Issue Brief: Yield BurningUpdated January 2008
The Government Finance Officers Association (GFOA) seeks to ensure that proposed arbitrage regulations curbing yield burning practices are not burdensome, that issuers are not forced to reimburse the federal government for arbitrage earnings illegally deflected to broker-dealers, and that existing securities laws and rules of conduct are relied upon to penalize securities dealers who sold securities at excessive markups.
Background
Yield burning refers to the practice of artificially depressing the yield on Treasury securities sold to state and local government issuers for advance refunding escrows by raising the sale prices of those securities. This practice transfers arbitrage profit to the seller of the securities. Arbitrage profit is earned by investing tax-exempt bond securities in higher-yielding investments. If arbitrage profit is not rebated to the U.S. Treasury, the tax-exempt bonds are so-called arbitrage bonds and the federal tax law provides that interest earned on those bonds is not exempt.
In June 1996, the IRS proposed arbitrage regulations that imposed new procedural, record-keeping and other responsibilities on issuers to ensure that securities purchased in the future for advance refunding escrows and other purposes were purchased at fair market value. The new requirements:
- mandate a competitive bidding process,
- require a certification from a bidding agent,
- mandate the retention of documents, and
- establish a rebuttable presumption.
In July 1996, the IRS unexpectedly released Revenue Procedure 96-41, which outlined a voluntary closing agreement program for advance refunding escrows of state and local bonds. This procedure permits issuers to make a payment to the U.S. Treasury equal to the excess amount paid for the securities over “spot” price, defined as the noncontingent price on the trade date for delivery on the next date.
In response to criticism and concerns, the IRS issued Notice 96-49 in August 1996 withdrawing a requirement for issuers to enter into closing agreements within one year and soliciting public comments.
In the meantime, the IRS, SEC, and Department of Justice settled a three-year investigation of alleged yield burning by CoreStates Financial Corporation. In April 1998, the agencies announced a settlement (that might serve as a model for future settlement negotiations) requiring CoreStates to pay $3.7 million. In April 2000, federal agencies achieved a settlement with 17 broker-dealers involved in yield-burning practices on municipal transactions in the early 1990s. This settlement, significantly larger than previous yield-burning settlements, includes $120 million in payments to the U.S. Treasury and approximately $18 million to issuers. The settlement preserved the tax-exempt status of the bonds and established liability on the party responsible for the violation. GFOA is hopeful that these or other settlements will serve as a model for future settlements. GFOA supports the cooperative efforts of the federal agencies to reach a settlement.
Policy Issues
GFOA and other major public interest groups have commented through the years on IRS and Treasury initiatives concerning yield burning and recommendations for greater federal coordination of enforcement efforts.
GFOA criticized the proposed rules, made final in December 1998, including the rebuttable presumption, calling instead for a safe harbor that would permit issuers to conclusively establish that they have purchased obligations that meet a fair market value test. Additionally, GFOA urged the IRS to consider a safe harbor that would permit issuers to continue to rely on certifications from qualified professionals attesting to the fact that the securities were purchased at fair market value. The final IRS rules replaced the rebuttable presumption with a safe harbor that includes a three-bid requirement for escrow securities. The regulations apply to bonds sold on or after March 1, 1999. The safe harbor bidding procedure applies to guaranteed investment contracts (GICs) and yield-restricted defeasance escrows.
Rev. Proc. 96-41 has been severely criticized by state and local government organizations because, among other things, it
- penalizes issuers, not the securities providers, who profited from yield-burning practices,
- retroactively imposes new statements of law that are at odds with industry practices, and
- fails to provide any guidance on how to review escrow pricing.
Another concern is that the revenue procedure is still being relied upon by IRS agents in their audits of state and local government bond issues, despite the lack of clear-cut guidance.
Recommendations
GFOA and other organizations requested that the IRS revoke Revenue Procedure 96-41. GFOA believes violators (including issuers) who were directly or indirectly responsible for the excessive price markups that undermine the federal arbitrage restrictions should be punished.
GFOA has been encouraging Treasury and IRS to not make any substantive changes to the State and Local Government Securities (SLGS) program that will cause yield burning problems to reemerge as a growing problem.
Additional Resources GFOA • Federal Liaison Center • (202) 393-8020 • (202) 393-0780 FAX • Email
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