretation of Section 903 as inapplicable to Puerto Rico would or would not lead to absurd results and/or results that Congress could not have intended, and on what Congressional intent can be inferred (given little, if any, applicable legislative history) from the chronology of revisions to provisions of federal bankruptcy statutes impacting the inclusion or exclusion from federal bankruptcy eligibility of the District of Columbia, Puerto Rico and other territories.  Each side construed the legislative chronology as clearly supporting their clients’ views of whether Congress’s ultimate exclusion of Puerto Rico’s instrumentalities from Chapter 9 eligibility was or wasn’t intended to leave Congress with the sole power to enact any bankruptcy statute for such excluded instrumentalities.  When Judge Torruella asserted that it would be highly unusual for Congress to leave Puerto Rico in a “no man’s land” with no recourse to any bankruptcy process, Chief Judge Lynch countered that perhaps Congress did not intend to leave Puerto Rico’s municipalities in limbo forever, but that it might take time for Congress to decide what approach to take.
  • Addressing arguments by the appellees that it would make no sense for Congress to eliminate Puerto Rico’s Chapter 9 eligibility while permitting Puerto Rico to “xerox Chapter 9 and make it worse” through a statute such as the Recovery Act, appellants’ counsel reminded the judges that Puerto Rico would be subject to substantial federal law constraints, such as the contracts clause, that would not be applicable in a Chapter 9 proceeding.   That is accurate, and brings to the fore the question of whether, even if Puerto Rico were to persuade the First Circuit or the U.S. Supreme Court that Section 903 does not preempt the Recovery Act or invalidate its key provisions, it will have done itself any favors.  Although the contracts clause is not impregnable, it sets a high bar for a public instrumentality’s restructuring of its own debts.  The Section 903 litigation is only the first salvo in an armada of facial and as applied legal assaults that would face any Puerto Rico issuer attempting to break its bond contracts.  Puerto Rico clearly believes that having a Recovery Act gives it more leverage in creditor negotiations than not having it, but any meaningful restructuring under the Recovery Act might well be legally ineffectual.  Whatever happens to the Recovery Act, Puerto Rico needs to find other ways to address its fiscal issues.

IRS Green Lights Section 529A ABLE Disability Programs

Posted in Tax/arbitrage

By LEN WEISER-VARON

Pi Day comes but once a century, on 3/14/15. The Internal Revenue Service receives praise approximately as frequently. But the IRS deserves applause for its Notice 2015-18, released March 10, 2015, giving the green light to states to proceed with the establishment of tax-free investment programs for the disabled under new Section 529A of the Internal Revenue Code.

Section 529A, which became effective January 1, 2015, grants tax-free treatment to the earnings in so-called ABLE accounts established for eligible disabled beneficiaries and used for qualified disability expenses. As is the case with Section 529 programs, which offer tax-free investment for higher education expenses, Section 529A programs must be established by state instrumentalities and must comply with a variety of statutory requirements. But unlike Section 529, which permits anyone to establish a Section 529 account (subject to the imposition of taxes and tax penalties on amounts withdrawn for purposes other than the account beneficiary’s higher education expenses), Section 529A imposes restrictions on the front end designed to ensure that the account beneficiary is disabled. (Section 529A likewise imposes taxes and tax penalties on amounts withdrawn for purposes other than the account beneficiary’s qualified disability expenses.)

Many families with children or other relatives who meet Section 529A’s disability definition and the statute’s requirement that the disability have occurred before age 26 are understandably eager to establish nest eggs that are not only tax-free but also, by statute, disregarded (up to a balance of $100,000) for purposes of determining the beneficiary’s financial eligibility for federal disability benefits. However, states seeking to make ABLE accounts available to their residents must work through a host of legal, contractual and investment option issues before launching these new programs.

By releasing Notice 2015-18, the Treasury Department and IRS have addressed, wisely and effectively, one factor that threatened to delay the launch of ABLE programs: uncertainty over how the Treasury Department and IRS will interpret certain provisions of Section 529A.

In particular, while Section 529A is clear that an ABLE account beneficiary’s disability qualification is determined by or through the federal government (through the beneficiary’s receipt of Social Security disability benefits or the beneficiary’s filing with the Treasury Department of a disability certification accompanied by a physician’s diagnosis), it is silent on whether the state program has some unspecified duty to obtain assurances or confirm that such actions, which don’t involve the state program, have occurred. Section 529A, which permits disability status to be established at any time during a tax year, also does not specify the treatment of account contributions made to or received by an ABLE account on a date in a tax year that precedes the date on which the beneficiary satisfies the disability status requirements for the applicable tax year. In addition, there is no statutory clarity on what a program is required to do to confirm compliance with Section 529A’s state residency restrictions.

The legislation pursuant to which Section 529A was enacted requires that the Treasury Department promulgate regulations under Section 529A by June 19, 2015 (six months from enactment.) It is unclear whether the Treasury Department will be able to meet this deadline. Even if the Treasury Department were to meet that deadline, some states might have concerns about structuring, much less launching, an ABLE program before there is regulatory guidance resolving some of the statutory ambiguities potentially affecting the program’s tax-exemption under Section 529A.

