Summary of the Final Treasury Regulations Pertaining to State and Local Government Securities (SLGS)

The Bureau of Public Debt of the United States Treasury Department (the Treasury) has issued final regulations revising its State and Local Government Securities (SLGS) program. The SLGS program was developed by the Treasury to assist state and local governments and other issuers of tax-exempt bonds. The Internal Revenue Code generally prohibits issuers of tax-exempt bonds from earning arbitrage by investing the proceeds of those bonds at a yield that is materially higher than the yield of the bonds. Through the SLGS program, the Treasury offers securities in which bond proceeds may be invested at a yield which complies with that arbitrage restriction.

An issuer of tax-exempt bonds has a choice between investing yield-restricted proceeds of its bonds in SLGS or investing those proceeds in other types of Treasury securities (or other permitted investments) acquired on the open market. The Internal Revenue Service, however, has frequently raised concerns about whether an issuer acquired "open market" securities at a cost greater than their fair market value in order to reduce (or burn) the yield on those securities to below the yield of the bonds. After identifying a large number of such "yield-burning" transactions that occurred during the late 1980’s and early 1990’s, the Treasury took several steps to prevent such transactions. One of those steps was to substantially revise the SLGS program during 1996 in order to make the purchase of SLGS much more attractive and, thereby, reduce the incentives for a bond issuer to purchase "open market" securities instead.

The new SLGS regulations were prompted by a perception on the Treasury’s part that issuers and their agents were taking advantage of certain changes to the SLGS program made in 1996, in ways that were not intended or anticipated when those changes were made. The Treasury has concluded that more restrictive rules governing subscriptions for SLGS, the cancellation of such subscriptions, and other aspects of the program were needed to prevent issuers from exploiting arbitrage opportunities made available by interest rate movements. Although some favorable changes have been made to the SLGS program, most of the changes make the program less flexible and, therefore, may lead to issuers investing in open market securities rather than SLGS.

Following is a summary of certain provisions in the final regulations governing the SLGS program. The new regulations became effective on August 15, 2005. The full text of the regulations can be found at: http://www.treas.gov/press/releases/reports/062905slgsfinal.pdf.

Previously, issuers could subscribe for SLGS by fax, mail and through SLGSSafe, the Internet site operated by the Bureau of Public Debt. Except in very limited circumstances, issuers are now required to use SLGSSafe exclusively for all transactions involving SLGS. Fax and mail subscriptions will only be allowed if the issuer establishes to the Treasury "that good cause exists for not using SLGSSafe." Waivers are not expected to be granted "based on a user’s status as a small firm or infrequent subscriber." Subscribers are now required to enter a description of the tax-exempt bond issue in SLGSSafe.

Previously, subscriptions for SLGS, as well as requests for early redemption of SLGS, were accepted by the Treasury through SLGSSafe between 8 a.m. and 10 p.m. Eastern time. The new regulations reduce the time period during which the SLGS window is open by two hours. Subscriptions for SLGS, as well as requests for early redemption of SLGS, will now only be accepted by the Treasury through SLGSSafe between 10 a.m. and 10 p.m. Eastern time. Access to all other functions, such as viewing account balances and obtaining account statements, will remain available between 8 a.m. and 10 p.m. Eastern time.

The most significant, positive change to the SLGS program is that in the daily SLGS tables, the maximum rate for each maturity will now be set at one basis point below the current Treasury borrowing rate. Previously, the maximum rates were set at five basis points below the current Treasury borrowing rate. This change should make the yield on SLGS more competitive with "open market" securities.

Previously SLGS rates were published by 10:00 a.m. Eastern time each day, but the rates were based on the Treasury’s yield curve determined the previous day. This delay in the pricing of SLGS could have caused the interest rates on the SLGS to be higher than that day’s open market prices. To correct this, the Treasury will now administratively set the SLGS rate on the same day as the rates are published, no later than 10 a.m., Eastern time. If the current day’s rates are unavailable by 10 a.m., the previous day’s rates will be used.

