The Internal Revenue Service ("IRS") has approved final issue price regulations under Section 148 of the Internal Revenue Code, effective for bond offerings sold on or after June 7, 2017.¹ The new definition of issue price establishes alternative methods for issuers to determine the issue price of a new issue for purposes of calculating the yield to which investments of bond proceeds must be restricted and the amount of any arbitrage rebate payments that must be paid to the Federal government.²

The final definition incorporates significant changes from two rounds of earlier proposals that were largely viewed as unworkable by municipal market participants, simplifying and expanding the range of alternative methods for determining issue price in an effort to address many of the concerns expressed by commenters. Issuers are free to choose any method (to the extent applicable), to apply different methods to different maturities within an issue, and to elect which method will be used at any time up to the issue closing date. As with the current definition, the new issue price definition begins with the premise that the issue price is the first price at which a substantial amount of the bonds (defined as at least ten percent of the bonds) are sold to the public. The new rule then provides specific alternative methods for determining issue price for certain private placements, negotiated offerings and competitive offerings, as described below.

General Issue Price Rule; Definition of "Public" and "Underwriter"

Unless the issuer chooses to apply one of the available alternatives provided under the rule as described below, the general rule is that the issue price for any maturity of a new issue is the first price at which at least ten percent of that maturity is sold to the public.³ While the new rule continues to exclude underwriters from the term "public," it broadens the concept of underwriter to include broker-dealers contracting with a lead or sole underwriter or a syndicate member to sell new issue bonds, such as a selling group member or a broker-dealer under a retail distribution agreement. In addition, the new rule treats sales to any underwriter's related parties (which may include a wide range of financial market affiliates under this expanded underwriter definition) as not being sales to the public. This broader reach of entities not qualifying as members of the public may create new pressures with regard to information collection and dissemination among underwriters, as well as with regard to the extent or manner of participation of the larger pool of institutional investors that may now be viewed as related parties for purposes of issue price determination. At a minimum, the lead underwriter will need to know which investors qualify as related parties for every underwriter participating in an offering in order to assist the issuer in determining issue price, and such knowledge also may prove helpful to the other underwriters in certain situations, such as where demand for an issue is weak.

Purchase Price Alternative for Private Placements or Direct Loans

If an issue is privately placed with a single buyer that would otherwise be considered a member of the public (i.e., not an underwriter or related party), the issue price is the price paid by the buyer. This alternative would also be available for non-securities loan transactions, such as bank loans.

Initial Offering Price Alternative for Negotiated Offerings

The IRS is replacing the "reasonable expectations" standard with regard to the initial public offering price currently used in most offerings with alternatives based on initial offering prices that meet specified requirements. In a negotiated offering, the issuer may treat the initial offering price on the sale date of a maturity of bonds as the issue price if the offering meets the following requirements:

• The underwriters offer the bonds of that maturity to the public at such initial offering price on or before the sale date
• The lead or sole underwriter provides to the issuer, by closing, a certification regarding such offering at the initial offering price, together with a copy of the pricing wire, equivalent communication or any other reasonable supporting documentation
• Each underwriter (i.e., the lead or sole underwriter, any syndicate or selling group members, and any other person considered an underwriter, such as a broker-dealer with a retail distribution agreement) agrees in writing⁴ that it will neither offer nor sell the bonds to any person (whether an investor or another broker-dealer) at a price higher than the initial offering price for such maturity beginning on the sale date to the earlier of:
  • The close of the fifth business day after the sale date; or
  • The date on which the underwriters have sold at least ten percent of such maturity of the bonds to the public at a price no higher than the initial offering price (i.e., sales are permitted at prices below the initial offering price)

If a negotiated offering does not meet these requirements, the initial offering price must be determined through the general rule described above. In particular, the IRS warns that a failure of an underwriter to abide by its agreement not to sell bonds at a higher price than the initial offering price during the so-called "hold-the-offering-price" period would result in a failure to establish the issue price for such bonds under this alternative and the issue price would instead need to be established through the general rule or another applicable alternative.⁵ Given the more expansive definition of underwriter in the new rule and the potentially significant consequences of failing to hold the offering price, issuers and underwriters will need to consider carefully how best to safeguard against inadvertent invalidation of an issue price determination under this alternative.

For example, an issuer may sell a new issue on a negotiated basis with a baseline expectation of relying on the initial offering price alternative rather than on the general issue price rule. However, if the requirements of the general issue price rule are met for certain maturities (whether on the initial sale date or thereafter prior to closing), the issuer may instead choose to rely on the general issue price rule rather than the initial offering price alternative for such maturities so as to eliminate the need to meet the additional conditions, and to bear the potential risks, of the initial offering price alternative as described above.⁶

Initial Offering Price Alternative for Competitive Offerings

The IRS established a second alternative method for determining issue price for competitive offerings based on overwhelming industry feedback that the prior proposals would be unworkable and, in many cases, counter-productive. Therefore, in a competitive offering, the issuer may treat the reasonably expected initial offering price on the sale date of a maturity of bonds as the issue price if the offering meets the following requirements:

The bonds are sold to an underwriter that is the winning bidder in a bidding process in which:

