WASHINGTON - Bond firms say Chicago could make millions of dollars from a proposed call waiver and interest rate swap-like transaction, but federal regulatory officials warn that the deal appears to violate tax laws and could undermine the tax-exempt status of some of the city's bonds.
The transaction, which could be completed by Jan. 4, calls for the Illinois Development Finance Authority to obtain a short-term, floating-rate bank loan to finance its purchase of up to $105 million of general obligation bonds that Chicago issued in 1982 and advance refunded in 1985 and 1986.
The 1982 bonds bear interest rates of 13.625% and 13.750% and have stated maturities of 2003 and 2013, but are due to be called on Jan. 1 at a price of 103% of their principal amount.
The authority, in a tender notice published this month, offered to buy the bonds before the call date at 103 1/4. It would use the bank loan to buy the bonds, restructure the escrow to defease them to maturity, and pay all costs associated with the transaction.
Chicago would waive its right to call the bonds and, in return, would be paid the difference between the low floating rates that would be due on the bank loan and the higher fixed rates that would be earned on the securities that were put in escrow to pay the bonds.
The floating rate on the bank loan would be 65 basis points over the London interbank offered rate, according to Joe Derezinski, the authority's director of programs. The loan amount would be between $175 million to $180 million if the authority purchased all of the bonds, participants said.
The transaction resembles an interest rate swap, participants said, in that Chicago and the authority would be paying floating rates and receiving fixed rates. in an actual swap, if interest rates move against an issuer so that it is no longer getting net payments, the issuer has to pay a fee to terminate the swap agreement. But in this proposal, there is no cost to unwind the deal. The authority would simply sell the bonds to pay off the loan.
"The point of the deal is you may make money and it's definitely not going to cost you money," said Lawrence Morris, a vice president with First Chicago Capital Markets Inc., which helped structure the deal along with the law firm of Chapman and Cutler.
First Chicago is the dealer manager on the tender and is the sister company of the First National Bank of Chicago, which is to provide the bank loan. Chapman lawyers are currently advising the city, the authority, and First Chicago on the legal issues associated with the deal. They would give the tax opinion on the transaction. The Northern Trust Co. is the financial adviser for the deal.
The purpose of the transaction is to give Chicago the opportunity to make money to offset its current budget problems, participants said. The City Council on Tuesday passed a $3.33 billion budget for fiscal year 1993, which begins Jan. 1, that eliminated a projected $89 million shortfall with tax increases, new taxes, fees, and layoffs. But the proposed deal would still "have a very positive impact on the city's budget" to the extent it prevents the need for further property tax increases, said Ronald Bean, the authority's executive director.
Bean said the city could make between $3 million and $7 million a year from the proposed transaction. First Chicago's Morris, however, pointed out there was a "mathematical possibility" that the city could make no money. Walter Knorr, the city's comptroller, would not comment on the potential profits from the deal, saying only that the city would not have any costs and its credit would not be put at risk.
The bonds would serve as collateral for the bank loan. If the value of the bonds dropped below a certain point, the authority would be required to sell the bonds to pay off the loan. The ratio of collateral to loan value that would trigger the sale of the bonds should be 102% to 103%, according to Morris.
He said the expectation is that the bonds will be able to serve as collateral for the loan for three to five years "if rates are stable or go down." He added that "if interest rates go up, it could end sooner, and if they spike up, it could end real soon."
The proposed transaction was approved by both the City Council and the authority's board this week, but is contingent on certain conditions, according to participants. At least $10 million of the bonds must be tendered, the authority must obtain the bank loan, and Chapman and Cutler must give a clean tax opinion on the deal. Chapman lawyers said they gave an opinion on a recent similar hospital deal, but would not identify it.
Participants said the call waiver and payment would cause the 1982 bonds to be considered reissued so that they are subject to current tax laws. But a reissuance would not affect the tax-exempt status of the bonds and the transaction would comply with all relevant federal tax laws, they said.
First Chicago's Morris said the securities in the restructured escrow would be invested on a yield-restricted basis, but could not provide details.
Some lawyers not involved in the transaction questioned the role of the authority. Authority officials said the authority would act as a conduit for Chicago and would be paid a negotiated fee. Derezinski said the authority was brought into the deal because the city needed a public entity to purchase the bonds and that it could absorb the loan without any effect on its balance sheet.
One lawyer not involved in the deal speculated that, under state laws, Chicago cannot purchase its own bonds without retiring them.
Knorr, the city comptroller, and Jeffrey Berry, a lawyer with Chapman, would not discuss tax law issues associated with the deal. Morris said the participants are concerned that certain information could affect the tender offer for the bonds.
But some lawyers and federal regulators, who were familiar with some of the deal's details, are worried that it may violate tax laws.
"What is the governmental purpose for having these bonds out another 10 years other than to earn arbitrage?" said a lawyer in New York who did not want to be identified. He called the proposed transaction "devious."
Federal regulators and some lawyers are concerned the proposed transaction may be an "artifice and device" under the tax laws that could undermine the tax-exempt status of the 1982 bonds purchased by the authority.
Under the tax laws, a bond issue is an artifice and device, and therefore taxable, if it enables the issuer to exploit the difference between tax-exempt and taxable interest rates to gain a material financial advantage and if it increases the burden of tax-exempt bonds on the market.
"The biggest concern is that it certainly appears to be an overburdening transaction," one federal official said.
The deal would increase the tax-exempt burden in the market, he said, because the bonds would remain outstanding until 2003 and 2013 instead of being called in January. At the same time, Chicago would be exploiting the difference between taxable and tax-exempt rates, he and others said, because some of the money in the restructured escrow would be considered to be the tax-exempt proceeds of the reissued bonds.
Another concern, federal regulators said, is that the proposed transaction may violate refunding rules that took effect in June, in particular a provision that prohibits replacing previously established refunding escrows.
The deal is like a refunding in that Chicago reduces its cost of borrowing, but it is not structured as a refunding and would avoid arbitrage-related refunding restrictions, federal officials said.
"It looks like a structure that avoids arbitrage restrictions through artificial and unreasonable methods of accounting and allocation of the use of the bond and loan proceeds," the federal regulatory official said.
Another federal official said that even if the bonds were found to be taxable, there would be no adverse tax consequences for the Illinois Development Finance Authority because the authority is not subject to federal taxation. However, the deal could be adversely affected because a change in the tax status of the bonds could diminish their value as collateral for the loan and could make them difficult to sell to public investors, participants said.
First Chicago's Morris said the transaction will meet all federal tax law requirements. "If we didn't think it did, we wouldn't do it," he said.
Morris said the transaction is unique and would not be repeated.
"This is something that's not going to be duplicated a million times," he said. Such deals can only be done with high-coupon bonds that are still outstanding and that were not refunded after 1986, he said. The Tax Reform Act of 1986 requires bonds being refunded for interest rate savings to be called at the first call date, he said. Most of the high-coupon bonds that were issued in 1981 and 1982 have already been called or were refunded after 1986, he added.
"There may be some others out there, but not many," he said.
