Auction Rate Preferred Stock

Transcription

1 IRS Provides Guidance on Effect of Liquidity Facilities on Equity Character of Issued by Closed-End Regulated Investment Companies SUMMARY On June 13, 2008, the IRS issued Notice , providing guidance as to the effect of arranging a liquidity facility on the characterization as equity of auction rate preferred stock issued by certain closedend regulated investment companies. The Notice provides administrative relief; the IRS will not challenge the equity characterization of auction rate preferred stock if the conditions specified in the Notice are met. The Notice augments prior guidance from the IRS, which held that certain auction rate preferred stock qualified as equity, in the light of recent significant failures in the auction markets and efforts to address these failures through the addition of liquidity facilities. BACKGROUND Auction rate preferred stock ( ARPS ) is preferred stock with a dividend rate that is periodically reset in an auction rate-setting process, or remarketing agent rate-setting process, that is designed to result in a dividend rate that enables holders to sell at a price equal to the liquidation preference of the ARPS, plus accrued but unpaid dividends. If the number of buyers willing to buy at a dividend rate at or below a specified maximum dividend rate is insufficient to allow all interested holders to sell, the auction or remarketing is considered to have failed, and the dividend rate is reset at the maximum rate until the next auction or remarketing. The terms of some ARPS may provide that, in the event of continued auction failures, the dividend rate will continue to rise. Historically, auctions of ARPS have had very low failure rates. However, in February 2008, for the first time, ARPS experienced widespread and continuing auction failures. In an effort to address such failures by expanding the investor base, certain issuers and third parties have been working to develop liquidity facilities that would make ARPS eligible for purchase by money market funds under Investment Company Act Rule 2a-7. New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney

2 The characterization of ARPS as equity was confirmed by the IRS in Revenue Ruling 90-27, but without consideration of the effect of a liquidity facility. 1 In holding that the ARPS would be treated as equity for tax purposes, the IRS noted that (a) the holder of the stock could not compel redemption, and (b) the issuer has not guaranteed or otherwise arranged to ensure that [the holder] can sell its stock in an auction. 2 These observations tended to call into question the continuing applicability of Revenue Ruling to ARPS if liquidity facilities were added. To date, no closed-end fund with outstanding ARPS has succeeded in implementing a liquidity facility, due at least in part to several issues that the facilities raise under the Investment Company Act of On June 13, 2008, Eaton Vance announced that it had obtained no action relief from the SEC s Division of Investment Management to permit its closed-end funds to issue a new type of preferred stock, which it designated liquidity protected preferred or LPP. LPP will include an arrangement with a liquidity provider to purchase all shares for which there is insufficient buying interest in any auction. The announcement suggests that Eaton Vance may seek to refinance outstanding ARPS with LPP. The Division s letter setting forth the terms of the relief is not yet publicly available. NOTICE Notice (the Notice ) clarifies the application of Revenue Ruling by offering administrative relief to issuers that are considering arranging liquidity facilities for their outstanding ARPS. 3 The Notice describes certain types of liquidity facilities proposed in order to facilitate successful auctions and remarketings, and provides conditions under which the IRS will not challenge the equity characterization of ARPS for which such liquidity features have been arranged. The liquidity facilities discussed would provide that, upon a failed remarketing (or, under certain circumstances, a failure to renew, replace, or extend an existing liquidity facility), holders of ARPS would be entitled to sell their stock to a third-party liquidity provider at a price equal to the liquidation preference plus accrued but unpaid dividends. The liquidity facility may also provide for redemption by the issuer of stock purchased by the liquidity provider under the liquidity facility, to the extent permitted by applicable state law, at a price equal to the liquidation preference plus accrued but unpaid dividends, after a minimum holding period of one year and after continuous good faith efforts to resell the stock in the periodic auctions. In addition, liquidity providers are expected to charge the issuer commercially reasonable liquidity fees for the liquidity facilities Rev. Rul , C.B. 50. Id. Notice (June 13, 2008). -2-

3 The Notice applies the safe harbor to additions of liquidity facilities which meet the following conditions: The ARPS was issued in the United States by a closed-end regulated investment company ( RIC ) that invests exclusively in (1) tax-exempt debt instruments bearing interest which is excludable by shareholders of the RIC; and/or (2) taxable instruments treated as debt for U.S. federal income tax purposes; The ARPS was outstanding on February 12, 2008 (or, in certain cases, was issued to refinance ARPS outstanding as of that date) and the liquidity facility was entered into between February 12, 2008 and December 31, 2009 (or the liquidity facility renews, replaces, or extends such initial liquidity facility); Dividends may be paid only if duly declared and paid out of legally available funds for payments in respect of stock under applicable state law; The liquidity provider must be a party who is not related to the issuer under Section 267(b) or Section 707(b) such that the relationship would result in a disallowance of losses; 4 and The right of a holder to sell pursuant to the liquidity facility must be triggered only on a failed auction or remarketing, or on a failure to renew, replace, or extend an existing liquidity facility by at least two auction or remarketing periods before the expiration of the current liquidity facility. In addition, if the liquidity provider has any contractual rights to require the issuer (or a related party of the issuer) to redeem stock purchased under the liquidity facility, the Notice does not apply unless the following conditions are met: The contractual rights must be limited by the same state law restrictions on redemptions that apply to other holders of the ARPS, and the liquidity provider must hold the ARPS for at least a year before a redemption or repurchase; During the required year-long holding period, the liquidity provider must offer the stock for resale at auctions or remarketings under the terms of the ARPS; and The liquidity provider may not otherwise have any greater rights with respect to the ARPS than other holders of the ARPS. If the liquidity provider does not have contractual rights to require redemption, any redemption of the ARPS purchased by the liquidity provider must, as above, be limited by applicable state law restrictions imposed on other holders. The liquidity provider may not, in order to obtain the protection of the Notice, have any greater rights against the issuer than other holders of the ARPS. Notice sets out additional rules with respect to interests in certain partnerships. The Notice provides that the IRS will not challenge the equity characterization of certain variable-rate interests in a partnership as a result of adding a liquidity facility. This relief applies only to a partnership (A) which issues (1) interests entitled to a preferred variable return on capital payable out of partnership income (the 4 Under these rules, two entities are considered related if there is cross-ownership (after applying applicable attribution rules) of more than 50%. -3-

4 variable-rate interests ), and (2) residual inverse interests that are entitled to all remaining income of the partnership; and (B) at least 95% of the assets of which are ARPS described in the Notice. The partnership must offer to sell the ARPS at each auction or remarketing, and must apply proceeds from disposition of ARPS to redeem partnership interests. The Notice further provides that if a partnership meets the above criteria, the partnership is treated as eligible to make a monthly closing election under Revenue Procedure The Notice is effective on June 13, The Notice applies to ARPS and liquidity facilities within the time limitations discussed above, and applies to certain partnerships and liquidity facilities within comparable time limitations, also as discussed above. * * * Copyright Sullivan & Cromwell LLP

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