Recent SEC Developments

1
Recent SEC Developments IRS Tax Exempt Bond
Audits A Practical Guide to Dealing with New
ChallengesEFC / NCHELP Legal Issues Meeting
New York, New YorkAugust 4-5, 2003Gilmore
Bell, P.C.
2
Recent SEC Developments IRS Tax Exempt Bond
Audits A Practical Guide to Dealing with New
Challenges

• Common themes at the SEC the IRS
• Enforcement actions are a relatively recent
  phenomena
• The statutory framework is imperfect
• Enforcement procedures are likely to continue to
  evolve over the next several years

3
Recent SEC Developments A Decade of SEC
Regulation of the Municipal Securities Industry

• Historically, municipal securities regulation has
  trailed corporate securities regulation 
• Original Rule 15c2-12 requirements to receive and
  review an official statement
• 1996 Amendments adds a continuing disclosure
  requirement
• Jawboning to achieve voluntary quarterly
  disclosures

4
Recent SEC Developments A Decade of SEC
Regulation of the Municipal Securities Industry

• Arthur Levitts Tenure at SEC (1993-2001)
•  
• Stated goals included cleaning-up of the
  Municipal Securities Industry
• The campaign to eliminate pay-to-play. MSRB
  Rule G-37
• Aggressive SEC Enforcement Actions
• Enforcement Actions premised on aggressive tax
  positions
• Yield Burning cases 
• Office of Municipal Securities created
• Rule 15c2-12 Amendments (95-96)Continuing
  Disclosure Requirements

5
Recent SEC Developments A Decade of SEC
Regulation of the Municipal Securities Industry

• July 30, 2002Sarbanes-Oxley Act signed by
  President Bush
• The farthest-reaching securities legislation
  since the 1933 and 1934 Acts
• Two Components 
• Improved Corporate Governance
• Enhanced Financial Disclosure

6
Recent SEC Developments A Decade of SEC
Regulation of the Municipal Securities Industry

• Sarbanes-Oxley Improved Corporate Governance
• Akin to Levitts clean-up of municipal securities
  industry previously described
• Expansion of Federal SEC powers into traditional
  state corporation matters
• Bootstrap through disclosure rules
• Compel Exchanges/Nasdaq to change listing
  standards
• SEC/IRS Yield Burning Cases
• SEC bootstraps a tax issue into a disclosure
  issue
•  

7
Recent SEC Developments A Decade of SEC
Regulation of the Municipal Securities Industry

• Sarbanes-Oxley Enhanced Financial Disclosure
• Possible Future Attractions for the Municipal
  Securities Industry
• Accelerated filing under Sarbanes-Oxley
• Critical accounting policies
• Disclosures of Derivative and Swaps
• Quantitative and Qualitative Disclosures About
  Market Risk
• Market risk refers to the risk that a change in
  the level of one or more market prices, interest
  rates, indices, volatilities, correlations or
  other market factors such as liquidity, will
  result in losses for a certain financial
  instrument or group of financial instruments.
• Disclosure Controls and Procedures

8
Recent SEC Developments A Decade of SEC
Regulation of the Municipal Securities Industry

• Disclosure - Secondary Trading
• What creates an affirmative duty to disclose?
• Primary offering of securities
• Issuer or insiders trading in securities
• Material information is leaked and market reacts
• Requirements of 1934 Actquarterly/annual reports
• Stock Exchange/Nasdaq Listing Requirement

9
Recent SEC Developments A Decade of SEC
Regulation of the Municipal Securities Industry

• Duty to Disclose - Municipal Securities Industry
• Pre-15c2-12 Continuing Disclosure Requirement 
• No affirmative duty to disclose material
  developments
• Silence, absent a duty to disclose, is not
  misleading under Rule 10b-5. No comment
  statements are generally the functional
  equivalent of silence.
• Premature public announcement may properly be
  delayed for a valid business purpose and where
  adequate security can be maintained.

10
Recent SEC Developments A Decade of SEC
Regulation of the Municipal Securities Industry

• Duty to Disclose - Municipal Securities Industry
• Post- Rule 15c2-12 Continuing Disclosure
  Requirement 
• Contractual duty to promptly disclose certain
  material events
• Payment and non-payment defaults
• Rating changes
• Adverse events affecting the tax-exempt status of
  the bonds
• Unscheduled draws on debt service reserves or
  credit enhancements reflecting financial
  difficulties 

11
Recent SEC Developments A Decade of SEC
Regulation of the Municipal Securities Industry

• Duty to Disclose - Municipal Securities Industry
• Post- Rule 15c2-12 Continuing Disclosure
  Requirement
• Continuing Disclosure Agreement/Undertaking
  creates a duty to disclose 
• Named material events
• Additional information necessary to make to the
  disclosed information complete (i.e., no material
  omissions) 

12
Recent SEC Developments A Decade of SEC
Regulation of the Municipal Securities Industry

• Duty to Disclose - Municipal Securities Industry
• When is disclosure of tax audit of bond issue
  required?
• When is the tax audit material? 
• Commencement of the audit?
• Preliminary adverse determination of taxability
  by IRS?
• Proposed adverse determination of taxability by
  IRS?
• Some point in between?

