Sept 30 -- The Department of the Treasury (Treasury) is issuing this notice of proposed rulemaking (NPRM) to amend the regulations governing State and Local Government Series (SLGS) securities. Treasury is proposing to amend the SLGS regulations to address misuse of the SLGS program, most notably the use of program flexibilities by tax-advantaged entities, usually a state or local government, investing in SLGS securities to create impermissible cost-free options. This NPRM proposes amendments to existing regulations to help stop such activity. In addition, this NPRM proposes administrative changes to increase efficiencies in the program. To be considered, comments must be received on or before November 29, 2022.
SLGS securities are non-marketable Treasury securities that are available only for purchase by an Issuer, as defined in 31 CFR 344.1, of tax-advantaged securities (Issuers). The purpose of the SLGS program is to assist Issuers when investing proceeds from bond issuances in complying with yield restriction and rebate requirements applicable to tax-advantaged securities under the Internal Revenue Code. Because an Issuer's bond issuance process is characterized by several variables that may take a number of weeks to resolve, flexibility has been built into the SLGS program to allow Issuers to customize the SLGS security terms such as interest rate, maturity, and issue date. Over the years, Treasury has amended the SLGS regulations in an effort to maintain SLGS securities as an attractive investment alternative to marketable securities for Issuers, while also preventing the program from being misused by Issuers and from becoming burdensome to Treasury financing operations.
Treasury has repeatedly stated that speculation by Issuers in interest rate movements between marketable Treasury securities and/or SLGS securities is both inconsistent with the purpose of the SLGS program and is prohibited by the SLGS regulations. Despite Treasury's prohibition on such speculation, impermissible transactions have been observed within the SLGS program. Treasury attributes the impermissible transactions to the exploitation of certain flexibilities in the program. The proposed amendments to the regulations are to reinforce to Issuers the prohibition on these transactions and to make it less likely that SLGS investors can use the flexibilities to impermissibly create cost-free options based on interest rate movements. This NPRM identifies in Section E the observed cost-free options that are prohibited and proposes amendments to reduce Issuers' flexibility in structuring the terms of SLGS securities to create such cost-free options. Treasury is also proposing other changes that are designed to improve the administration of the SLGS program. . . .
During escrow restructurings, Issuers often redeem SLGS securities before maturity (early redemption) and reinvest the proceeds in SLGS or marketable securities at a higher yield to eliminate “negative arbitrage” under the Internal Revenue Code. Negative arbitrage occurs when bond proceeds are invested by an Issuer at a yield that is less than the yield on the bond issue, often as a result of market conditions where the maximum SLGS rates available are lower than what would be permissible under arbitrage provisions of the Internal Revenue Code (26 U.S.C. 148). Such restructuring transactions to eliminate negative arbitrage generally are allowed under the current SLGS regulations, so long as a cost-free option is not created. However, changing the terms of or early redemption of SLGS securities to take advantage of infrequent pricing of SLGS securities is prohibited under the current regulations even when undertaken to eliminate negative arbitrage. . . .
To further clarify the boundaries of the cost-free option prohibition, Treasury proposes modest reductions in the current flexibilities available under the SLGS regulations to eliminate the following three types of practices that create cost-free options in violation of the SLGS regulations:
(1) Purchasing a long-term SLGS security and redeeming the security before maturity to capture redemption premium;
(2) Establishing or changing the maturity and associated interest rate on SLGS securities already subscribed for to take advantage of interest rate movements, either to capture redemption premiums or to minimize losses or
(3) Establishing or changing the SLGS subscription amount to maximize redemption premiums or minimize potential losses.
Any of these practices, alone or in combination, creates a cost-free option. Treasury has repeatedly stated that manipulating the administrative flexibility designed in the SLGS regulations to create a cost-free option is an inappropriate use of the program and inconsistent with its purpose even when undertaken to eliminate negative arbitrage. Treasury incurs a direct cost from such manipulation because it is not compensated for the value of the cost-free option, which may generate large gains in the hands of the SLGS purchasers. In addition, SLGS transactions motivated by cost-free options result in volatility in Treasury's cash balances and difficulty in forecasting cash balances, which increases Treasury's borrowing and administrative costs, as previously identified in 2004 and in 2005. 69 FR 58756 (September 30, 2004) and 70 FR 37904 (June 30, 2005). The three practices identified above create features that are not available in marketable Treasury securities and result in additional costs to the Federal taxpayer.
For these reasons, this NPRM proposes the amendments described below to the SLGS regulations to eliminate these practices. Treasury believes that the proposed amendments retain sufficient flexibility for Issuers to be able to select maturities and interest payment dates, thereby continuing to make SLGS securities an attractive investment vehicle for Issuers. The proposed rule amendments will apply only to SLGS subscriptions started on or after the effective date of the final rule. Treasury anticipates that the effective date will be six months after the final rule's publication in the Federal Register. . . .