Annex 1: Anatomy of the PEACe Bonds controversy

The Negotiations

The PEACe Bonds were first conceptualized as a negotiated deal. It was CODE-NGO’s initiative, because it was after a billion-peso profit. CODE-NGO lobbied with the Monetary Board, Treasury, the Bureau of Internal Revenue (BIR), and Insurance Commission, to ensure its profit. Both tax exemption and secondary reserve eligibility were obtained from the BIR and Monetary Board, respectively, within the framework of a negotiated deal. The negotiations had to be conducted in secret or there would be no billion-peso profit to speak of.

According to its own chronology of events, CODE-NGO first presented this idea to then Finance Secretary Alberto Romulo in the first week of March 2001. The negotiations continued through August 2001. According to CODE-NGO national coordinator Danilo Songco, CODE-NGO was still hoping to work out a negotiated sale with the Arroyo government ‘even after Lito Camacho had already said "na hindi na lang"’. It was towards the end of August or early part of September that the decision to switch to an auction rather than negotiated sale was finalized.

What's in a name

The name ‘PEACe Bonds’ was devised by CODE-NGO. It was adopted by the Monetary Board, the Treasury, the BIR, and the Insurance Commission, in their respective rulings/resolutions/decisions regarding the flotation. But the irony was, only if the bonds went to CODE-NGO could the name have any meaning. CODE-NGO’s intention was to use the profit it would earn from the transaction as a permanent endowment to fund poverty alleviation. As to the proceeds of the bonds, they would go to the government’s general fund to support the government’s expenses, including debt service and military spending as well as to fund the fiscal deficit.

So if the Bonds had been issued as a negotiated deal between the government and CODE-NGO, the name PEACe Bonds would make some sense. According to an official of RCBC (Jimmy Panganiban), the grant by the Monetary Board of various eligibilities was premised on the creation of an endowment fund for CODE-NGO’s Peace and Equity Foundation. But what happens when the award of the bonds had to be done through auction? How could the government continue to call the PEACe Bonds PEACe Bonds if CODE-NGO could not be sure of winning the auction?

The Auction

Only after questions regarding the negotiated deal were brought to the attention of the Finance Secretary, Jose Isidro Camacho, by the National Treasurer Sergio Edeza, and after questions were emerging in the media about the deal, did the government and CODE-NGO shift from a negotiated deal to an auction. After at least three appointments, the auction took place on 16 October 2001.

Edeza Questions Tax Exemption

Several things stood in the way of the deal-turned-auction. Primary among these were Treasurer Edeza’s concerns over the initial BIR ruling (No. 020-2001, 31 May 2001) exempting the PEACe Bonds from the 20 percent withholding tax as well as income and capital gains tax. In his 12 July memorandum to Secretary Camacho, Treasurer Edeza raised numerous questions regarding this ruling. These are as follows:

The BIR ruled that the PEACe Bonds were not ‘deposit substitutes’ because they were going to be issued to only one investor. Under Section 22(y) of the 1997 Tax Code, deposit substitutes to be considered as such must have two or more lenders. Edeza argued that although CODE-NGO would indeed be the only buyer, its intention was to resell the bonds to institutional investors. And if CODE-NGO sold this to more than 20 investors then the bonds should be taxed. After all, Section 22(y) of the 1997 Tax Code defined ‘public’ as 20 or more individual or corporate lenders at any one time, and not just at the point of origination of the bond.

Edeza also asked Camacho for a clarification regarding the BIR ruling that the gains from sale, exchange, or retirement of the PEACe Bonds shall be exempt from income tax as provided under Section 32(B)(7)(g) of the 1997 Tax Code. He reminded the Secretary that the DoF had suspended this same ruling in an earlier case. He further argued that the ‘gains’ contemplated under said section refer only to trading gains, and not the discount/passive income that CODE-NGO would get as a result of the tax exemption granted to it by the government.

