Lawyers debate what is 'reasonable' in case on IRS' right to tax housing bondholders.

LOS ANGELES -- Lawyers in the test case over the IRS's right to tax bondholders wasted little time this week carving out clearly distinct positions on whether the Whitewater Garden and Ironwood bond sales were properly handled.

Lawyers for Harbor Bancorp & Subsidiaries and Edward and Elena Keith -- the investors who are fighting attempts by the Internal Revenue Service to revoke the tax-exempt status of the bonds and collect back taxes on interest earnings -- used their opening statement and initial witnesses to highlight the review process that was required before a housing project could go forward.

Mary Gassmann Reichert, whose law firm of Bryan Cave represents the investors, stressed in her opening statement that a central question in the case involves the issuer's expectations at the time the debt was issued.

"Subsequent events don't change" what the issuer's expectations were at the time of issuance, Reichert said. This is an important point, she said, because the subsequent actions of others -- including any unauthorized conduct -- should not unduly color or distort what the issuer thought was likely to happen with the proceeds of the bonds.

The $17.5 million of Whitewater Garden bonds and the $13 million of Ironwood bonds were issued by the Riverside County, Calif., Housing Authority to build apartment projects. The Whitewater Garden project was never built. The Ironwood project was build under the name Cross Creek Village, but not with bond proceeds, according to the federal government.

Part of the dispute centers on the issuance date for the bonds. Harbor Bancorp and the Keiths claim the bonds were issued on Dec. 31, 1985, the date they were delivered.

The IRS, however, contends the issuance was a "sham" because it involved a so-called black box structure featuring a cashless closing scheme. This structure has been linked to Arthur A. Goldberg, a former executive at Matthews & Wright, the defunct municipal underwriting firm that underwrote the Whitewater Garden and Ironwood debt.

The IRS claims the bonds were not validly issued until a remarketing in 1986. The date would qualify the debt as "arbitrage bonds" subject to arbitrage rebate requirements for tax-exempt multifamily housing bonds issued after 1985.

Clifton B. Cates 3rd, who is representing the IRS, said in his opening statement Monday in the U.S. Tax Court here that the bonds would still be taxable, even if the debt had been issued on Dec. 31, 1985. Cates said that IRS regulations for such multifamily family deals required an issuer to have a reasonable expectation that arbitrage would not be earned and that the bond proceeds would be used for housing.

In the deals in dispute, however, Cates said 88% of the bond proceeds ended up in guaranteed investment contracts, rather than "brick and mortar"

~Where It Mattered'

The IRS takes the position "that ~reasonable' means something," Cates said. Although the investors' lawyers will try to present a "great deal" of evidence concerning the due diligence in surrounding the two bond issues, the IRS plans to show that the issuer and bond counsel -- Camfield & Christopher -- "fell far short" of meeting this reasonable expectation standard "where it mattered."

In her opening statement, Reichert said the case is an important one of "first impression" because it will attempt to pin down exactly what is meant by the term "reasonable expectation." Reichert said the criteria should be defined as what an issuer thought was "likely" to happen when debt was issued.

Juan D. Keller, another Bryan Cave lawyer, pursued this theme during his questioning of the first two witnesses, both public officials who had responsibility for reviewing one or both of the projects.

Ken Hobbs, the business development manager for Riverside County at the time of the bond sales, said he did not recall any unusual aspects during the approval process for the housing projects.

He testified it was "just the reverse" because the project had to jump the same hurdles as any other proposal. In response to Keller's questioning, Hobbs said "I do not recall a red flag being raised by any of the bond team" regarding any untoward activity involving the financings.

Regarding the Ironwood project, "I had every expectation that the project was going to built," Hobbs said, adding that he also believed the Whitewater Garden project would move forward.