• The issuer disseminates a notice of sale with specified written terms to potential underwriters in a manner reasonably designed to reach potential underwriters⁷
  • All bidders have an equal opportunity to bid (e.g., no bidders are provided preferred "last look" rights at other bids)
  • The issuer receives bids from at least three underwriters with established industry reputation for underwriting municipal bonds; and
  • The issuer awards the bonds to the bidder submitting a firm offer to purchase the bonds at the highest price (or lowest interest cost)
• The winning bidder provides to the issuer a certification of the reasonably expected initial offering price to the public as of the sale date upon which the price in the winning bid is based⁸

If a competitive offering does not meet these requirements, the initial offering price must be determined through the general rule or the negotiated offering alternative described above. For example, if a new issue is sold in a competitive offering where the notice of sale was provided only to a limited group of potential bidders, or where only two qualifying bids were received, the competitive offering alternative would not be available.

Documentation

Issuers must maintain reasonable documentation to support issue price determinations. The new rule specifically requires that the issuer record, on or before the closing date, the method selected for determining issue price for the bonds in its books and records maintained for the bond issue. In addition, any certifications and other reasonable supporting documentation obtained by the issuer under any of the issue price alternatives described above must be maintained. The IRS states, for example, that a certification from the underwriter of the first price at which ten percent of the bonds were sold to the public is reasonable supporting documentation for establishing issue price under the general rule.

Underwriter Regulatory Requirements Affecting New Issue Distribution

The new issue price rule will be implemented against the backdrop of heightened regulatory scrutiny and more extensive rule-based requirements on underwriters in connection with their new issue distribution activities. MSRB Rule G-11, on primary offering practices, mandates, among other things, the dissemination within the underwriting syndicate of certain items of information about orders and the nature of customers placing the orders, such as whether they are retail orders or orders for a "related account" of an underwriter or its affiliate,⁹ as well as the identity of customers placing group orders. With the new issue price rule eliminating most distinctions between syndicate members and selling group members, generally treating firms with retail distribution agreements as selling group members, and reaching related parties of all of these firms, the types of communication required among underwriters under the new issue price rule and under MSRB Rule G-11 are becoming increasingly divergent. The MSRB has noted that it intends to scrutinize during this coming year dealer syndicate practice rules, such as Rule G-11, for any necessary changes, which could take into account the modified information needs under the new issue price rule but also may seek to meet other regulatory goals. Underwriters will need to review and revise the basic documentation for their syndicates, selling groups and distribution arrangements to ensure that they continue to be consistent with evolving securities and tax law requirements that are increasingly seeking to regulate syndicate practices.

Finally, underwriters should remain mindful of the SEC's 2015 enforcement action in which it found that a syndicate member had failed to make bona fide public offerings at the initial offering price to its customers when it purchased new issues into inventory rather than immediately offering the bonds to its customers, and then sold the bonds to the public at prices above the initial offering price after they began trading in the market.¹⁰ While the SEC cited the firm for violations of MSRB Rules G-11, G-17 and G-30, SEC staff subsequently posed the question at industry conferences of whether the lead underwriter should be responsible for policing the offering practices of syndicate members. The question of this policing function may re-emerge in the context of ensuring that syndicate members adhere to the "hold-the-offering-price" period described above in the context of the initial offering price alternative for negotiated offerings under the new issue price rule.

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¹ Treasury Regulation Section 1.148-1(f). See Issue Price Definition for Tax-Exempt Bonds, 81 FR 88999 (December 9, 2016).

² The IRS has indicated that, while the new issue price rule would not apply to the related concepts of "sales proceeds," "net proceeds," "proceeds," "face amount" and "amount" that are relevant for tax law purposes other than the arbitrage restrictions, it expects to consider these concepts in future guidance.

³ Issue price is not reduced by issuance costs.

⁴ Presumably, this would be done through the agreement among underwriters or other written contracts among the firms that qualify as underwriters for purposes of the issue price rule.

⁵ In addition, the IRS warns that a false statement by an underwriter in a certification or agreement among underwriters relating to an alternative under the issue price rule may result in a penalty against the underwriter under Treasury Regulation Section 6700, depending on the facts and circumstances.

⁶ This assumes either that the first price at which a substantial amount of the bonds is sold equals the expected initial offering price, or the issuer accepts a price different from the expected initial offering price as the issue price for tax purposes for that maturity.

⁷ The rule provides examples of dissemination methods that emphasize wide distribution, including through electronic communication widely circulated to potential underwriters by a recognized publisher of municipal bond offering documents or by posting on a website or other electronic medium regularly used for such purpose and widely available to potential underwriters.

⁸ The IRS determined not to establish a new heightened diligence standard for issuer reliance on underwriters' certifications that it had previously proposed but to which market participants objected.

⁹ In general, a related account includes a municipal securities investment portfolio or arbitrage account of a syndicate member, sole underwriter or affiliate, and a municipal securities investment trust (or related accumulation account) sponsored by a lead or sole underwriter, syndicate member, or affiliate.

¹⁰ See In the Matter of Edward D. Jones & Co., L.P., Exchange Act Release No. 75688 (August 13, 2015).