MSRB NOTICE 2013-13 (JUNE 12, 2013)

NOTICE REGARDING TRANSACTIONS IN DIRECT-PAY MUNICIPAL BONDS SUBJECT TO SUBSIDY REDUCTIONS DUE TO THE FEDERAL SEQUESTER

This notice alerts investors to be aware of the terms of certain types of direct-pay municipal bonds, as described below, to better understand any potential impact of federal sequestration on such bonds.  In addition, this notice reminds brokers, dealers and municipal securities dealers (“dealers”) of their customer protection obligations under the rules of the Municipal Securities Rulemaking Board (MSRB) in connection with their transactions with customers relating to direct-pay bonds.  The MSRB notes that, because the terms of direct-pay bonds may vary considerably from issue to issue, investors, dealers and other market professionals should know the facts about their particular direct-pay bonds and should not make investment or pricing decisions based solely on other direct-pay bonds which may have dissimilar features or on generalized characterizations reported in the press or in other published reports.

FEDERAL SEQUESTRATION AND SUBSIDY REDUCTION

As a result of federal sequestration that became effective on March 1, 2013,[1] the Internal Revenue Service announced the reduction of refundable credits payable to issuers with respect to their Build America Bonds (BABs), Qualified School Construction Bonds (QSCBs), Qualified Zone Academy Bonds (QZABs), New Clean Renewable Energy Bonds (New CREBs) and Qualified Energy Conservation Bonds (QECBs) for which the issuer elected to receive a direct credit subsidy from the federal government (collectively, “direct-pay bonds”).[2]  While reductions in subsidy payments resulting from sequestration directly affect the issuers of direct-pay bonds, these reductions also have the potential to affect investors buying, selling and holding direct-pay bonds for which such subsidy payments have been reduced, depending on the specific terms of such direct-pay bonds.[3]

For example, in some cases, the terms of outstanding direct-pay bonds may permit the issuer to exercise an extraordinary redemption at a price of par upon reduction in the federal subsidy payment, whereas the terms of other outstanding direct-pay bonds may permit extraordinary redemption only under a more limited set of circumstances (e.g., a change in law relating to such subsidy payments, etc.) or at a higher “make-whole” redemption price.  The existence and specific terms of extraordinary redemption provisions, and the determination of whether the circumstances that can trigger the exercise of such extraordinary redemptions have occurred, has the potential of affecting the market value of the applicable direct-pay bond.

UNDERSTANDING THE TERMS OF DIRECT-PAY BONDS

While direct-pay bonds share certain general characteristics, investors, dealers and other investment professionals must review the specific terms of a particular direct-pay bond to fully understand its features and the potential impact, if any, of the federal sequester on such bond.  The basic terms of direct-pay bonds, with very few exceptions, are described in the official statement produced by the issuer and submitted by the underwriter of the bonds to the MSRB’s Electronic Municipal Market Access (“EMMA”®)[4] system.  These official statements – together with any continuing disclosures submitted to EMMA about such bonds, transaction data regarding any trades in such bonds and other related information – are available, free of charge, on the EMMA public website at emma.msrb.org.

The MSRB urges investors to use the resources available on the EMMA website to gain a fuller understanding of direct-pay bonds and other municipal securities they currently own or are contemplating acquiring.  In particular, in the context of the potential impact of the federal sequester on investors in direct-pay bonds, investors should review the terms of any extraordinary, mandatory or other redemption provisions as set forth in the official statement available on EMMA to determine whether the sequester may have triggered a right of early redemption and the terms on which such redemption could be exercised.  In addition, investors should review any continuing disclosures posted on EMMA by the issuer or its agents to monitor developments relating to the bonds since initial issuance, including but not limited to whether the issuer has exercised (or expressed an intent to exercise) any redemption rights.[5]  Finally, investors should never hesitate to ask their dealers or other investment professionals to assist in understanding the terms of their securities or to assess whether redemption rights have been triggered and the potential impact such redemption rights may have on the value of their bonds.

