WASHINGTON -- A revenue ruling issued last month by the Internal Revenue Service to crack down on bond deals involving bogus insurance covers similarly abusive transactions even if they are structured differently, a Treasury official said last week.
Revenue ruling 94-42, which is retroactive, was designed to quash bond deals in which the participants or an outside party use bogus insurance or some sort of security for the bonds to generate huge arbitrage profits, the official said.
Several bond lawyers and investment bankers have interpreted the ruling to apply only to deals with bogus insurance, since the abusive deal cited in the ruling as an example involved insurance that was not used as true credit enhancement, but rather as a shield to hide an arbitrage scheme.
"I was surprised at how narrow the ruling is," said a bond lawyer in New York City who did not want to be identified. "It really focuses on insurance."
But such interpretations of the ruling are incorrect and far too narrow, a Treasury official said on Friday.
"You don't have to have your name in the ruling for it to apply to you," the official said.
"We picked the toughest case as an example of the abuse, the case that had the most complexities and the most smoke and mirrors, and we concluded that it didn't work," he said. "If that case doesn't work then it should be obvious that other versions of it don't work."
In the transaction cited in the ruling, a county issued zero coupon bonds with a 30-year maturity and a stated redemption price of $204 million. One year later, in an unrelated transaction, the investor who bought the bonds paid a $14 million premium for insurance for the bonds. At that time it appeared that there would not be enough revenue from the county's bond-financed facility to pay debt service.
The "insurer" then bought $14 million of Treasuries to guarantee payment of "substantially all" of the debt service on the bonds. The bonds were given a higher credit rating and resold at premium prices. Participants reaped huge profits from the spread between the 8.3% yield of the reoffered bonds and the 9.6% yield of the Treasuries backing the bonds.
Even though this hypothetical deal involves bogus insurance, the Treasury official said, the ruling would apply to similarly abusive deals that have different structures or different circumstances.
For example, he said, the ruling would apply to such deals even if the insurance premium was purchased at the time the bonds are issued in a related transaction rather than a year later.
The ruling would also apply whether the bonds were purchased at issuance or in a secondary market transaction, the Treasury official said.
The ruling might apply in cases where the participants have a feasibility study showing that project revenues will be sufficient to pay debt service on the bonds, he said.
In addition, the ruling could apply to deals in which there is no bogus insurance involved at all. In these deals, Treasuries or other securities could be purchased and put into an escrow to back the bonds and they would still violate the ruling, the Treasury official said.
In another potentially abusive structure that would be covered by the ruling, the issuer might issue $100 million of bonds for legitimate needs and $100 million of zero coupon subordinate bonds. The subordinate bonds would be sold to the underwriter or another party that would use them to buy security for the bonds.
Many variations are possible in the structure of such deals, the Treasury official said. The common factor is that some type of security for the bonds is used to hide an arbitrage scheme, he said.
The Treasury official complained about those who are trying to interpret the revenue ruling narrowly.
"If the ruling had been favorable then everybody would be falling all over themselves to say it applies broadly," he said.
The transaction cited in the ruling appears to be similar to a deal done in 1989 by the Marengo County (Ala.) Port Authority. In fact, many bond lawyers think the Marengo County deal prompted the IRS to write the revenue ruling.
But a lawyer from the firm that served as special tax counsel for that deal said recently that the ruling has nothing to do with the Marengo County deal. "I do not think this ruling applies to it," said William Slaughter, who is with Haskell Slaughter Young & Johnston in Birmingham, Ala.
"That was a perfectly legitimate and defensible transaction," Slaughter said of the Marengo County deal.
In the Marengo County deal, $3.9 million of municipal junk bonds were issued. They were then "insured," given a credit-rating of triple-A, and resold a day later for more than $20 million. The proceeds from the reoffering were used to pay the "insurer," a Bermuda-based bank, a premium of about $12.75 million, which then purchased enough taxable securities to fully pay the debt service on the bonds.
Slaughter said as far as he knows, neither he nor anyone else connected with the transaction has been contacted by the IRS or the Securities and Exchange Commission. The two agencies do not appear to be investigating that deal, he said.
