California Debt and Investment Advisory Commission Arbitrage Compliance

California Debt and Investment Advisory Commission Arbitrage Compliance for Bonds February 3, 2011 Hawkins Delafield & Wood LLP

What is Arbitrage? Simultaneous Transactions to Exploit Difference in Yield or Price of Securities Make Arbitrage by ◦ Borrowing at Tax-Exempt Rate, and ◦ Investing at Taxable Rate Page 2 Hawkins Delafield & Wood LLP

What is Arbitrage? Figure 1 - Actual Investment Yield 7. 00% Positive Arbitrage 6. 50% 6. 00% Yield 5. 50% 5. 00% 4. 50% Negative Arbitrage 4. 00% 3. 50% 3. 00% 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 3 Year Construction Period (Months) Bond Yield @ 5. 30% Investment Yield Page 3 Hawkins Delafield & Wood LLP

What is Yield Restriction? The Internal Revenue Code imposes a general requirement that proceeds of tax exempt bonds not be invested at more than the yield on the bonds. Four Exceptions to general yield restriction Requirements (e. g. temporary period, Reasonable Required Reserve, Bona Fide Debt Service Fund and Minor Portion) Yield Reduction Payments ◦ Payable at Same Time as a Rebate Payment ◦ Not Available in all Instances (e. g. , Restricted Reserve Fund Allocable to Advance Refunding) Page 4 Hawkins Delafield & Wood LLP

What is Rebate? Certain proceeds can be invested at more than the bond yield (e. g. , make arbitrage during the temporary periods) but, any arbitrage must be rebated to the federal government unless an exception to rebate is available and qualified for. Page 5 Hawkins Delafield & Wood LLP

General Arbitrage and Rebate Rules General Arbitrage Rule: No Arbitrage is Permitted – Subject to Yield Restriction Exceptions to General Arbitrage Rule: ◦ Temporary Periods ◦ Reasonably Required Reserve Fund ◦ Minor Portion ◦ Bona Fide Debt Service Fund General Rebate Rule: Must Rebate if Arbitrage is Made Exceptions to General Rebate Rule: ◦ Spending Exceptions ◦ Small Issuer Exception ◦ Bona Fide Debt Service Fund Exception Page 6 Hawkins Delafield & Wood LLP

Importance of Temporary Periods Purpose or Fund • Construction Fund Subject to Rebate • Yes • Escrow Fund (current refunding) • Escrow Fund (advance refunding) • Working Capital • Bona Fide Debt Service Fund • Replacement Proceeds • Yes (usually waived) • Yes Subject to Yield Restriction • Proceeds After 3 years from the issue date of the bonds • Proceeds After 90 days from the issue date of the bonds or waiver of temporary period • After 30 days • After 13 Months from the issue date of the bonds • After 13 Months • After 30 days Page 7 Hawkins Delafield & Wood LLP

Reasonably Required Reserve Fund (RRR) Amount Invested Without Yield Restriction 3 Prong Test: The RRR is the Least of ◦ 10% of Principal or Issue Price ◦ Maximum Annual Debt Service ◦ 125% Average Annual Debt Service Page 8 Hawkins Delafield & Wood LLP

Minor Portion Lesser of 5% of Sale Proceeds or $100, 000 Page 9 Hawkins Delafield & Wood LLP

Bona Fide Debt Service Fund Definition: A Fund Used Primarily to Achieve Matching of Revenues with Debt Service Within Each Bond Year Requirement: Fund is Depleted at Least Once Each Bond Year Except for Carryover Amount Not to Exceed the Greater of: ◦ Earnings in the Fund for the Bond Issue for Immediately Preceding Bond Year, or ◦ One-Twelfth of Debt Service on the Bond Issue for Immediately Preceding Bond Year Page 10 Hawkins Delafield & Wood LLP

Rebate and Exceptions General rule: All Arbitrage Must be Rebated to U. S. (100% tax) Exceptions to Rebate: ◦ Any of Three Spend-Down Exceptions ◦ Small Issuer Exception ◦ Bona Fide Debt Service Fund Exception Page 11 Hawkins Delafield & Wood LLP

Rebate Spend-down Exceptions 6 -Month Rebate Exception (Any Expenditure) ◦ 100% of “Adjusted Gross Proceeds” at End of 6 Months 18 -Month Rebate Exception (Capital Expenditures) ◦ 15%, 60% and 100% of “Adjusted Gross Proceeds” at End of Each 6 -Month Period 24 -Month Rebate Exception (at Least 75% “Construction Issue”) ◦ 10%, 45%, 75% and 100% of “Available Construction Proceeds” at End of Each 6 -Month Period Page 12 Hawkins Delafield & Wood LLP

Small Issuer Exception to Rebate Government Bonds for Issuers with Taxing Power; ◦ $5 Million limit; ◦ $5 Million limit Increased when Financing Public School Capital Expenditures by the lesser of $10 Million or so much of the aggregate face amount of the bonds attributable to financing the Construction Conduit Borrowers Qualify if: Not private activity bonds (bonds and loans) Meets all requirement for small issuer exception Page 13 Hawkins Delafield & Wood LLP

Bona Fide Debt Service Fund Amounts in BFDSF are Exempt From Rebate if: ◦ Governmental Bonds, Fixed Rate and WAM >= 5 years ◦ Annual Earnings are <= $100 K Deemed Met if Weighted Annual Debt service is <= $2. 5 M Page 14 Hawkins Delafield & Wood LLP

Arbitrage Rules Bond Year ◦ A One Year Period Ending on a Date Selected by the Issuer but not Later Than 5 th Anniversary After Issue Date ◦ First or Last Bond Year May be Less Than a Year ◦ Special Rules for Variable Rate Issue ◦ May Affect Amount of Rebate Payment Particularly for Variable Rate Bonds Page 15 Hawkins Delafield & Wood LLP

