The Bonds are Sold: Pitfalls of Post- Issuance Compliance MIDWEST REGIONAL PUBLIC FINANCE CONFERENCE April 21, 2017 Joe L. Norton Bill Burns Beth Warren

A New Focus on Compliance Lost Federal Revenue from Tax-Exempt Bonds: $187.7 Billion over 5 Years!

A New Focus on Compliance

A New Focus on Compliance

A New Focus on Compliance Issuing tax-exempt debt provides economic advantage to Issuers In exchange, limitations are imposed by the federal government at the time the bonds are sold AND as long as the bonds are outstanding. “Post-Issuance Compliance”

A New Focus on Compliance Post-Issuance Compliance Requirements Where are they found? Federal Tax Code & Regulations Tax Certificate for each financing Continuing Disclosure Undertakings Written Compliance Procedures Regulators are asking… Can you prove you are in compliance?

A New Focus on Compliance How does my Issuer prove compliance?

The Compliance Requirements Account for Expenditures Account for Investments Account for Use Account to Investors

The Compliance Requirements Account to Investors

Accounting to Investors SEC regulates the national securities markets Municipal bonds, notes, certificates of participation = securities SEC’s concerns Investor protection Market efficiency

Underwriters SEC has broad authority to regulate underwriters SEC uses its authority to regulate underwriters to indirectly impact disclosure obligations of municipal issuers

Rule 15c2-12 Applies to underwriters (not issuers) Mandates a baseline of disclosure for municipal securities – - official statements - annual reports - event notices There are exemptions for certain offerings and financings

Continuing Disclosure Undertakings Underwriter must obtain an undertaking from an “obligated person” Contractual obligation of obligated person Components Annual Report (Audit + Operating Data) Event Notices (14 Events) Notice of failure to file In new official statements, disclosure about noncompliance during 5-year historical period

Rule 15c2-12 – Obligated Person The rule requires an underwriter to obtain from one or more “obligated persons” a compliant continuing disclosure undertaking “Obligated person” – an entity committed by contract or other arrangement to support payment of all or part of the offered securities

SEC and… Municipal Bonds?

Heightened Enforcement Recently Very significant activity by Muni Enforcement Division since 2013: State of Illinois; Allen Park, Michigan; Harrisburg, Pennsylvania; City of South Miami, Florida; West Clark, Indiana Community Schools; Miami-Dade County, Florida, Public Health Trust; Greater Wenatchee (WA) Regional Events Center; State of Kansas; Harvey, Illinois; Allen Park, Michigan; Westlands Water District (CA); Ramapo, New York Miami, Florida (Jury Trial – Verdict for SEC) MCDC (71 Issuer Settlements)

MCDC — Issuer Settlement Terms Cease and Desist Order Within 180 days establish policies and procedures, including training, regarding continuing disclosure obligations Disclose in future offering documents for 5 years Certify to SEC that you have done these things Cooperate with any future SEC investigations No civil penalties

Anti-Fraud Rules Anti-Fraud Rules – Primary Source of Issuer Liability Official Statement may not contain a material misstatement or omission It is illegal for an Official Statement to contain a materially inaccurate statement, or for an Official Statement to exclude a material piece of information Issuers and issuer officials may be liable

What “Fraud?” According to SEC, negligence may include: Failure to follow procedures Failure to review documents to certain standards Failure to have the correct personnel review documents (e.g., CFO may not have all operations details) Coupled with a material misstatement or omission Focus on omissions!

SEC’s Focus

Continuing Disclosure Compliance – Step 1 Find the undertakings **Continuing Disclosure Undertaking, Continuing Disclosure Agreement, Continuing Disclosure Certificate or Bond Resolution**

Continuing Disclosure Compliance – Step 2 Review the specific requirements of each undertaking Filing Deadline (e.g., 180 days after fiscal year end) Audit requirement specifics Other financial information and operating data Should be described by reference to specific tables in the Official Statement Operating data is information about the obligated person’s own operations Quantitative; not demographic information; not projections

