SECOND LIBERTY BOND ACT, AS AMENDED-BONDS ISSUED AT DISCOUNT-EFFECTIVE RATE OF INTEREST OR COST TO TREASURY

The Secretary of the Treasury has authority under the Second Liberty Bond Act of September 24, 1917, c. 56, 40 Stat. 288, as amended, to issue bonds for cash, exchange, or on advance refunding at a discount which would raise the effective rate, investment yield, or cost to the Treasury of those bonds above the rate of 44 percent, provided that the coupon rate does not exceed the statutory interest limit of 44 percent.

The word "interest" without further explanation refers to the ordinary meaning of that term, i.e., to the stated or coupon rate, and not to the accountants' concepts of "effective rate," "investment yield," or "cost to the obligor."

Establishment of a maximum interest rate for securities which at the same time permits their sale at a discount, merely requires that the coupon rate not exceed the statutory maximum, but has no bearing on the investment yield, or related accounting concepts. The Second Liberty Bond Act, as amended, indicates that Congress is fully aware of the difference between the coupon rate and the effective rate of securities.

THE SECRETARY OF THE TREASURY.

**

APRIL 25, 1961.

MY DEAR MR. SECRETARY: This is in reply to your request for my opinion as to whether you have the authority under sections 1 and 20 of the Second Liberty Bond Act to issue bonds for cash, exchange, or on advance refunding1 where such bonds bear a coupon rate not in excess of 44 percent but are issued at a discount which would raise the effective rate or cost to the Treasury of the bonds above the rate of 44 percent. For the reasons set forth hereinafter in detail I conclude that you possess such authority.

1 Section 1 of the Second Liberty Bond Act of September 24, 1917, 40 Stat. 288, as amended, 31 U.S.C. 752, authorizes the Secretary of the Treasury, with the approval of the President, to borrow on the credit of the United States for a number of purposes including "the purchase, redemption, or re funding, at or before maturity, of any outstanding bonds, notes, certificates of indebtedness, or Treasury bills of the United States *

Section 1 of the Second Liberty Bond Act authorizes the Secretary of the Treasury, with the approval of the President, to borrow on the credit of the United States and to issue therefor bonds of the United States which shall be. subject to a “rate or rates of interest, not exceeding 414 per centum per annum" and shall "be offered at not less than par. Section 20 of the Second Liberty Bond Act, as amended by section 3 of the Public Debt Act of 1942, 56 Stat. 189, 31 U.S.C. 754b,2 provides that the bonds authorized by section 1 of the act: "may be issued on an interest-bearing basis, on a discount basis, or on a combination interest-bearing and discount basis, at such price or prices and with interest computed in such manner and payable at such time or times as the Secretary of the Treasury may prescribe; and any such obligations may be offered for sale on a competitive or other basis under such regulations and upon such terms and conditions as the Secretary of the Treasury may prescribe; and his decision with respect to any such issue shall be final.”

On May 1, 1958, my predecessor concluded that the 1942 amendment of section 20 had repealed the earlier enacted requirement set forth in section 1 that bonds issued thereunder shall "be offered at not less than par" (41 Op. A.G. 357). He based this opinion on the conclusions that the two sections are irreconcilable and that the legislative history of the 1942 amendment of section 20 disclosed a congressional purpose "to give the Secretary of the Treasury greater flexibility in determining the terms upon which Treasury bonds, bills, notes, and certificates of indebtedness may be issued.” 3

That opinion, however, did not purport to consider whether the Secretary of the Treasury is authorized to issue bonds, bearing a stated coupon rate of no more than 41⁄44 per centum, for cash, exchange, or on advance refunding, if, as the result of a discount at which the bonds are issued, or for some related reason, their effective rate, investment yield, or cost

2 Section 20 was added to the Second Liberty Bond Act by section 14(a) (4) of the Gold Reserve Act of 1934, 48 Stat. 343.

H. Rept. 1876, 77th Cong., 2d sess., p. 4. See also S. Rept. 1173, 77th Cong., 2d sess., pp. 1, 2; Public Debt of 1942, Hearings before the Committee on Finance, U.S. Senate, 77th Cong., 2d sess. on H.R. 6691, p. 3; 88 Cong. Rec. 2184.

to the Treasury should exceed the statutory rate of 414 per centum per annum. I base my conclusion that you have this power on the following considerations: First, when Congress uses the term "interest" in connection with bonds without further explanation, it refers to the coupon or stated rate, the usual meaning of that term, and not to the accountants' concept of effective rate; second, when a statute limits only the coupon rate of a security issue, and permits it to be offered at less than par, it authorizes sales at an effective rate in excess of the maximum permissible coupon rate; and third, when Congress seeks to limit the effective rate of securities which may be sold at a discount, it does so expressly.

I

As originally enacted, section 1 of the Second Liberty Bond Act provided that the interest rate of the bonds should not exceed 44 percent per annum, and that they should not be issued at less than par. In view of the latter prohibition, the effective rate could not exceed the coupon rate, and it was therefore unnecessary to determine whether the 44 interest rate referred to the coupon rate or to the effective rate.