Because of these objections, CODE-NGO had to obtain a supplemental ruling from the BIR. On 08 August 2001, the National Treasurer also sought an opinion from the BIR. (Secretary Camacho’s self-inhibition may have compelled Edeza to write directly to the BIR.) Edeza’s letter, however, was still premised on a negotiated sale/purchase of the PEACe Bonds. All his questions regarding tax exemption were swept aside by BIR Commissioner Rene G. Bañez, in BIR Ruling No. 35-2001 (16 August 2001). Bañez affirmed the tax exemptions granted by the BIR in its ruling of 31 May 2001. He even specified that limiting the number of lenders to 19 at any one time ‘covers only the origination or original issuance of the bonds regardless of whether sale or trading is made in the secondary market’. This is contrary to the views expressed by Treasurer Edeza in his 12 July memo to Secretary Camacho.

Ironically, the BIR rulings that formed the basis for the tax exemption under the auction were the same rulings issued within the premise of a single investor, CODE-NGO, purchasing the bonds. There was no compelling economic reason given by the BIR for this specific tax break. Bañez merely pointed out in his 16 August ruling that there would be a single purchaser, RCBC, that in turn would sell the bonds to a single entity, CODE-NGO, which would likewise sell the bonds to RCBC Capital. When the decision came to sell the bonds via auction, all the Treasury did was to limit the government’s lenders to a maximum of 19 in order to keep the BIR rulings valid. What was the compelling economic reason for the Arroyo government to give a tax break at a time when it had a serious fiscal deficit to overcome? There appears to be none.

Because the BIR is not tasked with the economic analysis of policy, its opinion on these matters should have mattered less compared to a policy determination by the Secretary of Finance. It is at this juncture that the Secretary of Finance should have rendered his analysis and judgment as an economic manager rather than a plain and simple bureaucrat, and stopped the auction instead of merely inhibiting himself. His inhibition was costly because it led to a policy that benefitted CODE-NGO at great cost to the government.

Information Gaps

Treasurer Edeza made sure to brief members of the Investment House Association of the Philippines about the bond issue, at one of their regular meetings several weeks before the auction. Nevertheless we observe gaps in the official notices of the government regarding this flotation and the auction.

For one, even though this was a maiden issue of a zero-coupon bond of the Republic of the Philippines, neither a prospectus nor a tombstone was prepared and issued. Both the DoF/Treasury and RCBC/CODE-NGO also say that the notice to the market was issued through Bloomberg, Reuters and Bridges. We have asked CODE-NGO for these notices but have yet to receive these after more than a month has passed.

The first written notice of the Treasury to the GSEDs was dated 09 October 2001, a week before the auction. This memo made no mention of secondary reserve eligibility. It said only that the bond issue was limited to the 19-lender rule and therefore was exempted from the 20 percent withholding tax. The dealers were also required to fax their bids by 12 noon on the day of the auction, and to disclose the names of the institutions bidding through them.

The secondary reserve eligibility was finally mentioned in the Treasury Notice that was released on 15 October 2001, one day before the auction.

On the day of the auction the Treasury gave further clarification on the tax exemption and secondary reserve eligibility features of the PEACe Bonds.

We do not know what time this memo was released to the dealers, considering that the cutoff time for submitting bids was 12 noon. But this memo is also an indication that until the day of the auction itself, RCBC’s rival bidders needed further clarification on crucial aspects of the PEACe Bond float that should have been factored into their bids.

No mention at all was made of Insurance Commission eligibility, or that winning bidders could apply to Insurance Commission for eligibility.

Based on this information, we surmise that the GSEDs had far less time than CODE-NGO/RCBC to look for investors, price the bonds accordingly and submit a winning bid. On the other hand, because CODE-NGO and RCBC had worked on this flotation since the beginning and knew all the details surrounding the auction before it was announced to the bidders, they were extremely prepared to bid appropriately. They also had a seven-month headstart over their rival bidders, to mobilize the PhP10 billion of resources—whose nature has yet to be determined—needed to snag the entire auction. Between a bank that had seven months to accumulate several billions of pesos and others that had only a week’s notice—the cost of capital of the latter would be significantly much higher. This cost of quickly liquefying assets contributed to the costs of and the consequent weaker ability of the other banks to bid aggressively even if they intended to.