Arbitrage Rules Determination Dates ◦ Every 5 th Bond Year or Earlier, and ◦ Last Maturity or Redemption Date Payment Dates ◦ 60 Days After Every Determination Date Payment Amounts ◦ At Least 90% for All Determination Dates Except the Last Determination Date ◦ 100% of Accrued Rebate Amount for Last Determination Date Page 16 Hawkins Delafield & Wood LLP

Rebate Amount Determination Use Future Value Methodology Rebate Amount is: ◦ Future Value of All Payments (-) for and All Receipts (+) From Nonpurpose Investments Deemed Sold at PV or FMV on Determination Date ◦ Future Value of All Computational Date Credits $1, 520 for a Bond Year in 2011 and thereafter, the Credits will Increase Each Bond Year by the CPI Double the Credit for the Last Bond Year Page 17 Hawkins Delafield & Wood LLP

Basic Examples - #1 $1, 000 Invested @ 5% 6% Bond Yield Date Price 01/01/00 (1, 000. 00) 07/01/00 01/01/01 07/01/01/02 07/01/02 01/01/03 07/01/03 01/01/04 07/01/04 01/01/05 1, 000. 00 - Interest Total FV @ 6. 000% 25, 000. 00 25, 000. 00 (1, 000. 00) 25, 000. 00 25, 000. 00 1, 025, 000. 00 (1, 343, 916. 38) 32, 619. 33 31, 669. 25 30, 746. 85 29, 851. 31 28, 981. 85 28, 137. 72 27, 318. 18 26, 522. 50 25, 750. 00 1, 025, 000. 00 250, 000. 00 (57, 319. 40) Page 18 Hawkins Delafield & Wood LLP

Basic Examples - #2 $1, 000 Invested @ 5% 4% Bond Yield Interest Total FV @ 4. 000% 1, 000. 00 25, 000. 00 25, 000. 00 (1, 000. 00) 25, 000. 00 25, 000. 00 1, 025, 000. 00 (1, 218, 994. 42) 29, 877. 31 29, 291. 48 28, 717. 14 28, 154. 06 27, 602. 02 27, 060. 80 26, 530. 20 26, 010. 00 25, 500. 00 1, 025, 000. 00 - 250, 000. 00 54, 748. 60 Date Price 01/01/00 07/01/00 01/01/01 07/01/01/02 07/01/02 01/01/03 07/01/03 01/01/04 07/01/04 01/01/05 (1, 000. 00) Page 19 Hawkins Delafield & Wood LLP

Basic Examples - #3 Page 20 Hawkins Delafield & Wood LLP

Determination of Rebate Liability and Yield Restriction Liability Fund by Fund Analysis ◦ Rebatable funds may be netted against each other ◦ Yield restricted funds may generally be netted against each other ◦ Positive rebatable funds may be netted against negative yield restricted funds ◦ Positive yield restricted funds must not be netted against negative rebatable funds Page 21 Hawkins Delafield & Wood LLP

Required Documents Official Statement Tax Agreement IRS Form 8038 s (i. e. , 8038 -G, 8038 and 8038 -B) Verification Reports, if any L/C Reimbursement Agreement, if any Guarantee Investment Contracts, if any Hawkins Delafield & Wood LLP Swap Documents, if any Page 22

Procedures – Data Information Review Tax Agreement Sources and Uses of Funds Prepare Cash Flow of Investments and Expenditures (Purchases, Maturities, Sells, Interests, Transfers, and Withdrawals) for Each Fund and/or Gather Trustee Records from Issue Date of Bonds to Last Day Proceeds Have Been Expended for Each Fund Page 23 Hawkins Delafield & Wood LLP

Procedures – Bond Yield Information Review Tax Agreement Determine Fixed Rate or Variable Rate Fixed Rate – No Further Information Variable Rate ◦ Interest Payments on Bonds ◦ Principal Payments on Bonds ◦ Qualified Guarantee Fees for Bonds Qualified Hedges, if any Page 24 Hawkins Delafield & Wood LLP

Record Retention Basic Records Relating to Bond Transaction ◦ The trust indenture, loan agreements, and bond counsel opinion; ◦ Documentation evidencing expenditure of bond proceeds; ◦ Documentation evidencing use of bond-financed property by public and private sources (i. e. , copies of management contracts and research agreements); ◦ Documentation evidencing all sources of payment or security for the bonds; and ◦ Documentation pertaining to any investment of bond proceeds (including the purchase and sale of securities, SLGs subscriptions, yield calculations for each class of investments, actual investment income received the investment of proceeds, guaranteed investment contracts, and rebate calculations) ◦ Documentation of All Sources of Payments or Security for the Bonds, Including SWAP Payments and Receipts and Credit Enhancements Page 25 Hawkins Delafield & Wood LLP

Record Retention Records Should Generally be Kept Until 3 Years After Final Redemption Date of the Bonds. Certain Material Records Relating to the Original New Money Issue and all Material Records Relating to the Refunding Issue Should be Maintained until 3 Years after the Final Redemption of Both Bond Issues. Page 26 Hawkins Delafield & Wood LLP

What are the consequences of late payment or nonpayment of the rebate amount? The federal government may declare the interest on the bonds paid to the owners of the bonds to be subject to federal income taxation retroactive to the date of issue of the bonds Late interest (accrues at underpayment rate under Section 6621 beginning on the date the correct rebate amount is due and ending on the date 10 days before it is paid) and penalties (i. e. , nonprivate activity bonds 50% of liability all others 100% of liability) Nonpayment or late payment, if not timely cured, may constitute a violation of the tax covenants made by the issuer with respect to the bonds. Page 27 Hawkins Delafield & Wood LLP