Previously, issuers could purchase SLGS from any amounts that (a) constitute gross proceeds of an issue or (b) assist in complying with applicable provisions of the Internal Revenue Code relating to tax exemption. The final regulations now provide that issuers may purchase SLGS using any of the following "eligible sources of funds": (a) any amounts that constitute gross proceeds of a tax-exempt bond issue or are reasonably expected to become gross proceeds of a tax-exempt bond issue; (b) any amounts that formerly were gross proceeds of a tax-exempt bond issue, but no longer are treated as gross proceeds of such issue as a result of the operation of the universal cap on the maximum amount treated as gross proceeds (set out in the applicable tax regulations); (c) amounts held or to be held together with gross proceeds of one or more tax-exempt bond issues in a refunding escrow, defeasance escrow, parity debt service reserve fund, or commingled fund (as defined in the applicable tax regulations); (d) proceeds of a taxable bond issue that refunds a tax-exempt bond issue or is refunded by a tax-exempt bond issue; or (e) any other amounts that are subject to yield limitations under the rules applicable to tax-exempt bonds imposed by the Internal Revenue Code.

The previous regulations permitted an issuer that had subscribed for SLGS to cancel the subscription without penalty up to a week before the date the SLGS are to be delivered. This allowed issuers to subscribe for SLGS up to 60 days before the delivery date, to monitor the daily SLGS rates over that 60-day period, and, if the rates increase, to cancel the prior subscription and re-subscribe for SLGS paying a higher rate. It also permitted issuers to subscribe for SLGS up to 60 days before the delivery date, to monitor the rates available on "open market" securities over that 60-day period, and, if the rates increase, to cancel the prior subscription and instead acquire "open market" securities paying a higher rate.

The Treasury determined that this unrestricted ability to cancel a SLGS subscription without penalty is the equivalent of granting an issuer a cost-free option because the Treasury effectively has to bear this cost. To relieve itself of those costs, the Treasury has provided in the new regulations that an issuer may cancel a SLGS subscription only if it can establish to the Treasury that the "cancellation is required for reasons unrelated to the use of the SLGS program to create a cost-free option." Effectively, this means that cancellation of SLGS subscriptions will now be prohibited unless the subscriber establishes, to the satisfaction of the Treasury, that the cancellation is not for the purpose of investing the proceeds at a higher yield. Subscribers (issuers or conduit borrowers) found violating this rule will be barred from subscribing for SLGS for six months.

Previously, subscribers of SLGS could change the aggregate principal amount specified in the initial subscription up to $10 million or 10 percent, whichever was greater. Under the final regulations, issuers are now limited to modifying the aggregate principal amount of a SLGS subscription by no more than 10 percent. This change will be especially harsh on smaller issuers.

Previous regulations permitted a subscriber to change the issue date of the SLGS of up to seven days after the originally selected issue date. Under the new regulations, extensions of the issue date of up to seven days after the original issue date will be permitted only "if it is established to the Treasury that the change is required as a result of circumstances that were unforeseen at the time of the subscription and are beyond the issuer’s control (for example, a natural disaster)." Issuers who do not take delivery of a subscription will not be permitted to participate in the SLGS program for six months from the date the subscription is withdrawn, or the proposed issue date, whichever occurs first. The penalty will be imposed upon the issuer or a conduit borrower, provided the issuer provides the Taxpayer Identification Number of the conduit borrower.

Under the previous SLGS regulations, issuers were permitted to redeem SLGS before maturity for the purpose of reinvesting the redemption proceeds at a higher yield. This is often done to reduce or eliminate negative arbitrage. Negative arbitrage exists when an issuer purchases securities, such as SLGS, with bond proceeds and those securities pay interest at a rate that is less than the yield on the bonds.