The 1942 amendment of the Second Liberty Bond Act, while leaving the 414 per centum limitation on "interest" untouched, permits bonds to be issued on a discount basis, or on a combination interest-bearing and discount basis. In view of this amendment, it becomes material to ascertain whether the words "rate or rates of interest" in section 1 refer to the coupon rate or to the effective rate. The pertinent judicial decisions indicate that the first alternative is the correct one; hence, that a limitation on "interest" has no direct bearing on the effective rate.

In Old Colony R. Co. v. Commissioner, 284 U.S. 552 (1932), the Supreme Court was confronted with a situation closely related to the one at hand. A corporation which had sold its bonds at a premium sought to deduct the entire interest payments on those bonds from its gross income for income tax purposes. The Government claimed that this

In the interest of brevity I shall use only the term "effective rate" when referring to the three related concepts of "effective rate," "investment yield,” and "cost to the Treasury."

was not permissible because these payments included in part the repayment of the premium, which constituted a loan and consequently had to be amortized over the life of the bond. Hence, the "interest" payments constituted in part "genuine interest" which was deductible, and in part payments on a loan which could not be deducted. In a nutshell, the Government's position was that where bonds were sold at a premium, the effective rate of interest was lower than the coupon rate, and that the excess of the coupon over the effective rate did not constitute deductible interest but a repayment on capital (284 U.S. 552, 559). The Supreme Court held that when Congress uses the word "interest" without further amplification it refers to the normal meaning of the word, i.e., the stated or coupon rate, and not to the accountants' concept of the effective rate. The Court said (284 U.S. 560-561): “*** the usual import of the term [interest] is the amount which one has contracted to pay for the use of borrowed money. He who pays and he who receives payment of the stipulated amount conceives that the whole is interest. In the ordinary affairs of life no one stops for refined analysis of the nature of a premium, or considers that the periodic payment universally called "interest” is in part something wholly distinct—that is, a return of borrowed capital. It has remained for the theory of accounting to point out this refinement. We cannot believe that Congress used the word having in mind any concept other than the usual, ordinary and everyday meaning of the term, or that it was acquainted with the accountants' phrase 'effective rate' of interest and intended that as the measure of the permitted deduction." The holding in Old Colony that Congress and courts use and interpret statutory language according to its usual meaning and not on the basis of accounting theories does not constitute an exception to the general course of decisions." The State courts also hold that the

6

See also Brief for the United States in No. 349, Oct. T. 1931, pp. 6-7, 10-14, 50-52. Significantly, the brief and the accounting authorities quoted in it stressed that these considerations applied conversely where bonds had been sold at a discount.

The holding in Old Colony therefore applies with equal force to an advance refunding of bonds at an increased interest rate which, according to some accountants, constitutes the issue of the bonds at a discount.

See, e.g., Woolford Realty Co. v. Rose, 286 U.S. 819, 326-327 (1982); Orane v. Commissioner, 331 U.S. 1, 3-7 (1947).

term "interest" without explanation normally refers to the coupon rather than the effective rate.

II

The limitation on the interest rate set forth in section 1 therefore refers exclusively to the coupon rate of the bonds. The original prohibition on the offering of those bonds below par, however, constituted a bar on their sale at an effective rate in excess of the coupon rate. Indeed, it has been recognized by students of public finance that one of the functions of a statutory prohibition of the sale of securities below par is to prevent their sale at an effective rate in excess of the coupon rate. Thus it was stated by Dr. Robert A. Love in his treatise on Federal Financing, A Study of the Methods Employed by the Treasury in Its Borrowing Operations (1931) at p. 210:

"We are accordingly justified in thinking that the everpresent restriction against sale below par is in reality a logical team-mate of the restriction on the nominal rate of interest, and that it was only by combining the two that the public's wishes in respect to limiting the net yield on securities were carried out."

It follows that prior to 1942, bonds authorized by section 1 of the Second Liberty Bond Act could not be issued at an effective rate in excess of 414 percent because the statute barred the sale of those securities below par. When the Public Debt Act of 1942 repealed that prohibition and expressly authorized the sale of those bonds at a discount, the basis of the restriction on the effective rate of interest disappeared."

This, indeed, has been a source of complaint on the part of accountants, see, 6.g., George O. May, Accounting and the Accountant in the Administration of Income Taxation, 47 Col. L.R. 377; Jacob Mertens, Jr., The Law of Federal Income Taxation (1960 Revision of Vol. 4), sec. 23.162.

B Golden Gate Bridge etc. District v. Filmer, 217 Calif. 754, 21 P. (2d) 112 (1933); Stanley v. Mayor etc. of City of Baltimore, 146 Md. 277, 301-302, 126 Atl. 151, 160 (1924); Rowland v. Deck et al., 108 Kans. 440, 195 Pac. 868 (1921); Kiernan v. City of Portland, 61 Oreg. 398, 122 Pac. 764 (1912).

The decisions of the State courts agree that where a statute permits the sale of securities at a discount, the investment yield may exceed the statutory coupon rate; cf. the authorities cited supra, fn. 8, and Leonard A. Jones, The Law of Bonds and Bond Securities (4th ed., 1935), sec. 369.

Where a statute establishes a limit on the coupon rate and does not expressly authorize the sale of the security below par, the courts are split on the question whether the sale at discount is prohibited because it would result in an evasion of the statutory coupon rate; see, e.g., Ohio ex rel.