WASHINGTON -- The underwriter and bond counsel for seven Mississippi county housing bond deals are fighting SEC fraud charges by contending the commission has no jurisdiction over the tax issues that form the basis of the charges.
The Securities and Exchange Commission filed the charges last month against Thorn, Alvis, Welch Inc., an underwriting firm in Jackson, Miss.; John E. Thorn Jr., its president; and Derryl W. Peden, a bond lawyer with Stennett, Wilkinson & Peden, also in Jackson.
The SEC alleges that they failed to make proper disclosures in the offering documents for seven issues of multifamily housing bonds totaling almost $20 million that were sold by Hinds and Warren counties in 1992 and 1993.
Thorn and Peden, the SEC claims, paid the contractor more than $1 million of bond proceeds, which was then kicked back to them when the contractor paid issuance costs in violation of tax law limits.
The tax law limits to 2% the amount of bond proceeds that can be used to pay issuance costs in multifamily housing bond and other private-activity bond deals. It also limits to 5% the amount of the private-activity bond proceeds that are not used for the tax-exempt purpose of the bonds.
The SEC alleges the offering documents for the deals are misleading because they say the contractor made "contributions" to the projects when the money was actually used to pay excess issuance costs. The commission also claims the offering documents omit key information by failing to disclose that the bonds might be taxable because of tax law violations.
But in recent responses to the SEC, the Thorn firm, Thorn, and Peden said the SEC's charges are based on "disputed and undecided issues of federal income taxation" that fall within the jurisdiction of the Internal Revenue Service, rather than the SEC.
"There has been no finding by the [IRS] that the offerings at issue are not tax-exempt, and there has been no damage or any likelihood that any damage will occur to any investor," said Peden, who is being represented by the law firm of Arnall Golden & Gregory in Atlanta.
The SEC charges are "improper and premature" because the IRS "should have initial and primary jurisdiction" over these tax issues, said Thorn and his firm, which are being represented by the law firm of King & Spalding in Atlanta.
None of the seven bond issues violates tax laws, Thorn and Peden claim in their responses to the charges and other documents filed with the SEC.
Thorn and Peden say that while bond proceeds were used to pay the contractor, Mitchell & Company, for negotiating the purchase of the housing projects, analyzing the feasibility of rehabilitating them, and other services, the proceeds should be considered spent for tax purposes once Mitchell was paid.
Under tax laws and arbitrage rules, lawyers say, bond proceeds paid to a party that is unrelated to the issuer or borrower may be treated as spent for tax purposes. Although the shareholders and officers of Mitchell owned limited partnership interests in the partnerships put together by Thorn and Mitchell to own the projects, those interests did not exceed 50%, according to Thorn. Under the tax law, a limited partnership interest of 50% or less is not considered to be a related party to an issuer or a borrower, lawyers say.
Mitchell was therefore free to do anything it wanted with the money, including making an equity contribution back to the partnership by paying issuance costs, Thorn and Peden say. "Upon such disbursement, the funds became the property of the contractor subject to the contractor's sole and exclusive control, and they were no longer bond proceeds," Thorn and his firm told the SEC.
In the case of the $4.05 million bond issue for the Glen Oaks Apartments project in Hinds County, for example, Mitchell was paid a $242,450 development fee. Mitchell then contributed that money to Glen Oaks Associates Ltd., the project owner, which used the money to pay a portion of the bond counsel fee, the underwriter counsel's fee, and the underwriting fee, according to documents Thorn filed with the SEC. This amount was over the $81,000 of issuance costs that met the 2% limit.
But bond documents and the documents filed with the SEC by Thorn and Peden raise some troubling tax law questions, according to lawyers who are not involved with the deals or the parties but have reviewed the bond documents.
Even though the shareholders and officers of Mitchell, Thorn, and in some cases a third company each had limited partnership interests in the projects, only Mitchell appears to have made equity contributions.
One lawyer representing Thorn said the other partners with limited partnership interests may have simply cut better deals than the Mitchell partners.
Some of the lawyers who reviewed these structures say they appear to have been set up to, in effect, "launder" the bond proceeds so they could be treated as spent for tax purposes and kicked back to the deal's participants. The substance of what is going on appears to be that bond proceeds are being used to pay issuance costs over the 2% limit, they said.
Another troubling tax question, according to the lawyers, involves a "credit enhancement fee" that was paid to Mitchell from the bond proceeds in each of the deals. Mitchell, according to the bond documents, was obligated to guarantee the principal payments on the bonds.
Mitchell used the credit enhancement fees it was paid to buy zero coupon bonds that, at maturity, would pay all of the principal on the bonds, according to the bond documents and interviews with lawyers familiar with the deal. In each case, the fee amount was equal to the amount of money needed to fully collateralize the principal payments from the bonds.
In the case of the Glen Oaks Apartments project in Hinds County, Mitchell was paid a $623,133 credit enhancement fee on top of the $242,450 development fee. The credit enhancement fee was used to buy enough zero coupon bonds to pay the $4.05 million of principal on the bonds when it became due in 2019.
Some lawyers suggest this is not legitimate credit enhancement and that the credit enhancement fees therefore would exceed the 5% limit on bond proceeds not spent for the tax-exempt purpose of the project.
The lawyers say this type of credit enhancement is similar to the bogus insurance cited as abusive in the IRS' recently issued Revenue Ruling 94-42. In the ruling, the IRS concluded that credit enhancement is not legitimate when the credit enhancement fee is large enough to cover the entire portion of the debt service that is guaranteed.
In addition, if the yield of the zero coupon bonds is higher than the yield of the bonds, the bonds would violate arbitrage restrictions, the lawyers say.
A lawyer representing Thorn, however, said these deals are not like the example or the abusive deal cited in the revenue ruling because in that deal, bogus insurance was used to buy securities to back all of the debt service on the bonds. In these deals, he said, Mitchell is only guaranteeing the principal payments on the bonds. He said he thought the zero coupon bond yield was lower than the bond yield.