Summary of the Proposed Treasury Regulations Pertaining to SLGS

By Michael L. Weiner (Lakeland)

Originally published January 2005

The Bureau of Public Debt of the United States Treasury Department (the Treasury) has filed a notice of Proposed Rulemaking, which, if approved in its current form, will have a significant impact on issuers of municipal bonds that utilize the State and Local Government Securities (SLGS)¹

program. The Treasury concluded that issuers and their agents are abusing the SLGS program to exploit arbitrage opportunities by taking advantage of interest rate movements. Following is a summary of the measures that the Treasury proposed to eliminate actions which it has deemed to be inappropriate.

The Treasury concluded that it is inappropriate for issuers to sell or redeem SLGS before maturity to take advantage of higher interest rates. The Treasury considers this inappropriate even when the purpose is to eliminate negative arbitrage. Currently, issuers can invest in yields up to their bond yield limit. Negative arbitrage exists when an issuer purchases securities with bond proceeds at an interest rate that is less than their bond yield limit. It is unclear under the proposed regulations whether redemption proceeds of zero rate SLGS could be invested at yields above zero.

Additionally, the Treasury has proposed that a SLGS subscription may not be cancelled for higher yielding SLGS or open market securities. The current regulations permit an issuer to obtain a higher yield by canceling a SLGS subscription up to a week before the issue date. The Treasury believes that it is improper for an issuer to cancel a SLGS subscription to take advantage of more favorable interest rates, even when done within the federal arbitrage guidelines.

These proposed SLGS regulations will further limit the yield issuers may receive on bond proceeds without regard to the federal arbitrage limits that are already imposed. With the proposed regulations, issuers would be unable to recover their negative arbitrage by purchasing, selling or canceling SLGS subscriptions for a more favorable interest rate. The proposal effectively freezes the investment return an issuer may earn when it either buys or sells a SLGS security prior to its maturity.

Following is a summary of the proposed Treasury Regulations related to the purchase, sale and cancellation of SLGS:

• Purchase and Sale of SLGS

1. Issuers would not be permitted to purchase higher yielding SLGS from the proceeds of a sale (prior to its maturity) of a lower yielding security. Additionally issuers would be prohibited from investing any amount received from the redemption (before its maturity) of a SLGS security at a greater yield than the yield from the redeemed SLGS security.
2. The issuer would be required to certify meeting the yields requirements upon a request to purchase SLGS and/or a redemption request of SLGS before maturity. The proposed definition of "yield" used in the certifications would require that the yield of the marketable debt instrument be computed using the same compounding intervals and financial conventions used to compute interest on the SLGS. The proposed definition of "yield" would not include any adjustment for credit quality of securities purchased on the open market (i.e., corporate debt obligations) other than U.S. Treasury securities. Because all corporate securities have a risk premium built into them, which in turn results in a higher yield than U.S. Treasury securities, by not including such risk premium in the yield calculation, it would prevent an issuer from using proceeds derived from the early redemption of SLGS to purchase a corporate security with a higher yield.

• Cancellation and Amendments of SLGS Subscription

1. Cancellation of SLGS subscriptions would be prohibited unless the subscriber establishes, to the satisfaction of the Treasury, that the cancellation is required for reasons other than for the purpose of re-subscribing later for higher yields. Subscribers (issuers or conduit borrowers) found violating the rule would be barred from subscribing for SLGS for six months.
2. Issuers would be limited to modifying the aggregate principal amount of a SLGS subscription by no more than 10 percent. Currently, subscribers of SLGS may change the aggregate principal amount specified in the initial subscription up to $10 million or 10 percent, whichever is greater.
3. The proposal would prohibit subscribers from changing the issue date once it is reserved. Current regulations permit a subscriber to change the issue date up to seven days after the originally selected delivery date.
4. Subscribers would be required to certify that the issuer has authorized the issuance of the state or local bonds and to provide a description of the municipal bond issue. (This was done to prevent financial advisors or other agents from reserving SLGS before there was an identified issuer, as a means of the financial advisor or agent using the subscription as a means of obtaining business.)

Subscriptions and requests for early redemption of SLGS would be limited to eight hours, from 10 a.m. to 6 p.m., eastern time instead of the current midnight deadline. This would be especially difficult on issuers on the West Coast where 6 p.m. eastern time would be 3 p.m. western time. Access to other functions, such as viewing account balances and obtaining statements of accounts, would be provided from 8 a.m. to 10 p.m. eastern time.

Currently, SLGS rates are published by 5 p.m. based on that day’s closing prices. This delay in pricing SLGS based on the prior day’s closing price can cause the interest rates on the SLGS to be higher than that day’s open market prices. To correct this, the Treasury has proposed setting the SLGS rate by 10 a.m., eastern time, each business day. If the current day’s rates are unavailable by 10 a.m., the previous day’s rates will be used.

The Treasury has also proposed prohibiting the purchase of SLGS with a maturity longer than is reasonably necessary to accomplish a governmental purpose of the issuer.

Issuers would be required under the proposed regulations to use SLGS Safe exclusively for all transactions involving SLGS, including the subscription, cancellation and amendments to SLGS subscriptions. SLGS Safe is an Internet site operated by the Bureau of Public Debt. Currently, issuers may also subscribe by fax and mail service.

The Treasury is proposing that in cases where SLGS are needed for maturities currently not issued by the Treasury, it would have the option of establishing the SLGS rates by using suitable proxies and/or a different rate setting methodology. Currently the definition of SLGS rate is the "current Treasury borrowing rate" minus five basis points.

Under the proposed regulations, SLGS subscribers would be required to provide 14 day advance notice to redeem their SLGS, instead of the current 10-day requirement.

The Treasury has proposed that SLGS may only be purchased from amounts that constitute gross proceeds of an issue. Currently, issuers may purchase SLGS from any amounts that (i) constitute gross proceeds of an issue or (ii) assist in complying with applicable provisions of Internal Revenue Code relating to tax exemption.

The proposed regulations have received significant criticism from the municipal bond industry. It has been argued that many of the changes go too far and will lead to issuers avoiding the SLGS program. The National Association of Bond Lawyers (NABL) filed formal comments with the Treasury on the proposed regulations.² In its letter, NABL endorsed the requirement that SLGSsafe be required to subscribe and change SLGS subscriptions, requiring proper authorization by issuers to subscribe for SLGS and a requirement that issuers show their intent to issue bonds before being allowed to subscribe for SLGS. NABL also suggested that that the proposed regulations be changed, at a minimum, in the following manner:

1. to permit penalty free cancellation of subscriptions, and re-subscriptions at higher rates, for up to 60 days
2. eliminate proposed "reinvestment yield" restrictions on redemptions and subscriptions
3. retain the existing definition of moneys eligible for SLGS investment
4. retain the flexibility to extend issue dates by up to seven days, modify subscription amounts by up to $10 million and to specify maturities of choice

NABL concluded its letter by requesting a public hearing on the proposed regulations. Municipal bond market participants must now wait and see what the final regulations are and the impacts it will have on the purchase, sale and cancellation of SLGS.