Notice 2015-18 straightforwardly acknowledges the tax uncertainty concerns and addresses them, asserting that “[t]he Treasury Department and the IRS do not want the lack of guidance to discourage states from enacting their enabling legislation and creating their ABLE programs, which could delay the ability of the families of disabled individuals or others to begin to fund ABLE accounts for those disabled individuals.” The Notice goes on to state that “the Treasury Department and the IRS are assuring states that enact legislation creating an ABLE program in accordance with section 529A, and those individuals establishing ABLE accounts in accordance with such legislation, that they will not fail to receive the benefits of section 529A merely because the legislation or the account documents do not fully comport with the guidance when it is issued.”

The Notice further states that “the Treasury Department and the IRS intend to provide transition relief with regard to necessary changes to ensure that the state programs and accounts meet the requirements in the guidance, including providing sufficient time after issuance of the guidance in order for changes to be implemented.”

This language represents a fairly extraordinary expression by the Treasury and the IRS of their intent to get out of the way as a potential obstacle to, or delaying factor in, the launching of ABLE programs. This approach is sympathetic to the cause and needs of families of disabled individuals, and deserves commendation. Although the Notice will not result in instantaneous availability of ABLE programs given the non-tax complexities of structuring the programs, it makes the states’ task in launching such programs appreciably less daunting.

Notice 2015-18 also includes an advance notice which acknowledges that, although Section 529A requires that the disabled beneficiary of an ABLE account be the account owner, someone other than the disabled beneficiary may have signature authority for the account. The advance notice, unsurprisingly, indicates that the regulatory guidance when issued will preclude any such person with signature authority who is not the account owner from acquiring a beneficial interest in the account, and will require such person to administer the account in the interests of the account owner/beneficiary.

Current and Former SEC Officials Speak About Enforcement Issues Concerning Municipal Securities

Posted in Disclosure

By JOHN REGIER and BRETON LEONE-QUICK

Last week, the National Association of Bond Lawyers held its 13th Annual Tax and Securities Law Institute.  Some of the panels included current and former employees of the SEC who spoke on several of the more notable recent developments with respect to enforcement actions in the Municipal Securities space:

1)  The SEC is policing negligence.  Peter Chan, a former staff member of the SEC’s Enforcement Division, acknowledged that suspicion of recklessness is no longer seen by the Staff as a prerequisite for opening an SEC investigation of an issuer – negligence is sufficient.  He noted how “people walking in a fog can cause as much harm as people conspiring to do wrong.” Chan also cited SEC Chairman White’s “broken windows” strategy in support of this practice, and said that the MCDC Initiative is a prime example. However, Chan also acknowledged that the SEC is not likely to bring a case if an issuer has followed sound disclosure policies and procedures and engaged in thoughtful deliberations, even if the SEC questions the accuracy of statements made in the Official Statement.

2)  Exploration of Allen Park and control person liability.  During one of the panels, Mark Zehner, Deputy Chief of the Enforcement Division’s Municipal Securities and Public Pension Division Unit, spoke at some length about the Allen Park, Michigan case in which the SEC, for the first time, charged a municipal official (the mayor of the city) as a “controlling person” under Section 20(a) of the Exchange Act.  Mr. Zehner noted that the SEC has a lot of experience with control person liability, and has brought more than one thousand such cases in the private sector. From his presentation, it appeared as if one of the reasons why the SEC chose to assert a Section 20(a) claim in the Allen Park case was the somewhat more flexible standard for proving control person liability that exists in the Sixth Circuit.  Mr. Zehner noted that the SEC has a lot of ways to hold someone liable (e.g., aiding and abetting) without having to resort to Section 20(a) liability and that there is a good faith exception to control person liability written right into the statute. Reading between the lines, it appears as if the SEC believed they had proof that Allen Park’s mayor was complicit in the alleged fraud and they had an opportunity to use control person liability in a way that would make headlines and create a deterrent for other municipal officials around the country.

3)  Update on the MCDC initiative.  LeeAnn Gaunt, Chief of the Enforcement Division’s Municipal Securities and Public Pensions Unit, spoke at some length about the MCDC Initiative. She did not disclose the number of reports the SEC received, but from her comments it appears as if the SEC received a substantial number of them.  She explained that the Staff is dealing with the broker-dealer submissions first, but are cross-checking to see if issuers reported the same transactions. Settlement orders will be released in batches so as not to stigmatize individual broker-dealers. The orders will identify two or three types of material failures but will not identify issuers or transactions. The broker-dealers will be given two weeks to sign the papers and return them. Ms. Gaunt did not commit to a timetable as to when this would occur, but implied that there would likely be several waves of orders during this calendar year. Every party that self-reported will receive a response from the SEC at some point. Issuers who were reported by broker-dealers but did not self-report will not necessarily hear from the SEC.

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.