Dealers that effect transactions in direct-pay bonds with customers also must understand their duties under MSRB rules in connection with such transactions.  For example, Rule G-17 requires a dealer engaging in a municipal security transaction with a customer to disclose, at or prior to the time of trade, all material information known about the transaction, as well as material information about the security that is reasonably accessible to the market through established industry sources.  These sources include the EMMA website, rating agency reports, and other sources of information relating to municipal securities transactions generally used by dealers that effect transactions in the type of municipal security at issue.  Such information, to the extent material, must be taken into consideration by the dealer in meeting certain of its other investor protection obligations, such as its fair pricing duty under Rules G-18 (for agency transactions) and G-30 (for principal transactions) and its suitability duty with respect to recommended transactions under Rule G-19.  With respect to the price at which a dealer effects a transaction with a customer, the dealer is required to take into consideration all relevant factors to establish a transaction price that is fair and reasonable and that is reasonably related to the prevailing market price of the security.  Depending on the specific facts and circumstances, the likelihood that a call prior to maturity will be exercised, and the price at which such a call could be exercised (e.g., at par, at a make-whole price, or at some other price),[6] may be relevant factors to be taken into consideration in establishing a fair and reasonable transaction price for a particular direct-pay bond trading in the secondary market.

Some issuers have elected to exercise extraordinary redemption provisions for certain of their issues of direct-pay bonds as a result of the federal sequester, and market participants must take this fact, and the specific terms of such redemption, into account in connection with their trading activities in called bonds prior to their redemption date.  In addition, market participants should be making the appropriate assessments as described above in connection with their trading activities in any direct-pay bonds that permit an extraordinary redemption at par merely upon a reduction in the federal subsidy payment, even if such bonds have not been called.[7]  However, market participants also should be aware that only some direct-pay bonds permit an extraordinary redemption at par merely upon a reduction in subsidy payment,[8] and therefore attention to the specific terms of such bonds is important.  In particular, the MSRB emphasizes that, because the terms of direct-pay bonds may vary considerably from issue to issue, investors, dealers and other market professionals should know the facts about their particular direct-pay bonds and should not make investment or pricing decisions based solely on other direct-pay bonds which may have dissimilar features or on generalized characterizations reported in the press or in other published reports.

June 12, 2013

[1]  See Budget Control Act of 2011 (Pub.L. 112-25); American Taxpayer Relief Act of 2012 (Pub.L. 112-240).

[2]  See Internal Revenue Service, Effect of Sequestration on Certain State & Local Government Filers of Form 8038-CP, revised version dated April 23, 2013, available at http://www.irs.gov/Tax-Exempt-Bonds/Effect-of-Sequestration-on-Certain-State-and-Local-Government-Filers-of-Form-8038CP.

[3]  Prior to the sequester taking effect, certain industry organizations published alerts to the marketplace regarding some of these potential impacts on investors. See, e.g., National Association of Bond Lawyers, Effect of Sequester on Direct-Pay Bonds, September 21, 2012, available at http://www.nabl.org/uploads/cms/documents/NABLNet_Alert_Effect_of_Sequester_on_Direct_Pay_Bonds.pdf; Securities Industry and Financial Markets Association, SIFMA Member Notice, September 28, 2012, available at https://www.sifma.org/uploadedfiles/for_members/committees/capital_markets/equity_markets(4)/sifma_member_notice_sequestration.pdf.

[4]  EMMA is a registered trademark of the MSRB.

[5]  Issuers of direct-pay bonds subject to the Securities and Exchange Commission’s Rule 15c2-12 normally will be obligated under a continuing disclosure agreement to submit to EMMA a notice of such an extraordinary redemption as contemplated under clause (b)(i)(C)(8) of the rule.  In addition, issuers of direct-pay bonds can use EMMA’s voluntary continuing disclosure process to provide additional public disclosures as to their intent with regard to future exercise of their redemption rights to assist the market in better understanding any potential impact of sequestration on such bonds.

[6]  In addition to serving as the price at which a bond would be redeemed by the issuer and paid to the investor upon an extraordinary redemption, the redemption price often will be an important factor that an issuer likely would consider in determining whether to exercise such redemption right.

[7]  The MSRB has previously stated that the likelihood that a call provision may be exercised can be a factor in meeting the MSRB’s pricing requirements.  See MSRB Interpretive Notice on Pricing of Callable Securities, August 10, 1979 (relating to pricing duties under MSRB Rule G-30).

[8]  Some market participants have estimated that most direct-pay bonds require a higher threshold (such as change in law or other conditions) for exercise of their extraordinary redemption provisions and/or a higher make-whole redemption price intended to compensate the investor for lost earnings due to the earlier call.  See, e.g., Kelly Nolan, “Columbus, Ohio, Moves Ahead With Plan for ‘Build America’ Bonds,” Dow Jones Newswire, May 13, 2013.