IMPERMISSIBLE SLGS TRANSACTIONS

A High Level and Historical Look at Cost-free options

2 0 1 3 S TAT E A N D L O C A L G O V E R N M E N T S E R I E S S E C U R I T I E S F O R U M

Contents• I. What is the purpose of the SLGS Program?• II. What is a cost-free option?• III History of the prohibited practices section of the SLGS

Regs • IV Why the need for this prohibition?• V. Some of the prohibited practices• VI. Cursory review of examples in regulations• VII. Questions

I. What is the Purpose of the SLGS program?

The primary purpose of the SLGS program is to assist state and local government issuers in complying with yield restrictions and rebate requirements applicable to tax exempt bonds under the Internal Revenue Code.

SLGS offer issuers flexibility in choosing:• Issue dates• Interest rates (within rate table range)• Maturity dates ( up to 40 years)• First interest payment dates (for notes and bonds)

SLGS offer the ability to make changes from the subscription date up to 3:00pm on the issue date:

• Interest rate (within given ranges)• Maturity dates • First interest payment dates (for notes and bonds)• Issue amount ( up to 10% from the original aggregate

amount) • Issue date (can move back up to seven calendar days - with

approval)

II. What is a cost –free option?

A cost-free option is the use of the program to exploit movements in interest rates, including, but not limited to, those aspects of the program that are designed to provide marginal flexibility to issuers in structuring their SLGS investments.

III. History of prohibited practices section of the SLGS Regulations

• SLGS Reg modifications of October 28, 1996 made the program more flexible

• Prohibited practices language /examples first appeared in the September 3, 1997 amendments to the SLGS regs.

• The June 30, 2005 modifications created section 344.2 (f) by:– providing a functional description of 3 specific impermissible practices

including the specific prohibition against using the SLGS program to create a cost-free option [section 344.2(f)(1)(i)]

– expanding the examples of impermissible transactions from 5 to 6

IV. Why the need for this prohibition?

• It is not the intended purpose of the program.• The prices established by the Treasury for SLGS

securities do not include the cost of an option.• Cost-free option practices lead to higher borrowing

and administrative costs for Treasury.

V. Some of the prohibited practices

• To use the SLGS program to create a cost-free option. [344.2(f)(1)(i)]• To purchase SLGS with proceeds from the sale or redemption of

marketable securities if the yield on the SLGS exceeds the yield at which the marketable security was sold or redeemed. [344.2(f)(1)(ii)]

• To invest the proceeds of a redemption of SLGS (other than 0% SLGS) at a yield that exceeds the yield at which the SLGS were redeemed. [344.2(f)(1)(iii)]

VI. Example 1 “Simultaneous Purchase of Marketable and SLGS Securities” [ 344.2(f)(2)(i) ]An issuer enters a contract for the purchase of marketable securities to fund an advanced refunding escrow and simultaneously subscribes for SLGS to fund the escrow as well. Each individual transaction would be sufficient to fund the escrow, but together the transactions greatly exceed the funding level of the escrow.

During the time between the subscribed for date and the issue date of the SLGS securities the issuer plans to:• 1) Enter into an offsetting contract to sell the marketable securities and use the refunding bond

proceeds to purchase the SLGS securities should interest rates decline.• 2) If interest rates do not decline, the issuer plans to use the bond proceeds to purchase the

marketable securities and cancel the SLGS subscription. This example violates the prohibition on cancellation and no waiver would be granted as it is a cost-free option.

VI. Example 2 “Sale of Marketable Securities Conditioned on Interest Rates.” [344.2(f)(2)(ii) ]

The existing escrow for an advanced refunding contains marketable securities which produce a negative arbitrage. In order to reduce or eliminate this negative arbitrage the issuer:

• Subscribes for SLGS at a higher yield than the yield on the existing escrow securities but still less than the permitted yield.

• At the same time agrees to sell the marketable securities to a third party at a yield less than the SLGS yield and use those proceeds to purchase the SLGS if interest rates decline between the subscribed for date and the issue date of the SLGS.

