(See also “Basic Arbitrage Restriction Discussion” topic for additional information concerning this subject matter)
A. General Context:
Treas. Reg. 1.148-1(c)(1) provides that replacement proceeds include, but are not limited to, sinking funds, pledged funds, and other replacement proceeds described in (c)(4), to the extent that those funds or amounts are held by or derived from a substantial beneficiary of the issue. Thus, such funds or amounts that are not held by and not derived from a substantial beneficiary of the issuer should not be considered replacement proceeds.
A substantial beneficiary of the issue includes (1) the issuer and (2) any related party to the issuer, and (3) if the issuer is not a state, the state in which the issuer is located. A person is not a substantial beneficiary of an issue solely because it is a guarantor under a qualified guarantee.
B. Definition of a Qualified Guarantee:
A “qualified guarantee” is defined in Treas. Reg. 1.148-4(f). Under such section, a guarantee is defined as a “qualified guarantee” if the guarantee satisfies each of the following requirements:
- Interest savings: As of the date the guarantee is obtained, the issuer must reasonably expect that the PV of the fees for the guarantee will be less than the PV of the expected interest savings on the issue as a result of the guarantee. PV is calculated using the yield on the issue, determined with regard to guarantee payments, as the discount rate.
- Guarantee in substance: The arrangement must create a guarantee in substance. It must impose secondary liability that unconditionally shifts substantially all of the credit risk for all or part of the payments, such as payments for debt service, redemption prices, or tender prices, on the guaranteed bonds. […] The guarantee may be in any form. The guarantor may not be a co-obligor. Thus, the guarantor must not expect to make any payments [other than …]. The guarantor and any related parties together must not use more than 10 percent of the proceeds of the portion of the issue allocable to the guaranteed bonds.
- Reasonable charge: Fees for a guarantee must not exceed a reasonable, arms’-length charge for the transfer of credit risk. The issuer may not rely on the representations of the guarantor as to this factor. Fees for services other than transfer of credit risk must be separately stated, etc.
This section of the Treasury Regulations sets forth certain other requirements, including requirements as to the allocation of qualified guarantee payments, payments coinciding with payments on the related bonds.
“Related party” is defined in Treas. Reg. 1.150-1(b). In reference to a governmental unit or a 501(c)(3) organization, a related party is any member of the same controlled group. E.g., if the conduit borrower is a LLC the sole member of which is the guarantor (a 501(c)(3) organization), the borrower is a related party. Therefore, the guarantor would be deemed to use more than 10 percent of the proceeds which causes the guarantee to fail the “qualified guarantee” test. Such guarantee would then need to be crafted in such a way that it does not cause replacement proceeds problems.
C. Bond Yield Calculations:
Under Treas. Reg. 1.148-4(f), payments for purposes of calculating yield include not only all unconditionally payable payments of principal and interest, but also all fees for qualified guarantees on the issue and amounts reasonably expected to be paid as fees for qualified guarantees of the issue. This means that guarantee fees have the effect of increasing the yield, which is good for the issuer. In order to calculate the bond yield, the present value of all of those payments is deemed to be the issue price. Bond insurance premiums are treated like qualified guarantee fees for this purpose.
Note that there is a special rule for including qualified guarantee payments for variable yield issues – in such issues, any up-front and non-level guarantee payments must be allocated to each computation period.
D. Other Matters:
Working Capital: Payment of guarantee fees, which usually would be considered a working capital payment, is excepted from the restrictions on financing working capital. See Treas. Reg. 1.148-6(d)(3)(ii).
Issue Price: Qualified guarantee fees do not reduce the issue price (even though they are included in the calculation of bond yield).