Sample Undertaking Language Section 2. Provision of Annual Reports.   (a) The Issuer shall not later than 180 days following the end of the Issuer’s fiscal year commencing with the year ending June 30, 2016, file with the MSRB, through EMMA, the following financial information and operating data (the “Annual Report”): (1) The audited financial statements of the Issuer for the prior fiscal year, prepared on a modified-cash basis. If audited financial statements are not available by the time the Annual Report is required to be filed, the Annual Report shall contain unaudited financial statements in a format similar to the financial statements contained in the final Official Statement relating to the Bonds, and the audited financial statements shall be filed in the same manner as the Annual Report promptly after they become available. (2) Updates as of the end of the fiscal year of the financial information and operating data contained in the final Official Statement related to the Bonds, as described in Exhibit A, in substantially the same format contained in the Official Statement Filing Deadline Audit requirement, including accounting basis Operating Data Required – included in an exhibit

Continuing Disclosure Compliance – Step 3 Prepare annual report(s) Obstacles Information not yet available Audit delays Information provided by third party sources (County Assessor)

Continuing Disclosure Compliance – Step 4 File the annual report; document compliance by keeping records

Event Notices The Frequent Three* Bond calls (if material) and tender offers Defeasances Rating changes *In a timely manner, notice of a failure to file Annual Report

Event Notices The Other Eleven Payment delinquencies Non-payment related defaults (if material) Unscheduled draws on reserves reflecting financial difficulties Unscheduled draws on credit enhancements reflecting financial difficulties Substitution or failure of credit or liquidity providers Material events affecting tax status (including adverse tax opinions and IRS determinations of taxability) Modifications of bondholder rights (if material) Release, substitution or sale of security (if material) Bankruptcy or similar events Merger, consolidation, acquisition or sale of substantially all of the assets of an obligated person (if material) Appointment of successor or additional trustee (if material)

Fool me once… SEC views an issuer’s prior compliance with undertakings during prior 5 years as “material” Disclose to investors in Official Statements Include a plain-language summary of material failures to comply in the past five years Be wary of “remedial” language unless you are sure it is correct! (“…the Issuer is now in full compliance with its undertakings”)

The Compliance Requirements Account for Expenditures

Accounting for Expenditures Identify the Project Identify Total Project Costs Identify Bond Proceeds and Earnings Complete a Final Written Allocation

Accounting for Expenditures Spending Bond Proceeds vs Accounting for Project Expenditures

Accounting for Expenditures How do we ensure Bond proceeds only go to eligible Project costs? “Final Written Allocation”

Accounting for Expenditures Final Written Allocation Needed for New Money Financings Prepared After the Project is Complete Uses Issuer’s Accounting Records Includes Expenditures for Bond Proceeds & Other Money Tells the IRS How ALL the Money was Used

Accounting for Expenditures Should we just keep bond money in a separate bank account? Separate account = simple tracking? Total Project costs need to be tracked Incorporate into regular accounting system Decide before bonds are issued

Accounting for Expenditures Identify the Project & Your Budget

Accounting for Expenditures Track TOTAL costs for the entire Project regardless of “financing source”

Accounting for Expenditures Once Project is complete… Update the Project budget to account for Actual Results

Accounting for Expenditures What does a Final Written Allocation look like? Anything missing?

Accounting for Expenditures Accounting Records! Date Payee Amount Invoice number

The Compliance Requirements Account for Investments

Accounting for Investments Identify money that must be tracked Account for proceeds and earnings Comply with rebate and yield restriction rules Follow special investment pricing rules

Accounting for Investments General Investment Limits (Arbitrage) Bond Yield vs. Investment Yield Example Bond Yield = 3% Bond proceeds invested at 4% 1% of excess earnings must be paid or rebated to the Federal Government

Accounting for Investments Financing “proceeds” MUST be tracked: Construction/Project Fund Costs of Issuance Fund Escrow Fund Debt Service Reserve Fund

Accounting for Investments Other money MAY need to be tracked: Debt Service Reserve Fund Debt Service Fund Revenue Fund Operating Fund Depreciation and Insurance Fund How do you know what funds to track?

