NATIONAL ASSOCIATION OF BOND LAWYERS
Voice from the Past
Chapter 16
One day in 1960 or thereabouts I got a call from Dave Lawrence,
then head of the
municipal bond department of Boettcher and Company in Denver, who
wanted to talk about
some proposed financing. He really wanted to talk with my senior
partner, Joe Matter, who
was out of the country; yet he was willing to discuss his plan
with me. I agreed to see him,
and none of our lives has been the same since.
We discussed the situation in the City of Phoenix, which had
issued two series of
water revenue bonds, first and second lien, with no provision for
additional parity bonds.
These issues were not yet callable for redemption, and the City
needed to finance more water
system facilities. Mr. Lawrence had heard of a practice in
Alabama in which an issuer
delivered refunding bonds several years before the refunded bonds
could be redeemed,
invested the proceeds in government bonds, and was able to sell
junior lien refunding bonds
as if they were first lien bonds by convincing investors that the
revenues of the system would
not be needed to pay the prior lien bonds. The interest on the
government bonds would more
than cover the interest on the refunded bonds, so the issuer
would not have to pay interest on
both issues at the same time. He wondered if this could be done
in Phoenix.
I had learned not to say no to a client unnecessarily, so I took
the easy way out by
saying that the proposed financing could be done with authority
from the State Legislature.
He said, to my surprise, that obtaining legislation would not be
a problem. I couldn't think of
any constitutional objection, and so my advance refunding career
was born.
Although it was known that the government bonds, bearing taxable
interest, would
bear a slightly higher rate than the tax exempt refunding bonds,
most of the people involved
in the transaction did not, at that time, realize that the
difference could, in a carefully
structured transaction, be wonderfully magnified by the magic of
compound interest. When
this information got out, it was mostly used in the West for a
few years. The number of
advance refundings was limited by the availability of
underwriters and bond lawyers who
knew how to do them. Whether or not a given refunding made sense
otherwise, the arbitrage
was enough to make it profitable for all concerned.
The original dealers were sensitive enough about public opinion
and their view of their
rightful place in society so that they didn't engage in many
transactions that the local
newspapers considered abuses. I suspect that the staffs of the
local newspapers didn't pay
much attention to the arcane aspects of the Federal-State
relationship involved, and that the
public, if it thought at all about the matter, would have
approved of making money at the
expense of the Federal Government. In time, of course, people in
other parts of the country
found out about the practice and imitated it. Someone had the
lack of judgment to ask the
Internal Revenue Service for a ruling on a particularly abusive
transaction.
On August 11, 1966, the Internal Revenue Service whelped a
Technical Information
Release -- TIR 840. This was really just a press release, but it
said that pending a study, the
IRS would not grant any rulings on the tax exemption of municipal
bonds in situations:
"1.Where all or a substantial part of the proceeds of
the issue (other than normal contingency reserves such as debt
service reserves) are only to be invested in taxable obligations
which are, in turn, to be held as security for the
retirement of the
obligations of the governmental unit.
"2. Where the proceeds of the issue are to be used to
refund outstanding obligations which are first callable more
than
five years in the future, and in the interim, are to be
invested in
taxable obligations held as security for the satisfaction of
either
the current issue or the issue to be refunded."
Neither a regulation nor a ruling, TIR 840 had no force under the
tax laws, but
probably would have caused securities law problems for anyone who
sold bonds of the sort
covered without disclosing the implied threat. I don't know of
anyone who tried.
The Tax Reform Act of 1969 first defined "arbitrage bonds" and
declared the interest
on them taxable. Exceptions from a prohibition against investing
tax exempt bond proceeds in
higher yield taxable obligations were established for "materially
higher" and amounts less
than a "major portion." Precise definitions of these terms were
left up to Treasury - IRS
regulations.
A group of bond lawyers headed by Danny Goldberg of New York met
several times
with people from Treasury and the IRS to discuss what ought to go
into such regulations. Joe
Johnson, Jim Perkins, Don Hodgman and I were in the group.
Later, I testified at public
hearings on a succession of proposed arbitrage regulations.
I recall telling one Treasury-IRS panel that its proposed
regulations would stimulate
refunding issues by requiring them to be very profitable to
underwriters. It was the
underwriters who induced issuers to undertake such refundings;
cities seldom regarded bond
issues (which they had to pay back with interest) as a way to
make money. By requiring
issuers to invest at a yield below market, the law would open a
flood of opportunity to
underwriters. They would provide government bonds at prices well
above their market value
to reduce the yield on investments of the major portion of a
refunding issue, and let the
issuers earn whatever they could from investing the minor
portion.
The panel members may or may not have believed me, but the
proposed regulations
were not changed much. For years thereafter, many refunding
issues that had no beneficial
municipal purpose but saving very modest amounts of money came to
market. Many
underwriters and lawyers (including me) profitably devoted
substantial parts of their careers to
such issues.
Manly W. Mumford