Auction rate securities have been popular finance vehicles, especially among municipalities and other governmental agencies, although they were issued by commercial firms as well. These securities allow a borrower to tap capital markets for the equivalent of a variable rate loan it might have otherwise obtained from a bank.

With a regular bond, if market interest rates change after the bond is issued, or the issuer’s credit rating gets better or worse, the price at which the bond trades in the market will increase or decrease. Auction rate securities always trade at par. Typically, every 28 days (sometimes even weekly) auctions are held where the interest rate is re-set to the lowest rate at which all sellers can be matched with buyers. Before this year, these securities were popular with investors because the rates tended to be higher than many alternative short term investments and the securities could always be sold at par every 28 days.

All of this changed in February of this year when, during a single week, nearly 1,000 auctions failed. That means that given the number of sellers, there were not sufficient buyers to purchase the securities, even at the maximum interest rate provided for in the terms of the security. When an auction fails, the investor begins to collect interest at the highest rate provided, but is not able to sell his position. Before February, auctions rarely failed because investment banks and other broker-dealers would step up and buy enough securities to clear the auction. The sudden loss of liquidity in this market caused major consternation and turmoil along with threats of litigation.

Many issuers began to issue settlement offers to forestall litigation. Settlement offers typically give the investor the right to “put” the security to the issuer at par for a period of time. The investor will continue to receive the periodic interest payments until it exercises its put option, either at the maximum rate or, if the auctions begin to succeed, at the periodic rates set by the auctions. Some settlement offers also give the issuer the equivalent of a “call” option to purchase the security at par. This affords the issuer the opportunity to limit its losses where it can re-sell the security to another investor at a small discount to par. Certain settlement offers also permit the holder of these securities to borrow funds from the issuer, secured by the auction rate security.

The various features of these settlement offers raise interesting and uncertain tax issues including whether the holder is still considered the tax owner of the security or whether he has constructively sold it. The IRS has issued Rev. Proc. 2008-58 to provide some clarity in this area and hopefully further stabilize this market. In the revenue procedure, the IRS said: i) a holder will not be deemed to have sold the security merely because it receives a settlement offer; ii) a holder will not be treated as realizing any taxable income because it receives a settlement offer or receives a loan against the security pursuant to the settlement offer; and iii) if the holder sells the security to the issuer pursuant to a settlement offer, its full amount realized for purposes of its tax gain or loss is the amount of cash paid by the issuer in the transaction. This last point apparently negates any concern that the options themselves contained in the settlement offer are some additional form of valuable consideration.