LOS ANGELES - While the municipal market took Memorial Day off, a small group of people gathered in a Los Angeles courtroom Monday in an attempt to unravel the unusual events surrounding a slew of bond closing at the offices of Matthews & Wright on Dec. 31, 1985.
U.S. Tax Court Judge Julian I. Jacobs convened the unusual holiday session to keep to his schedule of completing the Whitewater Garden and Ironwood black box bond trial in two weeks.
The case is being brought by Harbor Bancorp, a bank based in Long Beach, Calif., and Edward and Elena Keith, residents of Pebble Beach, Calif. The bank and the Keiths are challenging the Internal Revenue Services' right to collect a total of $67,833 in back taxes on their interest earnings from the Whitewater Garden and Ironwood black box bonds.
Edward Keith appeared in Jacobs' courtroom Monday to testify about his decision to buy the bonds. Keith, an expert in earthquake-related engineering, said that he began investing in municipal bonds in 1973.
The Whitewater Garden and Ironwood bonds met his investing criteria: They carried a triple-A rating, based on the underlying security backing the debt, and the yields were "just about on par" with other bonds in the market at the time, Keith testified.
Keith said his long-term broker at Bear, Stearns & Co., with whom he had had a good relationship, recommended the Whitewater Garden and Ironwood bonds. He said he did not see the offering circular before purchasing the bonds because "usually, you have very little time to make a buying decision." If he had waited to see the prospectus before making a purchase decision, "the bonds would be gone," Keith testified.
Keith also recalled the events last year when he was first notified by the IRS that back taxes were being sought on the interest earnings.
This came as a surprise, Keith said. "I thought once they were declared tax-free, they were tax-free."
Keith said he had no knowledge of any defects with respect to the bonds. Asked if he would have bought the bonds if they had been taxable, Keith replied: "I certainly would not have."
Keith was the final witness called by lawyers at Bryan Cave, the law firm representing the bondholders in the case.
Throughout their presentation last week, the Bryant Cave lawyers attempted to hammer home a common theme, that officials for the issuer - the Riverside County Housing Authority - and many others connected with the transactions had expected the bond proceeds to fund two multi-family projects. They continued to hold this belief, the officials testified, up through the time they believed the deals closed on Dec. 31, 1985.
Part of the dispute centers on the issue date for the bonds. Both Harbor Bancorp and the Keiths claim the bonds were issued on Dec. 31, 1985, the update they were delivered.
The IRS contends, however, that the issuance was a "sham" because it involved a so-called black box structure featuring a cashless closing scheme.
The IRS claims the bonds were not validly issued until a remarketing in 1986, which would qualify the debt as "arbitrage bonds" subject to arbitrage rebate requirements for tax-exempt multifamily housing bonds issued after 1985.
Arthur A. Goldberg, the former executive vice president of Matthews & Wright, the defunct municipal underwriting firm, is believed to have been the chief architect of a circular cashless closing scheme for about two dozen bond issues, including Whitewater Garden and Ironwood, that were rushed to market in the mid-1980s to beat new arbitrage restrictions contained in the Tax Reform Act of 1986.
In these deals, called black boxes because of their complex circular structure and numerous participants, bond proceeds seemed to disappear and to ultimately be locked into long-term guaranteed investment contracts that paid debt service on the bonds, rather than being available for the projects.
The bonds were purchased with checks from a credit union and temporarily warehoused in an unlicensed, offshore shell bank for several weeks until they were sold to public investors for cash.
On Monday, the IRS began calling witnesses who recalled their involvement with the closings.
Joel Schwartz, who in 1985 was general manager of the New American Federal Credit Union, testified to his recollection of the events on Dec. 31, 1985, when Goldberg asked Schwartz to bring three so-called checking starter kits to Matthews & Wright's New York offices.
Share drafts from the kits, which would typically be used to start checking accounts, were then used to help close the bond transactions.
Schwartz testified that the credit union did not follow the procedures it would typically use in giving out the starter kits, including the requirement of a corporate resolution from Matthews & Wright.
This, said Schwartz, "was done as an accommodation" to Goldberg, who also was Schwartz's immediate supervisor at the credit union. Goldberg founded the credit union and at the time served as its president.
Schwartz, who emphasized that he had no role in structuring the transactions, also testified about how Goldberg asked him to sign documents on Dec. 31 on behalf of Commercial Bank of Americas, the offshore bank.
Under the closing arrangement, the bond trustee - InterFirst Bank Houston - was directed to sign the share drafts over to Commercial Bank of the Americas in exchange for "investment agreements" from the offshore bank for the bond proceeds.
In turn, Commercial Bank of the Americas then endorsed the checks back to Matthews & Wright.
Schwartz noted that the checks used to close the various bond transactions that day totaled roughly $750 million, far more than the credit union's $50 million in assets. But Schwartz said he believed the credit union was protected since the checks were returned to him and never run through the banking system.
"The checks couldn't go anywhere," and did not actually result in money being moved, Schwartz testified.
Although Bryan Cave lawyers have said they will show the housing authority acted with "diligence" in establishing reasonable expectations that the bonds would be used for their intended purpose, the IRS plans this week to have its expert witness take the stand to raise another view of the actions of the issuer and the bond counsel, Camfield & Christopher.
Neil Arkuss, a lawyer with Palmer & Dodge in Boston, concluded in his written expert report that "the issuer's conduct was such that its no-arbitrage certifications were not reasonable."
"It is my opinion that bond counsel did not meet minimally acceptable practice standards, Arkuss said."