New Jersey Official Was On the Alert For "Special" Deals
Lawrence L. Singer, former public finance director of New Jersey, had heard about some shadowy lease deals, so he asked a few bond firms who work for the state to be on the lookout.
"I felt there may be some deals around that purport to be New Jersey deals," he said.
His alert paid off last fall. One of the firms sent him a copy of a letter from a New Jersey lease dealer to individual investors advertising a "November Special," a $1.3 million state and federally tax-exempt "issue" billed as a "direct obligation of the state treasury" that the firm was negotiating with the state.
The issue would have maturities of one, two, and three years, with yields of 7%, 7.25%, and 7.5%, respectively, according to the letter, signed by Robert L. Maggs, senior vice president of First Interregional Advisors Corp., the leasing affiliate of a New Jersey investment firm specializing in sales to retail investors.
Those rates were lucrative -- more than two points above the yields on the state's own short-term paper at the time, Mr. Singer pointed out. But the letter did not mention that the "issue" was apparently an amalgamation of private lease contracts for state copier equipment, fire engines, and police cars that the state was negotiating with vendors.
"This was being circulated as if it was an approved obligation of the state, as if the state approved the issuance of these bonds," said Mr. Singer, who recently stepped into a new post overseeing the state's pension funds. "That was a mis-representation, because the only thing we approved was an obligation subject to appropriation, which is a lot less than a bond.
"The phrase 'direct obligation' is particularly misleading to a less sophisticated type of investor because it's so close to the term 'general obligation,' which has a specific legal meaning," he said. And the talk of negotiations between the firm and state treasury officials, he added, was a "blatant fabrication."
Samuel Goldstein, a Florida investor who received the firm's letter, said he had suspected its veracity. It was one of a series of unsolicited circulars First Interregional has sent him to advertise lease offerings, he said. The yields were "impossible," Mr. Goldstein recalled. "When something looks too good to be true, it's not to be touched." He said he has never bought any of the instruments, and usually throws away the circulars.
To Mr. Singer, the letter provided the evidence he had been seeking of a cottage industry in the undisclosed sale to investors of lease contracts that had been privately negotiated by New Jersey and other states. "We knew that the money to pay for the leases had to come from somewhere. I always suspected that we'd come across this market," he said.
Mr. Singer conferred with the state attorney general's office and decided to confront the dealer. Inquiries to Mr. Maggs of First Interregional were referred to the firm's general counsel, Andrew M. Heath 3d.
Firm Concedes Misstating Terms of the Lease Deal
Mr. Heath said he conceded to the state that the term "direct obligation" incorrectly suggested the leases were virtually equivalent to bonds. First Inerregional has dropped the phrase because of Mr. Singer's objections, he said.
The firm also stopped saying it negotiates such deals directly with the state, he said.
Mr. Heath insisted that the dispute was primarily "semantic," however. "The state has not pledged to pay these particular lease holders, but it has made a promise which is typical in any lease contract" to be diligent in making payment to the vendor, he said. The vendor was planning to pass on the rights to those payments to investors, as permitted in the lease contract, he said.
Mr. Heath denied any possible disclosure problems with the circular, saying the issue would not come under the Securities and Exchange Commission's official sltatement rule or other public offering requirements because it did not qualify under securities laws as a public or long-term offering.
"We take the position, as do dozens if not hundreds of firms throughout the country, that lease payment obligations are promisory notes," he said.
"What is there to disclose, anyway? We're not defrauding investors by not giving them the state's balance sheet in three cardboard cartons. That would be unnecessary and burdensome in this transaction," he said.
But Mr. Singer wasn't at all satisified with Mr. Heath's explanations.
"We are not the party the bondholder ought to be looking to" for payment, he said. "The bondholder has a contract with the lessor, not the state. Any confusion on that point can be very damaging to us."
Mr. Singer, who describes himself as a "fairly shy person," wanted to make sure the leasing firms got the point. So he sent registered letters to both firms spelling out that the proposed lease issue was not a "direct obligation" and disavowing any participation in the transaction.
The letter also questioned the basis for claiming federal tax exemption for the issue. The state usually files federal tax forms stating that equipment it lease-finances will be used for public purposes, Mr. Singer said, but that is not a sufficient basis for claiming tax exemption.
Richard Nicholls, attorney with Mudge Rose Guthrie Alexander & Ferdon, agreed that the tax filing "doesn't automatically make interest on the lease tax exempt." He said the sellers would also have to determine that the financing complied with the tax law's private-use restrictions, arbitrage limits, and other provisions. But Mr. Singer said, and Mr. Heath confirmed, that no one had contracted the state to make such a determination.
Besides raising these points, the letter Mr. Singer sent to the lease dealers warned investors that the state would not take responsibility for the issue if problems developed. "It cannot be stated strongly enough that the investors need to know what they are getting into," he said.