The Treasury has concluded that it is inappropriate for issuers to sell or redeem SLGS before maturity to take advantage of higher interest rates, even when done to eliminate negative arbitrage. Under the final regulations, issuers are not permitted to purchase higher yielding SLGS from the proceeds of a sale (prior to its maturity) of a lower yielding "open market" security. Additionally, issuers are prohibited from investing any amount received from the redemption (before its maturity) of SLGS at a greater yield than the yield of the redeemed SLGS. Issuers will now be required to certify to meeting this yield-restriction requirement as part of a subscription to purchase SLGS (other than zero interest SLGS) and/or a request to redeem SLGS before their maturity. The final regulations apply to SLGS subscriptions made on or after August 15, 2005.

Under the final regulations, the Treasury also described one situation in which the yield-restriction requirement will not apply. If amounts received from the sale or redemption of an investment are invested in a second investment with an earlier maturity, and the issuer holds the second investment to maturity, then the yield-restriction requirement would expire at the maturity of the second investment, provided that the other requirements of the final regulations are met, including "the requirement that the SLGS program not be used to create a cost-free option." The Treasury regards this rule as addressing issuers’ concern that, if they are permanently barred from investing in higher yielding securities, they would be prevented from ever recovering negative arbitrage. Under the final regulations, open market securities in a sinking fund or a debt service reserve fund for refunded bonds are subject to the same yield restrictions that apply to other marketable securities.

Under the final regulations, SLGS subscribers are now required to provide 14-day advance notice to redeem their SLGS, instead of the current 10-day requirement.

The new rules described above governing cancellation of SLGS subscriptions and early redemption of SLGS do not apply to zero coupon SLGS.

The final regulations revise the definition of "issuer" to make it clear that the issuer does not have to be a governmental body. This change was made to clarify that a non-profit corporation issuing bonds on behalf of a governmental body can qualify as an "issuer."

The regulations also specify that the sanction for erroneous certifications in a SLGS subscription prepared by an agent of the issuer may either be imposed on the issuer or the agent, as the Treasury deems fit.

1. Except in limited circumstances, SLGSSafe is now required for all transactions involving SLGS.
2. Subscriptions for SLGS must be made between 10 a.m. and 10 p.m., Eastern time.
3. SLGS rates are set on the same day as the rates are published.
4. Maximum SLGS rates are set at one basis point below current Treasury borrowing cost.
5. SLGS may be purchased only from "eligible sources of funds" which include: (a) gross proceeds of a tax-exempt bond issue, (b) amounts that were formerly gross proceeds of a tax-exempt bond issue, (c) amounts held or to be held together with gross proceeds of a tax-exempt bond issue, (d) proceeds of a taxable bond issue that refunds a tax-exempt bond issue or is refunded by a tax-exempt bond issue, or (e) any other amounts that are subject to yield limitations.
6. Cancellation of SLGS subscribed for after August 15, 2005, are prohibited unless the subscriber establishes, to the satisfaction of the Treasury, that the need for "cancellation is required for reasons unrelated to the use of the SLGS program to create a cost-free option" (i.e., for a reason other than to purchase a different investment returning a higher yield.)
7. Issuers are now limited to modifying the aggregate principal amount of a SLGS subscription by no more than 10 percent of the principal amount.
8. Extensions of the issue date of SLGS of up to seven days after the original issue date will be permitted only "if it is established to the Treasury that the change is required as a result of circumstances that were unforeseen at the time of the subscription and are beyond the issuer’s control (for example, a natural disaster)."
9. Issuers are now prohibited from using the proceeds of open market securities or SLGS purchased on or after August 15, 2005 (other than zero interest SLGS) to purchase higher yielding securities (SLGS or open market securities).
10. Subscribers must provide 14-day advance notice to redeem SLGS.

The final regulations have made the use of the SLGS program more complex and less flexible than under the former regulations. The final regulations took effect on August 15, 2005. Issuers are advised to discuss with their bond counsel and financial advisors how these new regulations will apply to their particular transactions.