WASHINGTON -- The Hemet, Calif., Housing Authority and the Internal Revenue Service approved an agreement this week that settles charges that the $17.8 million Fountains and $6.06 million Willows black box housing deals violated tax laws.

Capping about six months of negotiations, Hemet's city council voted unanimously to approve the agreement on Tuesday, and the IRS approved it yesterday, according to Steven Temple, Hemet's director of finance.

Although the agreement officially was between the Hemet authority and the IRS, it calls for the under-writing firms and lawyers involved in the two multifamily housing deals to pay the IRS $1.1 million. In return, the IRS will not revoke the tax-exempt status of the bonds, Temple said.

"We are not contributing any of the money," Temple said.

John R. Larson, a lawyer with Holmes & Graven in Minneapolis, represented the Hemet authority in the negotiations with the IRS, Temple said.

The Hemet authority issued the multifamily housing bonds in May 1986 and lent the proceeds to a developer to finance the construction of the Fountains and Willows apartment projects.

But the bond proceeds were locked into long-term guaranteed investment contracts, and the projects were never built.

The IRS contended that the two deals violated the tax laws' arbitrage rebate requirements, which took effect for housing bonds issued after Dec. 31, 1985. Although the two deals earned arbitrage, none was ever rebated to the federal government.

The IRS also found that the bonds were not used for a governmental purpose and that the two issues could be deemed taxable private-activity bonds.

The money paid to the IRS under the settlement agreement compensates the agency for the arbitrage or back taxes it should have received on the bonds.

Under the agreement, the bonds will retain their tax-exempt status and will remain outstanding until April 1996.

The underwriting firms, law firms, and lawyers paying the $1.1 million to the IRS are: Miller & Schroeder Financial Inc. in Minneapolis, the lead underwriter; First Bank [formerly The First National Bank of Saint Paul] in Minneapolis, another underwriter; James Warren Beebe, a retired lawyer in Los Angeles who was bond counsel; and Stubbeman, McRae, Sealy, Laughlin & Browder in Houston and Bankston, Wright & Greenhill in Austin, the law firms in Texas that served as counsel to the underwriters.

Other participants in the two deals that are not part of the settlement include: National Bank of Texas [formerly InterFirst Bank Houston] in Houston, the trustee for the issues; Abe Grossman, the Los Angeles-based developer that was to build the projects; Hanover West, Inc., formerly an underwriting firm based in Aurora, Calif.; Southwest Capital Investment Corp., which served as mortgage broker; Cambridge Credit Corp. II in Newport Beach, Calif., the letter of credit provider; and State Mutual Life Assurance Co. in Boston, the guaranteed investment contract provider.

The deals were called black boxes because they were complex and had cash flows that were difficult to trace. In the deals, which were done in the mid-1980s, the bond proceeds were supposed to be used for housing projects. The proceeds from the sale of participation interests in the mortgage notes were supposed to be used for credit enhancement.

But in many cases, as with the Hemet deals, third party investors were never found for the mortgage notes. Instead, the bond proceeds were used to acquire guaranteed investment contracts to back the letters of credit that paid debt service on the bonds.

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