[Federal Register Volume 62, Number 170 (Wednesday, September 3, 1997)]
[Rules and Regulations]
[Pages 46444-46446]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-23422]


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DEPARTMENT OF THE TREASURY

Fiscal Service

31 CFR Part 344

[Department of the Treasury Circular, Public Debt Series No. 3-72]


Regulations Governing United States Treasury Certificates of 
Indebtedness, Treasury Notes, and Treasury Bonds--State and Local 
Government Series

AGENCY: Bureau of the Public Debt, Fiscal Service, Treasury.

ACTION: Final rule.

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SUMMARY: The Department of the Treasury (Department or Treasury) is 
issuing in final form an amendment to its regulations governing State 
and Local Government Series (SLGS) securities. It has been brought to 
the attention of the Department that the SLGS securities program can be 
misused when subscriptions for SLGS securities are used as a cost-free 
interest rate hedge or option (option) for speculation in open market 
securities. This final rule clarifies that the use of SLGS securities 
for option purposes is prohibited. The purpose of the SLGS securities 
program is to assist state and local government issuers of tax-exempt 
bonds in meeting certain Federal tax restrictions, not to provide a 
cost-free option.
    Treasury is considering first, whether it would be consistent with 
the purposes of the SLGS securities program to allow SLGS securities to 
serve as options if Treasury were appropriately compensated and second, 
if the answer to the first question is affirmative, whether there is a 
practical way for the Department to charge for the use of SLGS 
securities as options. Neither question, however, has yet been 
answered. Unless Treasury does determine that it would be both 
advisable and practical to allow SLGS securities to serve as options if 
Treasury is appropriately compensated, the use of SLGS securities for 
such purpose will continue to be an inappropriate use of SLGS 
securities.

EFFECTIVE DATE: September 3, 1997.

FOR FURTHER INFORMATION CONTACT: Howard Stevens, Director, Division of 
Special Investments at 304-480-7752, Jim Kramer-Wilt, Attorney/Adviser, 
Office of the Chief Counsel, at 304-480-5190 or Edward C. Gronseth, 
Deputy Chief Counsel, Office of the Chief Counsel, at 304-480-5192.

SUPPLEMENTARY INFORMATION:

1. Background

    The SLGS securities program was established and is maintained to 
assist state and local government issuers in meeting yield restriction 
and rebate requirements applicable to tax-exempt bonds under the 
Internal Revenue Code. On October 28, 1996, the Department published 
revised regulations to make the SLGS securities program a more flexible 
and competitive investment vehicle for issuers. In response to requests 
by state and local government issuers to shorten the minimum time for 
subscribing for SLGS securities, the Treasury revised the regulations 
to permit an issuer to subscribe for SLGS securities up to 60 days 
prior to their scheduled issue date and then to cancel that 
subscription within five days of that issue date for subscriptions of 
$10 million or less and within seven days for subscriptions of more 
than $10 million, without penalty. The regulations also provide that an 
issuer canceling a SLGS securities subscription after that five/seven-
day period is not subject to a monetary penalty, but is prohibited from 
subscribing for SLGS securities for a six month period.
    The Department understands that the ability to cancel a SLGS 
securities subscription without a monetary penalty has led some market 
participants to conclude that they can both subscribe for SLGS 
securities and enter into a contract for the purchase of securities on 
the open market for the same defeasance transaction or fund deposit in 
order to create a cost-free option in connection with a defeasance 
escrow or fund.
    The prices established by the Treasury for the SLGS securities do 
not include the cost of an option. The Treasury believes it is 
inappropriate for government bodies to use the SLGS securities program 
to create an option. Treasury is considering first, whether it would be 
consistent with the purposes of the SLGS securities program to allow 
SLGS securities to serve as options if Treasury were appropriately 
compensated and second, if the answer to the first question is 
affirmative, whether there is a practical way for the Department to 
charge for the use of SLGS securities as options. Neither question, 
however, has yet been answered. Unless Treasury does determine that it 
would be both advisable and practical to allow SLGS securities to serve 
as options if Treasury is appropriately compensated, the use of SLGS 
securities for options will continue to be an inappropriate use of SLGS 
securities. The Department has therefore decided to amend the SLGS 
securities regulations to clarify that transactions in which issuers 
use SLGS securities to provide a cost-free interest rate hedge or 
option are prohibited.
    The following examples are illustrative of certain acceptable and 
unacceptable practices:
    (1) In order to fund an escrow for an advance refunding, an issuer 
simultaneously enters into a purchase contract for open market 
securities and subscribes for SLGS securities, such that either 
purchase is sufficient to pay the cash flows on the outstanding bonds 
to be refunded but together, the purchases are greatly in excess of the 
amount necessary to pay the cash flows. The issuer plans that, if 
interest rates decline during the period between the date of 
subscribing for the SLGS securities and the requested date of issuance 
of the SLGS securities, the issuer will enter into an offsetting 
agreement to sell the open market securities and use the bond proceeds 
to purchase the SLGS securities to fund the escrow. If, however, 
interest rates do not decline in that period, the issuer plans to use 
the bond proceeds to purchase the open market securities to fund the 
escrow and cancel the SLGS securities subscription. This arrangement in 
effect allows the SLGS securities program to provide a cost-free option 
to the issuer, and this amendment to the regulation clarifies that such 
transactions are prohibited.
    (2) The existing escrow for an advance refunding contains open 
market securities which produces a negative arbitrage. In order to 
reduce or eliminate this negative arbitrage, the issuer subscribes for 
SLGS securities at a yield higher than the yield on the existing 
escrow, but less than the permitted yield. At the same time, the issuer 
agrees to sell the open market securities in the existing escrow to a 
third party and use the proceeds to purchase the SLGS securities if 
interest rates decline between the date of subscribing for the SLGS 
securities and the requested date of issuance of the SLGS securities. 
The issuer and the third party further agree that if interest rates 
increase during this period, the issuer will cancel the SLGS securities 
subscription. This arrangement in effect allows the SLGS securities 
program to provide a cost-free