The state's show of force had the desired impact. "We just dropped it," said Thomas Wittwer, president of Government Leasing Corp. of Colorado, the lease whoelsaler in the deal. "I'm a small businessman. There's no way I want to be fighting the state of New Jersey. Besides, there's a lot of this business out there, and it wasn't worth the aggravation."
The vendor in the deal, whom Mr. Singer said he was unable to ascertain and Mr. Wittwer and Mr. Heath refused to identify, had to find a way to finance the lease transaction through private channels, Mr. Wittwer said. "Because of the small numbers, we couldn't COP it," that is, issue certificates of participation, he said.
Mr. Heath confirmed that his firm scuttled the deal, though he maintained it would not have been illegal or unethical. "This was not a ruse. It was kosher," he said.
Mr. Wittwer and Mr. Heath maintained that the incident boiled down to a dispute between big business and bureaucracy on the one hand, and small equipment vendors and leasing firms on the other. The small firms have played an important role in providing financing for small state and local equipment purchases in the last decade, they said.
Government need the flexibility to make such small purchases as well as large ones through off-budget lease financings, especially in the antitax and anti-debt environment that arose in the 1980s, Mr. Heath said.
"There's no way the large underwriters would even look at these small deals. Most major investment houses will not even look at anything under $10 million. They thumb their noses," Mr. Wittwer said. "We fill that niche in the market. We provide a valuable service."
Mr. Heath said small leasing firms can place small lease note at less cost because they do not have to go through the machinations of large public offerings. "The absence of transaction costs is what makes this sort of thing fly," he said.
Mr. Singer agreed that the small vendors and financiers play an important role. "I don't have a problem with the business," he said. "I have a problem with the misrepresentations" being made by some firms who are "out to make some fast money."
Some Lease Dealers May be Overcharging
In particular, Mr. Singer said some firms may be price gouging. He said they negotiate a private lease contract at taxable interest rates, claiming they will have to get taxable bank finacing to underwriter the deal, and then turn around and sell the paper to private investors at much lower tax-exempt rates.
State and local government officials say most of their private lease contracts are negotiate at taxable rates, which may be twice as high as their tax-exempt rates. New Jersey, Washington, and other states reported contact with rates typically around 10% to 11%, but ranging up to 14%.
These high rates enable the dealers to unload the paper on the tax-exempt market at yields significantly higher than those on the issuers' own securities, and still make a handy profit, Mr. Singer said.
"People need to be aware of the arbitrage potential between the taxable and tax-exempt rates," he said. After the incident with First Interregional, he said he undertook a campaign to "educate" officals around the state who negotiate lease contracts to be wary of any sleight of hand, and to require vendors to say whether they intend to get taxable or tax-exempt financing.
Mr. Wittwer agreed that some vendors may have the intent of reselling their lease contracts at tax-exempt rates, even as they negotiate taxable rates with the issuer. But he said the vendors usually do not know for sure where their financing will come from at the time they negotiate the contracts.
All of the lease dealers interviewed denied that they make inordinate profits, even with the large. spreads between the lease rates and market rates. Mr. Heath, who said 11% was not an unreasonable rate for lease that are ultimately sold as tax-exempt, said the lease rates have to be high to attract investors to such unrated paper.
Rates also must be high because the paper passes through so many hands -- including wholesalers who buy the leases from the vendors, as well as retail investment banking firms -- all of whom hope to make some profit, he said.
"There's got to be enough room for everyone involved to make money. There's got to be room if this type of business is to continue," he said.
Mr. Heath presented a challenge to Mr. Singer and other issuers who think the rates they are paying are unfair. "If they're indignant that people are making money, they can offer to do lease deals at whatever they feel are the proper rates, and see if there are any takers," he said.
Mr. Singer said he has done exactly that and has reaped enormous benefits for his state. When Bell Atlantic Corp. asked to sell $90 million of taxable state leases it had in its portfolio as tax-exempt last November, he insisted that a good portion of the savings -- between $12 million and $15 million -- be passed on to the state, he said.
The state has also been getting better rates on its vendor lease deals, he said, while, in an innovative transaction, it recaptured a significant amount of interest on a New Jersey transit building lease that recently was securitized and sold in the tax-exempt market.
"People have to understand that everythin is being securitized these days. There's a secondary market for everything," he said.
That trend is "not necessarily bad, if you keep it in mind in negotiating the transactions," he said.
The state now imposes concessions on vendors who want to resell their leases to the public, including requiring them to renegotiate their contracts so the state also benefits from the sale, in exchange for getting the state's permission to use its financial statements and disclosure language, he said.
"Issuers can be saving themselves money if they take control and don't see this as a gross negative, but rather as something that needs to be managed," he said.