13
Recent SEC Developments A Decade of SEC
Regulation of the Municipal Securities Industry

• Balancing test for determination of
  materiality
• Basic Incorporated v. Levinson, Supreme Court,
  1988
• With respect to contingent or speculative
  information or events, materiality will depend
  at any given time upon a balancing of both the
  indicated probability that the event will occur
  and the anticipated magnitude of the event in
  light of the totality of the company activity.

14
Recent SEC Developments A Decade of SEC
Regulation of the Municipal Securities Industry

• Example of Materiality Balancing Test
• TSC Industries, Inc. v. Northway, Supreme Court,
  1976
• Since a merger in which it is bought out is the
  most important event that can occur in a small
  corporations life, to wit, its death, we think
  that inside information, as regards a merger of
  this sort, can become material at an earlier
  stage than would be the case as regards lesser
  transactionsand this even though the mortality
  rate of mergers in such formative stages is
  doubtless high.

15
Recent SEC Developments A Decade of SEC
Regulation of the Municipal Securities Industry

• Protecting investors from uncertainty is
  rejected by the Supreme Court as a basis for
  nondisclosure
•  
• The policy-based rationale for non disclosure
  based on a desire to protect investors from
  disclosures of uncertain or speculative
  information assumes that investors are nitwits,
  unable to appreciate - even when told - that
  mergers are risky propositions up until the
  closing.
•  
• The role of the materiality requirement is not to
  attribute to investors a child-like simplicity,
  an inability to grasp the probabilistic
  significance of negotiations. 

16
The IRS Tax Exempt Bond Audit Program

• The IRS announced late last year that it intended
  to initiate audits of Student Loan Bonds within
  the year
• The audits are designed to review overall
  compliance levels rather than to focus on any
  particular issue or issuer
• Similar industry audit programs have been
  undertaken for other industry groups
• In some cases the IRS has found significant
  problems in as many as one in four issues that
  were audited

17
The IRS Tax Exempt Bond Audit Program

• Identify the significant differences between
  tax-exempt bond audits and typical IRS audits
• Identify how these differences present unique
  challenges for issuers and their legal counsel
• Suggest some strategies for dealing with these
  challenges

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The IRS Tax Exempt Bond Audit Program
Significant Differences Between Tax-Exempt Bond
Audits and Typical IRS Audits

• Typical Tax Audit
• Statutes, regulations and court decisions govern
  the audit and enforcement of tax laws
• Goal of the tax audit is to review compliance
  with tax law and to enforce the payment of the
  proper amount of tax by the taxpayer

• Tax-Exempt Bond Audit
• Audit procedures are based on IRS administrative
  policy decisions
• Audit procedures are designed to review
  compliance with tax law and to solicit
  voluntary payments by issuers and/or other
  financing participants to remedy violations of
  the tax laws

19
The IRS Tax Exempt Bond Audit Program
Significant Differences Between Tax-Exempt Bond
Audits and Typical IRS Audits

• Typical Tax Audit
• Taxpayer runs the risk of paying additional
  taxes, interest and penalties as a result of
  failing to comply with the tax laws

• Tax-Exempt Bond Audit
• The IRS treats bond issuers as taxpayers for
  many purposes and attempts to collect tax from
  bondholders only as a last resort

20
The IRS Tax Exempt Bond Audit Program
Significant Differences Between Tax-Exempt Bond
Audits and Typical IRS Audits

• Typical Tax Audit
• IRS decisions are subject to multiple avenues of
  judicial review

• Tax-Exempt Bond Audit
• Generally, there is no direct way for bond
  issuers to appeal an adverse tax determination to
  a court

21
The IRS Tax Exempt Bond Audit Program
Significant Differences Between Tax-Exempt Bond
Audits and Typical IRS Audits

• Typical Tax Audit
• The focus of the tax audit is the proper
  reporting of items of income, deduction and
  credit on a tax return
• Statutes and regulations provide guidance on
  records which must be retained

• Tax-Exempt Bond Audit
• The audit process relates to compliance with tax
  statutes and regulations
• Typically there is no information on the tax
  return relating to compliance with the tax laws
  after the bonds were issued
• No guidance on what records need to be retained
  and for what period of time

22
The IRS Tax Exempt Bond Audit Program
Significant Differences Between Tax-Exempt Bond
Audits and Typical IRS Audits

• Typical Tax Audit
• Audit limited to a particular tax year or several
  tax years
• Statute of limitations usually limits IRS inquiry
  to three prior tax years

