Introduction. The American Recovery and Reinvestment Act of 2009 (the "Act") became law earlier this year. Its provisions include several attempts to provide additional options to states and local governments with respect to how they borrow money. Some of the provisions seek to improve the "buy side" of the market by easing certain restrictions on purchasers of municipal bonds. Additionally, the bond provisions attempt to assist the "sell side" of the market by providing issuers with new types of bonds to accomplish their financing objectives. An example of the latter can be found in the provisions regarding Build America Bonds ("BABs"), an entirely new type of municipal bond. What follows is a brief explanation of the types of Build America Bonds, the features common to each type as well as the differences between each kind. In part because of the newness of the obligation, whether BABs will attain popularity with issuers and purchasers of bonds will depend on the answer to a number of questions that exist with respect to this innovative development.
BABs differ from most municipal bonds in that the BABs are a type of tax credit bond. Most municipal bond issues are structured such that the interest payable on them is excludable from gross income for federal income tax purposes -- a condition usually called "tax-exempt." BABs, however, are structured as tax credit bonds, meaning that the interest payable is not excludable from gross income, rather a credit against federal income tax is allowed with respect to the interest paid. Additionally, BABs differ from other, more traditional, tax credit bonds in that other tax credit bonds, such as qualified zone academy bonds and clean renewable energy bonds, are designed to allow the issuer to borrow at an interest rate of 0%; the repayment terms and amount of the credit allowed to a holder are hoped to provide a return such that no additional interest rate will be required by holders. BABs, however, apply a fixed percentage to the interest payable on the obligation to determine the amount of the credit. The credit rate and recipients of credits will vary depending on which type of BAB is issued.
Varieties of Build America Bonds. There are four types of BABs: Tax Credit BABs, Direct Payment BABs, Recovery Zone Economic Development Tax Credit BABs and Recovery Zone Economic Development Direct Payment BABs. Some characteristics are common to each type. All BABs must be structured such that, absent the election by the issuer to treat them as taxable obligations, they would be tax-exempt. Thus, for example, the arbitrage restrictions with respect to yield, expenditure timing and rebate will apply to all BABs. Additionally, the BABs may not be private activity bonds within the meaning of the federal tax code. This means, among other things, that the items financed with the bonds must be governmentally owned. Finally, BABs may not have more than a di minimus amount of original issue discount.
Now let's examine some of the distinctions among the types of BABs. The proceeds of a Tax Credit BAB may be used for capital expenditures, as well as refunding and working capital purposes. There is no limitation on the amount of proceeds that may be used for issuance expenses. The holder is entitled to receive a credit against his federal income tax liability in the amount of 35% of the interest received on the BAB. The credit is not refundable, meaning that to the extent the credit causes the holder's tax liability to fall below zero, the excess must be carried forward and applied to a future year's liability. The credit is also includable in the gross income of the holder as is the interest on the BAB, with the net result being that a holder will receive a return anticipated to be 74.1 percent of taxable interest rates. The credits themselves are severable from the BABs, that is, they can stripped and sold separately from the BAB.
In the case of Direct Payment BABs, the issuer receives the value of the credit (35% of the interest) as a subsidy from the U.S. Treasury on each interest payment date. In the case of Tax Credit BABs the holder includes into income the full amount of the interest received, while, in the case of Direct Payment BABs, the issuer receives the subsidy, which is, of course, not subject to taxation in the hands of the issuer. Since the issuer pays no taxes, the net amount of the benefit to the issuer is expected to be higher to in the case of Direct Payment BABs as compared to Tax Credit BABs. The permitted use of proceeds is more limited than is the case with Tax Credit BABs; all of the available project proceeds (sales proceeds plus investment earnings) must be used to pay capital expenditures and issuance costs not in excess of 2% of the issue price, to or fund a reasonably required debt service reserve fund. Essentially, this means that working capital financings and refundings of existing debt are not permitted with the proceeds of a Direct Payment BAB.
The Direct Payment BAB and Tax Credit BAB distinctions apply to another type of tax credit bond created by the Act, the Recovery Zone Economic Development Bond ("RZEDBs"), which are Build America Bonds that have met certain additional targeted restrictions. The size of the credit is 45% of the interest payable. As with other BABs, RZEDBs may be issued as either Tax Credit BABs ("Recovery Zone Tax Credit BABs") or Direct Payment BABs ("Recovery Zone Direct Payment BABs"). All of the sales proceeds, plus investment earnings, must be used for some combination of eligible expenditures, a reasonably required reserve fund and issuance expenses not in excess of 2% of the issue price. Eligible expenditures are (i) capital expenditures with respect to property in a recovery zone; (ii) expenditures for public infrastructure and construction of other public facilities that promote development in a recovery zone; (iii) expenditures for job training and educational programs.