Accounting for Investments **Tax Certificate or Tax Agreement**

Accounting for Investments How does my Issuer comply? **Arbitrage Computation**

Accounting for Investments Is Arbitrage Compliance required for every bond issue? YES! Exception to rebate may be available All Issuers must account for investments Yield reduction calculation

Accounting for Investments Any chance we can keep all the earnings? Slide 8 – Any chance we can keep the excess earnings?   Unfortunately, this hasn’t been a concern in today’s market – no one has earned above the bond yield for some time now. However, when the market starts to turn around…everyone’s focus will change. Question will be if we earn above the bond yield is there any chance we can keep the money? Yes, there are exceptions that apply that would allow an issuer to keep the money provided they spend the money fast enough. A 6-month, 18-month or 2-year spending exception may apply provided certain mandatory benchmarks are met. Another reason to have your arbitrage computation done on annual basis vs end of 5-year period.

Accounting for Investments What “investment pricing” rules apply? Need to establish FMV purchase price Must follow bidding procedures Any “safe” investments? Slide 10 - Special investment pricing rules apply   IRS wants to ensure that investments purchased with proceeds are purchased and sold at fair market value Historically abuse in this area Special investment pricing rules may apply and need to followed – Guaranteed Investment Contracts require bidding procedure

The Compliance Requirements Account for Use

Accounting for Use Use an Annual Compliance Checklist Identify the rules and restrictions that apply to bond financed Projects Identify your role in tracking use of financed Projects

ANNUAL COMPLIANCE CHECKLIST Accounting for Use What has your Issuer agreed to and how do you prove compliance? ANNUAL COMPLIANCE CHECKLIST

What Projects are affected? Final Written Allocation Accounting for Use What Projects are affected? Only Projects paid for (in whole or part) with tax-exempt bond proceeds are subject to restrictions Final Written Allocation

Accounting for Use Permitted “Good Use” of financed Projects includes use by: The County The State Other local governmental entity General public *501(c)(3) entity - 501(c)(3) Bonds only*

Accounting for Use Nonqualified Use (“Bad Use”) may result from any arrangement with: Taxable entity Person engaged in trade or business 501(c)(3) entity Federal Government What is a “bad use” arrangement…

Accounting for Use Arrangements that may result in “Bad Use” include: Sale Leases Management/Operating Agreements Output Contracts Research Contracts Granting other special legal rights to Financed Projects (e.g. naming rights) *Unrelated Trade or Business Use - 501(c)(3)*

The sale of a financed Project results in Nonqualified Use What is “Bad Use”? The sale of a financed Project results in Nonqualified Use

Accounting for Use How long do we have to track this stuff? IRS restricts the use of financed Projects during the entire term of the bond issue (including refunding bond issues) Are you saying we have to track FOREVER….

What is “Bad Use”? Example: Bond issue finances computers for District administration building Two years later District decides to replace computers and sells at a substantial discount Ten years later the District disposes of the computers Exception: Do not need to continue tracking if project has no remaining useful life

What is “Bad Use”? A lease of all or a portion of a financed Project may result in Nonqualified Use

What is “Bad Use”? Example: District leases space within District building to local businesses for meetings Short Term Exceptions: Leases under 50 days Leases under 100 days pursuant to rate scale

What is “Bad Use”? Arrangements for a third party to operate or manage financed Projects may result in Nonqualified Use

What is “Bad Use”? Example: District enters into a contract with an entity to operate its bond financed cafeteria Lots of technical exceptions No sharing of “net profits” Contract term 5 years or less Discuss with bond counsel in advance

What is “Bad Use”? Use by a 501(c)(3) organization of a bond financed Project in an unrelated trade or business results in Nonqualified Use (regardless of profit)

How much “Bad Use” is permitted? Not more than 10% of the proceeds of a bond issue may be used in a “Bad Use” Limit is 5% for 501(c)(3) organizations May be reduced to 3% if finance max amount of COI “Qualified Equity” can float!

Accounting for Use Can we fix it? Modify contract Remedial action Voluntary Closing Agreement Program (VCAP)

Your Role Help track the use of financed Projects Annual Compliance Checklist Ask questions early and often! You’re not expected to be an expert Identify issues early… More options available Avoid jeopardizing tax advantaged status of bonds

Conclusion