Hobbs, now an assistant city manager for Victorville, Calif., said he considered it likely that the projects would be built because of a pressing need for low- and moderate-income housing in a certain parts of Riverside County at the time. The demand had been fueled partly booming growth in the early 1980s, when Riverside County was one of the fastest growing areas in the nation, he said.

Jon Dittmer, director of planning for Cathedral City in 1985 -- the proposed site of the Whitewater Garden project -- also testified.

Under Keller's questioning, Hobbs and Dittmer spent a lot of time outlining the approval process for each project. Both men testified that an advisory commission to the housing authority was not a "rubber stamp" body.

In her opening statement, Reichert said testimony will show that "five [governmental] bodies reviewed these deals," and "about 25 separate people" reviewed the two projects.

During the IRS cross-examination, however, Cates attempted to paint a different picture of just how involved Hobbs and Dittmer were in overseeing the bond issues.

Through his questioning, for example, Cates attempted to show that neither man had ultimate responsibility for signing off on key bond-related documents.

In response to Cates' questioning, Dittmer said he did not have any dealings with any of the underwriting officials who had assembled the Whitewater issue.

Meanwhile, Hobbs testified that "to his knowledge," Drexel Burnham Lambert Inc. was the underwriter as of Dec. 31, 1985. When asked by Cates if he knew at the time that Matthews & Wright had in fact been assigned the issue, Hobbs replied: "No sir, I did not."

During Keller's questioning, Hobbs also testified as to why a newspaper notice was apparently never published about a public hearing on the Whitewater Garden bond issue, in line with federal requirements for approving industrial development bonds.

"I don't have an explanation as to why that occurred, other than simple oversight," Hobbs said. His economic development department routinely went "above and beyond" requirements for such notices, he said.

Keller, at the conclusion of his questioning, tried to show that neither Hobbs nor Dittmer had ever been questioned by an IRS examiner or a government expert witness on their due diligence surrounding the projects.

Both men said they had never talked with Hyun Lee, the IRS examiner who audited the tax-exempt status of the interest on the bonds. Both witnesses also said they had never talked with Neil Arkuss, a lawyer with Palmer & Dodge who is serving as the government's expert witness.

Although most witnesses in the trial are not being allowed to hear other witnesses' testimony, Arkuss has been granted the right to stay in the courtroom.

Before the opening statements, Cates asked the presiding judge -- Julian I. Jacobs -- to let Arkuss stay so the lawyer could hear the Admissible evidence that helps form the foundation for his expert report.

Judge Jacobs agreed, saying "this is a very complicated case ... He ought to hear firsthand what goes on."

Cates based his argument for having Arkuss present on a provision in a court procedure known as Rule 145, which does not exclude a person from the proceedings "whose presence is shown by a party to be essential to the presentation of such party's cause.

Lawyers lined the courtroom with boxes of exhibits prior to starting the trial, and witnesses often have to leave the stand and locate the correct binder that contains one of the hundreds of documents being used in the case.

On Monday, before the trial started, a lawyer on an unrelated tax case came out of the courtroom and spotted a cart holding about 20 boxes of documents in connection with the bond case. "I'm glad that's not mine," the lawyer said. "You're going to be here until Christmas."

The Schedule

During the trial, however, Judge Jacobs reminded lawyers that he is adhering to a 10-day schedule for the proceeding. He stressed that each side is being timed to keep the matter on schedule.

Reichert, in her opening statement, said the IRS commissioner has brought "the wrong people before the court." The federal government has other grounds to pursue the "wrong-doers" for promoting an abusive tax shelter, she said.

Sympathy exists, Cates said in his opening remarks, for the other side's argument that individual bondholders had no knowledge of the alleged defects in the bond issues.

But once the housing authority refused to rebate the arbitrage profits, Cates said the IRS only had two choices -- to drop the matter or to declare the issue taxable.

Dropping the matter was "not possible" because of the IRS' serious concerns about a "sham closing, [a] naked arbitrage play." and other potential abuses.

"That's why we're here today," Cates said on Monday.

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