LOS ANGELES - While bond lawyers seek guidance from the Internal Revenue Service on whether California's registered warrants quality for tax-exempt status, one major bank said yesterday it will soon quit honoring the IOUs.
Bank of America, which underwrites many state financings, an announced it would stop accepting the registered warrants on Aug. 5.
That action, if matched by other key banks, could heighten pressure on state leaders to end their impasse over a fiscal 1993 budget, which was due July 1.
The registered warrants are promissory notes with no specific maturity that are being issued to state employees and others instead of checks because of the state's budget crisis. Some political observers believe that state leaders have not incurred their constituents' wrath over the budget problem because no one is suffering from being unable able to cash the IOUs.
Bank of America's action follows recent warning by bankers that they cannot keep cashing the individual IOUs indefinitely while the state fails to show tangible progress on a budget for the fiscal year that began July 1.
The announcement has no bearing, however, on the state's $475 million of tax-exempt revenue anticipation warrants that were sold in June and are due to mature today. State Controller Gray Davis already has said the state's cash flow would enable California to redeem the revenue anticipation warrants when due.
Kathleen Brown, the state treasurer, said in a statement that Bank of America's decision was not entirely unexpected. She also said other banks may well follow suit.
"The warrants are putting a drain on bank resources, and customers are beginning to question whether the institutions themselves are becoming part of the problem by continuing to accept warrants," Ms. Brown said.
If banks quit honoring the registered warrants, employees and other creditors who receive the IOUs could not negotiate the instruments until the state has funds to redeem them.
Meanwhile, questions are also arising over whether interest on the registered warrants, which is set at 5%, will be treated as tax-exempt or taxable.
"We are studying that intensely right now," after receiving inquiries from the state and a number of large banks, said Dean Criddle, a partner of Orrick, Herrington & Sutcliffe. As part of the process. tax lawyers and state officials are exploring the matter with the Internal Revenue Service.
Two key questions form the heart of the discussion, Mr. Criddle noted.
First, lawyers must determine if the IOUs meet the so-called registration requirement for tax-exempt debt, he said.
In this intance, the state issues the warrants in registered form in the name of the initial recipient. But if the IOUs are negotiated, such as when they are cashed at a bank, the state's books do not reflect that transfer. But that measure the IOUs apparently fail the so-called registration requirement.
But Mr. Criddle noted there is an exception to that requirement for state and local borrowings that have a maturity of not more than one year.
The California IOUs carry no stated maturity, so there is a separate set of discussions over whether they qualify for the exception when it is likely they will be redeemed before the one-year cutoff, Mr. Criddle said.
A 1983 IRS letter ruling in another case decided that short-term warrants with no stated maturity would meet the registration requirement, a finding that provides comfort for the state, Mr. Criddle said.
The other issue under study involves a requirement that debt instruments - to qualify for tax-exempt status - fall under the exercise of a state or local government's borrowing power. In essence, a question arises whether the California IOUs constitute such an exercise of borrowing power when creditors are involuntarily receiving the registered warrants.
This threshold is a "gloss that courts have added," initially in cases involving condemnation proceedings, Mr. Criddle noted. "That one's a lot more touchy-feely" because it is difficult to locate cases providing precedent for such IOUs, he added.
But he said the set of facts in California's case should be favorable in certain regards, especially since the state consulted with market participants in deciding what interest rate to pay on the IOUs.
Besides tax lawyers, officials in the California treasurer's office and the controllers office are discussing the tax-exempt questions with the IRS. "They're very cooperative discussions." because IRS officials are trying to be helpful in providing guidance, Mr. Criddle noted.
An IRS official studying the matter could not be reached for comment yesterday.
Market sources said this week that they have heard conflicting ideas from tax lawyers at different law firms over whether the IOUs might be treated as tax-exempt investments.
That debate, however, is being overshadowed by the broader developments affecting California's budget negotiations.
Richard M. Rosenberg, Bank of America's chairman and chief executive officer, expressed concern yesterday that banks are helping to prolong the state budget impasse by cashing the IOUs.
"In attempting to help ease the hardships their customers must deal with in the circumstance, the banks are inadvertently making it easier for the emergency to drag on," he said.
State leaders still are negotiating how to close a $10.7 billion shortfall for the 18-month budget period between last January and June 30, 1993. Partisan differences between a Republican governor and Democrats in the Legislature helped fuel the deadlock.
Bondholders have suffered primarily because the budget impasse prompted a series of downgrades by rating agency officials. The IOU controversy is less of a concern from a bond repayment perspective because the state is constitutionally required to make debt service payments with cash.
Ms. Brown noted that "Californians who have to pay mortgages and buy groceries" will suffer the most if numerous banks stop honoring the registered warrants.
Mr. Davis, the controller, said Wednesday that California should have enough cash redeem about $922 million of registered warrants from Aug. 3 to Aug. 6. The state already has issued more than $1 billion of the IOUs.
In announcing the redemption, Mr. Davis said he hoped it would lessen concern that banks are nearing a saturation point in their willingness to accept the IOUs. A handful of small banks already are refusing to cash the registered warrants.
An investment banker noted this week that his firm helped one bank by locating an institutional investor that agreed to buy the IOUs, thereby providing the bank with immediate cash. It is unclear, however, if much of an informal secondary market will develop for the instruments, especially in light of the controllers redemption announcement.
The investment banker said his firm represented the warrants as a taxable investment because tax lawyers have been unable to issue a clean opinion otherwise.
Besides the impact on individuals, a move by numerous banks to quit honoring the IOUs could also pinch some local government, depending on their cash position, another market participant said this week.