DALLAS -- Two Oklahoma taxpayers have withdrawn a lawsuit to recover damages from bond firms and others that profited from a controversial cash-management program after the Oklahoma City school board approved a resolution to refuse to pay arbitrage profits to the Internal Revenue Service.

"We feel it was both fair and necessary to withdraw the suit at this time," said Larry Patton, the attorney who represented the two taxpayers. "The ball is in the court of the Internal Revenue Service."

The suit, which was filed about two weeks ago in Oklahoma district court, sought to collect triple damages from the bond underwriter, bond counsel, tax attorney, and others who profited from an alleged arbitrage scheme investigated by the IRS.

Earlier this year, the IRS had demanded that the Oklahoma City school district pay more than $1 million in arbitrage profits, penalties, and interest for its sale of $30 million in tax-exempt tax anticipation and revenue notes during a fiscal 1990-91 cash management program. The IRS maintained that the school district appeared to have exaggerated a budget shortfall, and thus owed arbitrage rebate on the bonds.

The taxpayer suit contended that the bond firms, not the Oklahoma city taxpayers and district, should pay, citing Oklahoma state law that allows for the collection of triple damages resulting from unlawful or fraudulent conduct.

However, about 10 days ago, the Oklahoma school district board voted to refuse to pay more than $1 million it owed to the IRS. Among other things, the board attorneys maintained that using taxpayer funds to pay the IRS would be unconstitutional because the money would not be used for a public purpose.

"By such refusal, the district has eliminated, for the time being, any potential liability of the taxpayers of the district to pay demanded rebate, penalty, and interest," the plaintiffs for the taxpayer's suit said in their filing for dismissal last Friday.

In the meantime, the Oklahoma City school board is continuing to review its options concerning the IRS and future bond issuances. Jon Sellers, one of the board's attorneys, said the situation was expected to be discussed in executive session yesterday evening. "It's an ongoing situation," he said. "All issues are open for discussion."

Sellers said the IRS has not told Oklahoma City school district what action they are going to take.

But industry observers said options are limited if the school district does not pay the rebate. The IRS could declare the bonds taxable, and it could blacklist the Oklahoma City school district by revoking its tax-exempt status for future bond sales.

"The IRS wouldn't single out a particular issue, but [a blacklist] would apply to any bonds they would sell in the future," said Terrence Burke, a director at First Southwest Co. and an arbitrage rebate specialist.

Burke and other industry observers said they do not know what effect the board's move could have on the Oklahoma City school district plans to issue $90 million in general obligation bonds in mid-November because the IRS has not announced what action it will take.

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