Manual Bidding Process

In its 09 October memo to the GSEDs, the Treasury announced that it would use manual bidding rather than electronic bidding at the 16 October auction. The reasons for the manual bid, according to the Treasury and RCBC, is that the software cannot handle zero-coupons. But in its 12 October memo to the GSEDs the Treasury indicated that the formula to be used in the manual bid was that of a bond with semi-annual payments (two coupons) rather than zero payments. If so then the software could have handled that formula, and the bidding could have been done electronically.

The real reason for the manual bid was the 19-lender limit, without which there would be no basis for the the tax exemption. Unlike an electronic auction where there is no possibility of knowing before cut-off time what rival bidders are bidding, the manual bidding process of the Treasury leaves room for leakage that could influence the outcome of the results.

According to Mrs. Camacho-Reyes, the dealers were instructed to fax their bids to two separate numbers. The fax machines, according to the Treasury, are located in the room of the Treasury’s Securities Origination Division. This room is adjacent to the Auction Room. Staff of this division would receive these bids as they come in and encode them into the computer. The bids are faxed over a period of time (from 10 AM to 12 noon) and they are open for staff of the SOD to see. When all the bids come in and when all are finally encoded this is when the bids are flashed onto the screen in the Auction Room, minus the names of the bidders. But during the bidding time and until the cutoff time for the bids, it is highly possible for information to be leaked that could determine who would win the auction.

The Treasury reported having received 45 bids from 15 GSEDs. RCBC admitted in a forum organized by CODE-NGO last December that it submitted four bids and won all four bids. CODE-NGO and RCBC would not readily admit it, but they won the entire auction. If the auction were a ‘level playing field’ where GSEDs have the same competencies and access to the same information, the chances of RCBC winning all its four bids is 24 in 3,575,880 (0.0007 percent). Despite such odds RCBC won all its four bids. This means that RCB operated on either a tremendous advantage, or on a dire need far greater than its competitors, or both.

billion-peso profit. CODE-NGO lobbied with the Monetary Board, Treasury, the Bureau of Internal Revenue (BIR), and Insurance Commission, to ensure its profit. Both tax exemption and secondary reserve eligibility were obtained from the BIR and Monetary Board, respectively, within the framework of a negotiated deal. The negotiations had to be conducted in secret or there would be no billion-peso profit to speak of.

What CODE-NGO Needed to Obtain P1.4B

Government’s ok to float the bond.

A bank with resources, which is not necessarily in the form of money, for the deal (initially, PhP4 billion, eventually, PhP10 billion), one that is eligible to bid in the auction, and act as firm underwriter.

Government’s willingness to go somewhere between after-tax yield of 7.2 percent (for BSP secondary reserves) and tax-exempt current yield of ten-year notes of 14.14 percent. The winning bid approved by the Auction Committee was 12.75 percent. The Auction Committee consisted of representatives from the National Government (Treasury, DoF) and two regulatory bodies (BSP and the Securities and Exchange Commission).

Monetary’s Board ok to endow it with secondary reserve eligibility through several resolutions approved in June, August, and September 2001, and another one even two days after the auction and ironically signed one week after it officially takes effect.

Initial ruling from the BIR (No. 20-2001) on tax exemption.

Subsequent ruling from BIR (No. 35-2001) on tax exemption after Edeza raised questions.

Insurance Commission’s ok to endow it with reserve eligibility for capital and reserves of insurance companies several weeks after the auction, at the request of CODE-NGO, even if the PEACe Bonds were no longer in their possession as they publicly admit, but in RCBC Capital’s.

It needed to win the entire auction.

It needed the Treasury’s cooperation to accept RCBC’s bids amidst the risks and serious doubts that are now being raised.

The Profit

Both CODE-NGO/RCBC and the DoF/Treasury take great pains to explain that the PhP1.4 billion profit of CODE-NGO was a purely private transaction between CODE-NGO and RCBC. But their stories digress thereafter.

