WASHINGTON - Bond market participants last week applauded Internal Revenue Service and Treasury officials for proposing to overhaul and simplify the arbitrage rules, but said some of the proposals could be troublesome and should be modified.

"A valiant effort, but I think there are going to be a fair number of comments," said Dean Weiner, a lawyer with O'Melveny & Myers in Los Angeles.

Most market participants said they were having trouble focusing on the proposed rules because of the rush to close deals this year while interest rates are low. Also, the rules will not become effective until July 1993, after being adopted in final form, they said.

Another problem, they added, is the fact that issuers are more worried about avoiding losses than about earning arbitrage from deals in the current market. "Nobody cares about arbitrage right now," said an industry official who did not want to be identified.

Nevertheless, bond lawyers are warning that this is the bond market's last shot at helping to shape the arbitrage rules. It is important that market participants analyze the rules carefully and submit written comments on them to the IRS by the Jan. 15, 1993, deadline, they said.

"The message is, the IRS is getting sick of arbitrage," said Weiner. Treasury and IRS officials "are not going to diddle with these regulations after June 30, 1993. They're going to go on to other things like private-activity bonds," he continued, adding, "So it behooves the industry to take a very close look at these" and decide what revisions need to be made.

Most lawyers and industry officials were shocked that the Treasury and the IRS were able to complete such a comprehensive rewrite of the existing arbitrage rules in so short a period of time.

"It's an outstanding effort at coming up with workable arbitrage rules," said Charles Henck, a lawyer with Ballard Spahr Andrews & Ingersoll in Washington. "They had to rewrite regulations that in some cases had been on the books for over 20 years and that had come out in waves by different groups of drafters. They had to stand back and try to take an overview and say, ~What are we really trying to accomplish here?' They had to undo some rules they had put in place only a few months ago."

David Walton, a lawyer with Jones Hall Hill & White in San Francisco and a former Treasury official, agreed. "It was a tremendous amount of work and they should be complimented on it," he said.

Industry and issuers groups also were pleased with the proposed rules.

"The reaction that I'm getting from our members and lawyers is generally positive," said Michael Decker, manager of public policy analysis for the Public Security Association.

"Progress has been made," said Milton Wells, director of the National Association of State Treasurers' office of federal relations.

Those who had read the rules were impressed with the proposed 18-month spending exception from the rebate requirements, but a few of them worried issuers would not qualify for it if they were required to spend 30% of their proceeds in six months.

Industry officials said the proposed rules try to address longtime concerns. The preamble to the rules, for example, says the Treasury is considering revising the Slugs rules to make them more flexible and wants public comments for such revisions. Industry officials have complained for years that the Slugs programs are overly restrictive.

But some of the proposed rules have raised concerns among bond lawyers, such as a requirement that an issuer's arbitrage certificate include "a complete discussion of any material tax issues for which there is a reasonable possibility of challenge by the [IRS] commissioner."

An arbitrage certificate is an issuer's statement of the facts and expectations, at the time of bond issuance, regarding the potential for arbitrage earnings.

Perry Israel, a lawyer with Orrick, Herrington & Sutcliffe in San Francisco, said the IRS appears to be looking for an "an audit road map."

He and others said this proposed requirement would spawn tremendous controversy and debate within the bond law community. Bond counsel and underwriter's counsel would end up arguing about whether there were material tax law issues that should be disclosed in the arbitrage certificate and the official statement, they said.

Several lawyers said some of the proposed rules were both good and bad.

Simplification "is a two-edged sword," explained David Caprera, a lawyer with Kutak Rock in Denver. "The problem is that any time you write a simple set of rules, you end up cutting corners and eliminating options that were in the prior rules."

For example, he said, the proposed rules contain a definition of "materially higher yielding investments" that is shorter and much simpler, but that also could cause problems for student loan bond issuers.

Issuers have taxable arbitrage bonds if they invest their bond proceeds in materially higher yielding investments.

The arbitrage rules allow issuers of certain bonds to invest at a yield that is slightly above the bond yield without having materially higher yielding investments. Under the proposed rules, student bond issuers would no longer be given a one-eighth point spread that had allowed them to back out certain administrative costs from their investment yield, Caprera said.

The IRS also is proposing to eliminate a lot of detailed anti-abuse rules and replace them with a few broadbrush anti-abuse rules.

But several lawyers echoed a complaint made by Caprera that "it's going to cause everybody a little heartburn in trying to figure out where the edge of the envelope is."

Most lawyers said the proposed rules will work only if coupled with a strong IRS enforcement program.

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