[[Page 46445]]

option to the issuer, and this amendment to the regulation clarifies 
that such a transaction is prohibited.
    (3) Under the same facts as in Example 2, except that in this case, 
the agreement entered into by the issuer with a third party to sell the 
open market securities in order to obtain funds to purchase the SLGS 
securities is not conditioned upon changes in interest rates on 
Treasury securities. No option is created, and the issuer would not be 
prohibited from subscribing for SLGS securities.
    (4) The issuer subscribes for SLGS securities fifteen days before 
the settlement date of its bonds at the maximum rates on such day, but 
the resulting yield in the escrow is less than the permitted yield. The 
rates on the SLGS securities rise over the next few days, and, within 
the time periods permitted for cancellation by these regulations, the 
issuer cancels the earlier subscription and resubscribes at the higher 
rates. This transaction is permissible.
    (5) An issuer holds a portfolio of open market securities in an 
account that produces negative arbitrage. In order to reduce or 
eliminate this negative arbitrage, the issuer subscribes for SLGS 
securities for purchase in sixty days. At the same time, the issuer 
sells an option to purchase the portfolio of open market securities. If 
interest rates increase, the holder of the option will not exercise its 
option and the issuer will cancel the SLGS securities subscription. On 
the other hand, if interest rates decline, the option holder will 
exercise the option and the issuer will use the proceeds to purchase 
the SLGS securities. This arrangement uses the SLGS securities program 
to provide the issuer with a cost-free option and this amendment to the 
regulation clarifies that such transactions are prohibited.

2. Section by Section Summary

Subpart A--General Information

    (1) 344.1(f)--This is a new paragraph titled Impermissible 
transactions which applies to all escrows and funds subject to yield or 
rebate restrictions. It is impermissible to subscribe for SLGS 
securities for deposit in an escrow or fund (such as a reserve or 
construction fund) if, at any time between the close of business on the 
date of subscription and the close of business on the date of issue, 
the amount of SLGS securities subscribed for, plus the amount of other 
securities, if any, already in such escrow or fund, plus the amount of 
other securities the government body has acquired, or has the right to 
acquire for deposit in such escrow or fund, exceeds the total amount of 
securities needed for such escrow or fund. Securities held in the 
escrow or fund that are not subject to an agreement conditioned on 
changes in the interest rate on open market Treasury securities on or 
prior to the date of issue of the SLGS securities shall not be included 
in such computation. An adjustment in the initial subscription amount 
in accordance with 31 CFR Sec. 344.3(b)(3)(ii) will not in and of 
itself make the transaction impermissible.
    (2) 344.1(g)--This is the paragraph formerly numbered 344.1(f) and 
is amended to state that the Secretary may revoke the issuance of any 
security and may declare the subscriber ineligible thereafter to 
subscribe for SLGS securities if the subscriber uses SLGS securities in 
an impermissible manner as described in section 344.1(f), if the 
Secretary deems such action in the public interest.
    (3) 344.1 (h), (i) & (j)--These paragraphs are renumbered 344.1 
(i), (j) and (k) respectively.
    (4) 344.3(b)(3)(iii)--This paragraph is amended to read that an 
interest rate cannot e changed to a rate that exceeds the maximum 
interest rate in the table that was in effect for a security of 
comparable maturity on the date the initial subscription was submitted, 
unless the issuer obtains a higher rate by canceling and resubscribing 
in compliance with the provisions of 344.3(b)(1).