According to CODE-NGO and RCBC, the profits from the sale of the bonds in the secondary market were entirely to CODE-NGO. RCBC kept none for itself even though it was expecting to earn a net income of only PhP444 million in 2001. The DoF/Treasury version says that after RCBC bought the bonds, RCBC then sold these to CODE-NGO, which then turned around and sold the bonds to RCBC Capital, the investment arm of RCBC.

Neither story sounds plausible. CODE-NGO has admitted it did not have PhP10 billion to purchase the bonds. So the DoF/Treasury version is hard to believe.

Simulated Sale, Real Profit

But there are also indications that the alleged sale in the secondary market may be more simulated than real.

A week after the auction CODE-NGO was telling its members that the money was already in its hands. This implies that the supposed sale in the secondary market had already taken place.

However, two weeks later on 05 November 2001, Maria Socorro Camacho-Reyes, CODE-NGO chair, and Danilo Songco, national coordinator, wrote Insurance Commissioner Eduardo T. Malinis, requesting ‘that the PEACe Bonds be considered eligible as: 1) security/statutory deposits; and, 2) admitted assets for insurance company purposes’. These eligibilities, they added, would enable CODE-NGO ‘to realize a premium’. When the money was already in their hands? Mr. Songco has admitted on television (Pointblank, 24 January 2002) that CODE-NGO fronted for RCBC.

In a dialogue with the FDC on 08 January 2002, Mr. Songco disclosed that RCBC ‘retained a large amount of the bonds for the Yuchengco group of companies. Wala kaming binili e. Marami doon sa bumili mga insurance companies ng Yuchengco Group’.

Earnings from Margin: Incredible!

Both the CODE-NGO and the DoF/Treasury would have us believe that the PEACe Bonds flotation saved the government a certain amount in interest. According to the DoF/Treasury, the non-tax benchmark yield-to-market (YTM) rate was 14.14 percent. The PEACe Bonds were sold at a yield of 12.75 percent. The government therefore saved about PhP1.24 billion in interest.

The benchmark yield rate used by CODE-NGO was the rate of the most recent auction of ten-year Treasury Notes prior to the 16 October auction of the PEACe Bonds. That yield is 13.2 percent (comparable non-tax rate). Using this as the benchmark, the government saves a smaller amount in interest—PhP420 million.

Either story is credible, but it is not complete. It is only half of the story, and the lesser half at that. Both CODE-NGO/RCBC and the DoF/Treasury are silent about the bigger half of the profits, the lion’s share, which went to CODE-NGO and RCBC.

If the government’s benchmark ranged from 13.2 percent to 14.14 percent, the benchmark of the banks that bidded in the auction ranged from 7.2 percent (after tax) to 9 percent (pre-tax). This is what the BSP pays them for their secondary reserves. The profit potential of the exclusive buyers (after buying the bonds at 12.75 percent YTM), would range therefore from PhP4.3 billion to PhP7.1 billion. This is larger than government’s savings on interest by at least 3.5x and at most 16.8x.

Of the PhP4.3 billion to PhP7.1 billion potential profit of CODE-NGO/RCBC, CODE-NGO obtained PhP1.4 billion (including its 10 percent commission). Its financial advisers were paid at least PhP200 million in fees and RCBC earned PhP200 million in underwriter’s fees. The balance—ranging from PhP2.5 billion to PhP5.2 billion—is what could be earned by the actual holders of the bonds—mainly, the Yuchengco Group.

Crouching Profit, Hidden Losses?