A recovery zone is any area designated by the issuer, as well as any areas of economic distress occasioned by the closing of military bases. A $10 billion nationwide cap exists with respect to RZEDBs of either the credit type or the subsidy type, for 2009 and 2010. That means that no more than $10 billion of such bonds may be issued in each of those years. The Act provides that the cap is to be allocated among the several states based on the relative decline in employment in the states and then further allocated by the states among counties and cities with a population in excess of 100,000 on the relative decline in employment in those entities. Regulations are required from the Treasury Department to clarify the method for making allocations and to address various administrative matters, such as whether an issuer receiving a small amount of cap can convey it to another issuer. Further, each state may choose to make additional considerations applicable for cap allocation procedures, such as which government agency will be responsible for cap allocation.
Questions. The novelty of the BABs and the provisions of the Act regarding this type of obligation raise a number of questions. A fundamental uncertainty is whether a market will develop with respect to BABs. As was indicated above, BABs are an entirely different type of taxable, tax credit bond than has heretofore existed. Whether investors will be interested is unknown. Further, given that the investors in taxable securities are different from the typical municipal market investor, the nature of the form and substance of disclosure that will be satisfactory to such investors is uncertain. Similarly, although the credits may be stripped and sold separately, it is difficult to determine how to value such credits given their possible illiquidity and likely price volatility.
Another question is whether federal prevailing wage requirements, known as the Davis-Bacon Act, apply to BAB funded projects. Davis-Bacon is made expressly applicable to several tax credit bonds but BABs are not among them. The Act contains a general statement with respect to the applicability of Davis-Bacon to projects that benefit from provisions of the Act, however, that could be construed as a reference to the provisions of the Act related to direct grants. In any event, the matter will require clarification, perhaps in a technical corrections bill.
The program has a relatively short life -- no BABs are currently authorized to be issued after 2010. While Congress may elect to extend the termination date, the uncertainty regarding the future viability of the program may hinder the development of a secondary market for the credits and the BABs.
The Act provides that the tax credits are earned by the holder who holds a Tax Credit BAB or a Recovery Zone Tax Credit BAB on the applicable interest payment date. In the case of most bonds, the concept of accrued interest, whereby the seller receives as part of the purchase price the interest accrued since the preceding interest payment date is a well understood and a market convention designed to assure the selling holder receives the equivalent of a portion of the interest earned during the time that it held the bond. It is not clear how to properly value the portion of the obligation attributable to the credit for transfers between interest payment dates. This could be challenging in that the value to a holder-seller and a potential holder may vary because of their respective tax situations, a situation that could limit the liquidity of the obligations.
Additional technical questions also exist. For example, Direct Payment BABs may not be used for working capital purposes. Existing Treasury Regulations permit the use of bond proceeds for certain types of working capital items, such as capitalized interest. However, by definition, these expenditures are still a working capital expenditures -- the regulation just exempts them from the "gross proceeds spent last" requirements. It would appear reasonable to permit BAB proceeds to be used for all expenditures for which the proceeds of other governmental bonds can be used, subject to the express limitations in the BAB authorizing provisions (e.g., 2% issuance expense limitation), however, the issue is not clear. Another technical area relates to RZEDBs that fund job training programs. Since BABs must not be private activity bonds, any such program would have to avoid running afoul of the private activity bond tests. Private participation in any such program would presumably be desirable in order to help the program be more effective, however, the degree to which a private entity may do so and still not be a "user" of the program and not be deemed to be making private payments with respect to such program may require clarification. Additionally, the Act contains no limitation that any job training program be located within a recovery zone. Further clarification as to what limitations, if any, apply to the terms of prospective programs.
Conclusion. The creation of Build America Bonds in all their forms represents a substantial departure from previously used stimulus provisions. On the one hand, issuers who have had limited access to the market for their obligations during the recent financial upheaval my find BABs to be a useful addition to their financing toolkit. On the other, it is difficult to determine whether higher credit quality issuers will find a substantial benefit in pursuing the use of BABs. Certainly before the use of BABs is approved or rejected, the individual circumstances of each issuer, including its tolerance for the risk associated with the indicated uncertainties, should be thoroughly evaluated.