Procedural Requirements

    This final rule is not a significant regulatory action as defined 
in Executive Order 12866. Therefore, an assessment of anticipated 
benefits, costs and regulatory alternatives is not required.
    This final rule relates to matters of public contract. The notice 
and public procedures requirements of the Administrative Procedure Act 
are inapplicable, pursuant to 5 U.S.C. 553(a)(2). Since no notice of 
proposed rulemaking was required, the provisions of the Regulatory 
Flexibility Act (5 U.S.C. 601 et. seq.) do not apply.
    There are no collections of information required by this final 
rule, and, therefore, no approval pursuant to the Paperwork Reduction 
Act is required.

List of Subjects in 31 CFR part 344

    Bonds, Government securities, Securities.

    Dated: August 27, 1997.
Gerald Murphy,
Fiscal Assistant Secretary.

    For the reasons set forth in the preamble, part 344 of Title 31 of 
the Code of Federal Regulations is revised to read as follows:

PART 344--REGULATIONS GOVERNING UNITED STATES TREASURY CERTIFICATES 
OF INDEBTEDNESS, TREASURY NOTES, AND TREASURY BONDS--STATE AND 
LOCAL GOVERNMENT SERIES

    1. The authority citation for part 344 continues to read:

    Authority: 26 U.S.C. 141 note; 31 U.S.C. 3102.

    2. Section 344.1 is amended by redesignating paragraphs (f) through 
(j) as (g) through (k), adding a new paragraph (f) and amending 
paragraph (g)(3) as follows:


Sec. 344.1  General provisions.

* * * * *
    (f) Impermissible Transactions. It is impermissible to subscribe 
for SLGS securities for deposit in a defeasance escrow or fund if, at 
any time between the close of business on the date of subscription and 
the close of business on the date of issue, the amount of SLGS 
securities subscribed for, plus the amount of other securities, if any, 
already in such escrow or fund, plus the amount of other securities the 
government body has acquired, or has the right to acquire for deposit 
in an escrow or fund, exceeds the total amount of securities needed to 
fund such escrow or fund. Securities held in the escrow or fund that 
are not subject to an agreement conditioned on changes in the interest 
rate on open market Treasury securities on or prior to the date of 
issue of the SLGS securities shall not be included in such computation. 
An adjustment in the subscription amount in accordance with 31 CFR 
344.3(b)(3)(ii) will not in and of itself make the transaction 
impermissible.
    (g) Reservations.
* * * * *
    (3) To revoke the issuance of any security, and to declare the 
subscriber ineligible thereafter to subscribe for securities under this 
offering if the Secretary deems such action in the public interest and 
if any security is issued on the basis of an improper certification, 
other misrepresentations (other than as the result of an inadvertent 
error) or in an impermissible transaction as set forth in 
Sec. 344.1(f).
* * * * *

[[Page 46446]]

    3. Section 344.3 is amended by revising paragraph (b)(3)(iii) to 
read as follows:


Sec. 344.3  Subscription for purchase.

* * * * *
    (b) * * *
    (3) * * *
    (iii) An interest rate cannot be changed to a rate that exceeds the 
maximum interest rate in the table that was in effect for a security of 
comparable maturity on the date the initial subscription was submitted, 
unless the issuer obtains a higher rate by canceling and resubscribing 
in compliance with the provisions of Sec. 344.3(b)(1).
* * * * *
[FR Doc. 97-23422 Filed 8-29-97; 12:14 pm]
BILLING CODE 4810-39-U