There is another profit that CODE-NGO and RCBC may have earned, which is not readily visible. This is the tax foregone by the National Government when it exempted CODE-NGO from the 20 percent final tax. (Recall in the section discussing the auction, that Treasurer Edeza had questioned this tax exemption.) What is CODE-NGO/RCBC’s gain, is the Arroyo government’s loss in tax revenue. We estimate it at PhP1.44 billion, an amount that seems to approximate the endowment fund before the deduction of fees, arrived at as follows:

Face value of PEACe Bonds: PhP35.00B

Less: Net present value with yield of 12.75 percent: PhP10.17B

Interest: PhP24.83B

Final tax foregone of 20 percent on interest: PhP4.97B

Net present value of tax foregone: PhP1.44B

This issue, however, needs further clarification. On the one hand, if the bids were competitive, then it is possible that what is lost in taxes is more or less gained in terms of greater proceeds from the bond issuance. On the other hand, the question remains valid of whether this tax exemption is available only to CODE-NGO. On paper it is not. Bu the Treasury made the bond float conditional on the number of lenders being less than 20, so as to be consistent with the BIR ruling that was premised on CODE-NGO being the only buyer. That is in fact how it happened in the end.

At the same time, Deputy Treasurer Jose Antonio Tan III in his press release of 13 December 2001, cited the supposed savings from the PEACe Bonds based on previous auctions of bond floats (14.14 percent vs. 12.75 percent). Or was he unwittingly comparing apples (tax-ridden vanilla instruments) and oranges (tax-free sweetend bonds). The signals from the Treasury are unclear.

If the amount the Arroyo government gave up in taxes is even bigger than what it saved in interest, the answer is obvious.

The Implications Are Profound

First, the timing and process of disclosure by the financial and regulatory players in this deal did little to level the information field among rival bidders vis-à-vis CODE-NGO/RCBC. This casts doubt on the government’s seriousness in understanding even enforcing reforms that will improve the integrity and credibility of the Philippine capital markets. The means, which is the development of honest-to-goodness market mechanisms that ensure a level playing field, is more important than the ends, which are zero-coupon bonds laden with sweeteners.

Second, the behest nature of the deal is yet another indication that the Philippine government is still very much a ‘soft’ state. Rules exist only to govern those outside the so-called ‘circle of power’. Those within that circle can bend, subvert, or openly break these rules to favor a select few.

The deal also shows that cronyism, which Marcos propagated and reinforced, has not died. Nor are civil society organizations immune to it.

Third, for a foreign investor, this demonstration of a lack of an uncompromising rule of law and management measures to ensure fair play, especially with regard to basic financial instruments like Treasury Bills and Bonds, introduces yet again an added element of investment risk. It may possibly lead to the lowering of the country’s credit rating.

Fourth, there is a clear moral hazard of incurring a debt that favors a particular organization, then passing on the burden of repaying that debt to a successor government. If the responsibility of facing the creditors will be borne by the next administration, then the current administration of President Gloria Macapagal-Arroyo need not worry about how prudently it spends and how judiciously it collects revenues especially from those who will fund her re-election campaign. Nor does it have to worry about whatever concessions and collaborative efforts it could have possibly made towards the billion-peso profit of CODE-NGO.

Fifth, the Peace and Equity Foundation says the amount it will use every year to support poverty alleviation and poverty reduction is PhP100 million. This is minuscule in comparison to the amount the National Government has to set aside each year—at least PhP2.5 billion—for the next ten years as interest payment on these debt papers. (See table below)

Amount borrowed by Arroyo government—PhP35.00B

Less: Actual funds raised—PhP10.17B

Interest owed on PEACe Bond Float—PhP24.83B

Annual interest, next 10 years (interest 10 years)—PhP2.48B vs.

Annual amount lent out by Peace & Equity Foundation—PhP0.10B

Sixth, a billion-peso and over permanent endowment fund for a civil society organization is an amount that most NGOs could not even begin to think of having. While on paper the Peace and Equity Foundation says access to this fund is open to all civil society organizations and will not be limited to the network of CODE-NGO, there are many ways in practice to limit access to a select few. If this is not avoided then the divide between NGOs that have funds and access to these funds, and NGOs that don’t, may widen, all in the name of poverty eradication.

Seventh, unless steps are taken to prevent this, the temptation will be strong to use these funds in exchange for political favors, political patronage, and familiar forms of leverage.

And lastly, it shows that the Filipino’s greatest enemy is himself. For when he is thrust into a position of power and influence, he abandons the virtues he previously upheld and embraces the vices he so vociferously despised.