• Tax-Exempt Bond Audit
• The audit is not limited to specific tax years
• IRS can audit issuer compliance as long as any of
  the bonds or any refunding bonds are outstanding

23
The IRS Tax Exempt Bond Audit Program Unique
Challenges for Issuers and their Counsel

• The IRS treats bond issuers as taxpayers
• Audit procedures designed to solicit voluntary
  payments by issuers and/or other financing
  participants to remedy violations of the tax laws
• Generally, there is no way for bond issuers to
  appeal an adverse tax determination to a court

• Issuers typically have a contractual duty to
  work to preserve the tax exempt status of the
  bonds
• Issuers usually must find a way to settle with
  the IRS if a problem is found with the tax-exempt
  status of the bonds
• The Issuer typically will pay monetary
  restitution in order to preserve tax-exempt
  status of bonds

24
The IRS Tax Exempt Bond Audit Program Unique
Challenges for Issuers and their Counsel

• The audit process relates to compliance with tax
  statutes and regulations
• Typically there is little information on the tax
  return to audit
• No guidance on what records need to be retained
  and for what period of time. The audit is not
  limited to specific tax years
• IRS can audit issuer compliance as long as any of
  the bonds or any refunding bonds are outstanding

• Issuers may be unable to provide contemporaneous
  records to prove compliance with tax requirements
• Very difficult to know what records to retain,
  and how long they should be retained
• Loan purchase price records
• Borrower Nexus issues
• Expenses / Method of Accounting

25
The IRS Tax Exempt Bond Audit Program
Strategies for Dealing with Tax Audits

• Before the audit is initiated
• Assume every bond issue will be audited
• Bonds that have been outstanding 6-10 years may
  be the most likely to be audited
• Consider tax call or extraordinary call
• Understand the requirements of the tax agreement
• Types of loans that can be purchased with
  tax-exempt bond proceeds
• Rebate and loan forgiveness requirement
• Be on the lookout for new IRS guidance
• Post issuance return requirements
• Records retention guidance

26
The IRS Tax Exempt Bond Audit Program
Strategies for Dealing with Tax Audits

• Before the audit is initiated
• Make certain the accounting system and record
  retention policy will permit issuer to prove
  compliance with tax rules
• Loan nexus
• Monitor arbitrage rebate and yield reduction
  payment obligations
• Have a loan forgiveness plan in place

27
The IRS Tax Exempt Bond Audit Program
Strategies for Dealing with Tax Audits

• When the audit is initiated
• Identify the type of Audit
• Standard audit initiation letters
• Ask questions
• Identify a primary point of contact for the
  auditor
• Retain outside counsel
• Bond counsel
• Additional counsel?

28
The IRS Tax Exempt Bond Audit Program
Strategies for Dealing with Tax Audits

• Examination stage
• Information Document Requests (IDR)
• Meetings
• Summons
• TAM
• No Change Letter or Preliminary Adverse
  Determination Letter

29
The IRS Tax Exempt Bond Audit Program
Strategies for Dealing with Tax Audits

• Settlement Appeals Stage
• Agent may seek bondholder list
• Preliminary Adverse Determination
• Closing agreement offer and negotiation
• Settle for lost tax revenues
• Settle for arbitrage profits
• Other basis
• Proposed Adverse Determination
• Triggers right of appeal to Appeals office
• Next step bondholders assessed tax

30
The IRS Tax Exempt Bond Audit Program
Strategies for Dealing with Tax Audits

• When the audit is initiated
• Determine whether disclosure to bondholders is
  warranted
• Materiality analysis
• Type of Audit
• Potential settlement exposure amount
• Issuers ability / willingness to pay
• Likelihood IRS will contact bondholders

31
The IRS Tax Exempt Bond Audit Program
Strategies for Dealing with Tax Audits

• While the audit is ongoing
• Be prepared for a long-term project
• Complex audits may take more than a year to
  conclude
• Maintain the single point of contact for the
  auditor
• Be polite and be patient
• Provide requested materials on time or negotiate
  extensions of time as necessary
• Respond to the questions that are asked

32
The IRS Tax Exempt Bond Audit Program
Strategies for Dealing with Tax Audits

• While the audit is ongoing
• Periodically re-examine the initial decision not
  to disclose the audit to bondholders
• Preliminary adverse determination
• Proposed adverse determination
• Materiality analysis
• Cant protect bondholders from potential bad
  news
• Analyze as an issuer contingent liability
• Something more?

33
The IRS Tax Exempt Bond Audit Program
Strategies for Dealing with Tax Audits

• Issuers administrative review options
• Mediation program
• Technical advice memorandum
• Adverse decision may be appealed to tax court
• IRS Appeals Office
• Voluntary closing agreement program