• If however, the interest rate rise during this period the issuer and third party agree that the issuer will cancel the SLGS subscription.

This example violates the prohibition on cancellation and no waiver would be granted as it is a cost-free option.

VI. Example 3 “Sale of Marketable Securities Not Conditioned on Interest Rates.” [344.2(f)(2)(iii) ]

The facts are the same as in example 2 except the agreement between the issuer and the third party is not conditioned upon changes in the interest rates on Treasury Securities.

The existing escrow for an advanced refunding contains marketable securities which produce a negative arbitrage. In order to reduce or eliminate this negative arbitrage the issuer:• Subscribes for SLGS at a higher yield than the yield on the existing escrow securities but still

less than the permitted yield. • At the same time the issuer agrees to sell the marketable securities to a third party at a yield

less than the SLGS yield and use those proceeds to purchase SLGS.

This transaction is still prohibited because it violates 344.2(f)(1)(ii).

VI. Example 4 “Simultaneous Subscription for SLGS Securities and Sale of Option to Purchase Marketable

Securities.” [344.2(f)(2)(iv) ]The issuer holds a portfolio of marketable securities in an account that produces negative arbitrage. In order or reduce or eliminate this negative arbitrage the issuer: • Subscribes for SLGS securities to be purchased in 60 days• At the same time the issuer sells an option to purchase the portfolio of marketable securities. • If interest rates increase the holder of the option will not exercise it and the issuer will cancel

the SLGS subscription.• If interest rates decrease the holder of the option will exercise it and the issuer will use the

proceeds to fund the SLGS purchase. This example violates the prohibition on cancellation and no waiver would be granted as it is a cost-free option.

VI. Example 5 “Early Redemption of Time Deposit Security and Subsequent Purchase of Marketable

Security.” [344.2(f)(2)(v) ]• On 02/06/06 an issuer purchases a SLGS security maturing on 02/06/09 with a yield of 3.63%

using tax-exempt bond proceeds to fund a reserve fund. • On 03/01/07 the issuer submits a request to redeem the time deposit security on 03/15/07.

The yield used to determine the amount of redemption proceeds is 3.21%.• On 03/05/07 the issuer subscribes for the purchase of a second time deposit security on

03/15/07 earning 2.77% and maturing on 04/16/07 and pays for it with the proceeds from the redemption of the first time deposit security.

• On 04/09/07 the issuer enters into a contract to purchase on 04/16/07 a 10 year marketable treasury security yielding 4.02% with the proceeds from the maturity of the second time deposit security.

This is a permissible set of transactions under section 344.2 because: 1) no SLGS subscription was canceled, 2) there is no cost-free option present in this scenario, and the transactions are not subject to yield limitations identified in 344.2(f)(1)(ii) and (iii).

VI. Example 6 “Early Redemption of Time Deposit Security and Simultaneous Purchase of Marketable

Security.” [344.2(f)(2)(vi) ]• On 02/06/06 an issuer purchases a SLGS security maturing on 02/06/09 with a yield of 3.63%

using tax-exempt bond proceeds to fund a reserve fund. • On 03/01/07 the issuer submits a request to redeem the time deposit security on 03/15/07.

The yield used to determine the amount of redemption proceeds is 3.21%.• On 03/01/07 the issuer subscribes for the purchase of a second time deposit security on

03/15/07 earning 2.77% and maturing on 04/16/07 and pays for it with the proceeds from the redemption of the first time deposit security.

• On 03/01/07 the issuer enters into a contract to purchase on 04/16/07 a 10 year marketable treasury security yielding 4.02% with the proceeds from the maturity of the second time deposit security.

This example violates the prohibition on cost-free options per (344.2(f)(1)(i) and is an impermissible set of transactions.

VII. Questions?

If you would like to get more guidance on definitions of terms used in this section or the examples given please email your questions to OPDA-SIB@bpd.treas.gov.