WASHINGTON -- The Riverside County Housing Authority filed suit in a U.S. District Court in California yesterday to prevent the Treasury Department and the Internal Revenue Service from either revoking the tax-exempt status of the $ 17.5 million Whitewater Gardens black box bond issue or collecting $ 2.25 million in arbitrage profits from the deal.

Brown & Wood, attorneys for the authority, filed motions seeking a temporary restraining order as well as a pemanent injunction that would bar Treasury Secretary Nicholas Brady and, IRS Commissioner Fred T. Goldberg Jr. and their agencies from applying arbitrage rebate restrictions to the Whitewater Gardens multi-family housing issue.

The motions were filed with the U.S. District Court for the Central District of California in Los Angeles and are now under consideration by Judge Consuelo B. Marshall.

The case marks the first court challenge of IRS attempts to go after bond deals that were rushed to market to beat arbitrage rebate restrictions and closed without cash in the mid-1980s by Matthews & Wrights Inc., then a municipal underwriter.

The IRS has charged that Whitewater Gardens and four other municipal issues are subject to arbitrage rebate requirements because they were not validly issued until after those requirements took effect.

IRS officials put Riverside and the other issuers on notice earlier this year that they had to rebate the arbitrage profits by a certain date or the interest earnings from the bonds would be declared taxable.

The deadline given to Riverside for rebating the arbitrage profits from the Whitewater Gardens issue expired on June 14. The bonds are still outstanding.

But in documents filed with the court, authority officials and their lawyers said that the Whitewater Gardens issue was validly issued on Dec. 31, 1985, because the underwriter purchased the bonds with a check on that day.

"The regulations and relevant case law make clear...that bonds are 'issued' on the day the underwriter exchanges its check for the bonds. It makes no difference whether the check was drawn on insufficient funds," they said in a memorandum filed with the court.

In any case, the memo said, Riverside never had any reason to question the validity of the closing. After the closing, lawyers from Stubbeman, McRae, Sealey, Laughlin & Browder, which had been underwriter's counsel as well as special tax counsel, called Camfield & Christopher, Riverside's bond counsel, and said that the closing had occurred and that the proceeds had been received by Matthews & Wright. Riverside relied on its bond counsel as well as Matthews & Wright, the documents say.

Further, the trustee ultimately received all the proceeds from the underwriting of the issue and some of these were used to purchase land for the Whitewater Gardens housing project. The project "has not been completed due to a lack of economic feasibility as a result of problems in providing sewer services," the documents say.

The arbitrage earnings were not retained by Riverside, but rather were used to cover fees paid to other participants in the transaction, the lawyers said.

In arguing for the restraining order, the lawyers from Brown & Wood said that Riverside would be "irreparably harmed" if the IRS forced it to rebate arbitrage profits or taxed the interest earnings from the Whitewater bonds.

They said the authority's funds would be depleted and it would not be able to provide vital services and housing projects if it were forced to rebate $2.25 million. If the bonds' interest were taxed, Riverside's reputation in the municipal market would be ruined, and it would no longer be able to raise funds through bond issuances, they said.

IRS, on the other hand, 'will suffer virtually no harm" if it is locked from declaring the bonds taxable or collecting arbitrage, they said in documents filed with the court.

"Indeed, it is hard to imagine any reason why the IRS -- after waiting more than five years before demanding from plaintiff any money whatsoever -- would now object to maintaining the status quo...." the documents said.

Authority officials and their lawyers were confident that they could best the Treasury and IRS in court. "The IRS is going after innocent people who were snookered. They were snookered once, and now they are being snookered again by the IRS," said Henry S. Klaiman, a partne with Brown & Wood.

"The legal issue here is whether a closing took place on Dec. 31, 1985," Mr. Klaiman said. "And we think we have a very strong legal position that the transaction took place then and that no rebate is owed," he said.

The Riverside Authority is also under pressure from the IRS to rebate $1.54 million in arbitrage profits from a $12 million black box issue fro the Ironwood apartment project. That issue was closed on the same date as the one for Whitewater Gardens.

But the authority told the court, in the documents that were filed, that it was only challenging IRS on the Whitewater Gardens issue since negotiations for a possible settlement of claims are ongoing for the Ironwood issue. The Ironwood project was built but was renamed Cross Creek.

Whitewater Gardens and Ironwood are two of 26 deals totaling $1.3 billion that Matthews & Wright closed without cash for issuers in 1985 and 1986. The firm purchased the bonds with checks from an undercapitalized credit union and then temporarily warehoused them in an unlicensed offshore shell bank without selling them for cash to public investors until months after the closing.

The 26 transactions were a mix of black box and collapsible escrow deals. In black boxes, participation interests are supposed to be sold in the mortgage note of the property being financed with the bonds to provide funding for credit enhancement. However, in many of the black box deals under investigation by federal officials, there were never any investors in the mortgage note, and the bond proceeds were used to purchase a guaranteed investment contract, thereby ensuring that they would not be available for the project.

In collapsible escrow deals, most of the proceeds were locked into three- or five-year investments and not released until the project had been built with interim financing that had comparable credit enhancement to the bond issue. If the project was not built, the deal was collapsed. But in both black box and escrow deals, the bondholders have been paid in full regardless of whether the proceeds were used to finance a project.

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