WASHINGTON -- A $3.9 million municipal junk bond issue that was sold, insured, and resold a day later for $20.5 million appears to have been an arbitrage-driven deal designed to bail businessmen out of a financially troubled marina and reap huge profits for market participants, industry and federal officials said.

The parties to the June 13, 1989, issue and June 14 reoffering of the Marengo County, Ala., Port Authority bonds contend they did not violate tax laws or improperly benefit anyone. They said the bonds were issued to help the port authority save the ailing marina and were insured through a reoffering to protect bondholders against any losses.

But lawyers and municipal industry and federal officials who did not want to be identified said the transaction is among the most questionable they have seen and that the tax exemption of the bonds could be challenged. They made their remarks after reviewing the bond documents, the appraisal of the marina, and an arbitrage analysis.

They also said the transaction is representative of a growing number of such deals that have surfaced recently in the municipal bond market. They report having seen half a dozen such deals in the market in recent months.

These deals have structures similar to so-called gray box transactions in which a credit enhancer ends up with money that it invests without regard to restrictions on arbitrage profits. But they differ from gray box deals in that the credit enhancer appears to get the money it invests from bond proceeds rather than from the sale of a mortgage note.

Industry and IRS officials have been debating whether gray box deals are aimed at saving troubled housing projects or at skirting arbitrage restrictions. These deals have more traditional credit enhancement and and may not present any tax law problems. The IRS is currently studying such structures. The port authority transaction appears to take such a structure to an extreme.

Gray box structure taken to extreme, lawyers say

One lawyer from New York who is concerned that gray box-type structures invite abuse complaint, "In the absence of IRS guidance on gray boxes, we're seeing a lot of people trying to use credit enhancement devices to shield arbitrage investment."

In deals that appear to be taking the structure to an extreme, a private company or partnership that is billed as a credit enhancer, but that has no credit rating and few assets, provides credit enhancement for municipal junk bonds.

The bonds are then rated triple-A by a rating agency because money has been set aside to pay the debt service and are reoffered to investors at premium prices. Most of the proceeds from the reoffering are indirectly used to pay the credit enhancer, which then invests that money in high-yielding securities to back the bonds.

Instead of providing what is typically viewed as credit enhancement, the credit enhancer is setting up an invested sinking fund that will guarantee the payment of debt service. As a result, the credit enhancer earns arbitrage that the issuer could not because of the tax laws' yield-restriction requirements.

In the Marengo County Port Authority transaction, two Bermuda companies -- AROD Holdings Ltd., a short-lived company that was dissolved three months after the reoffering, and Investors Guaranty Fund Ltd., an insurance company with little operating experience, limited assets, and no credit rating -- appeared to serve as a "front" to earn arbitrage rather than to provide real insurance for the bonds, the industry and federal officials contended.

"It looks like the insurance company was acting as a shell to set up a sinking fund to pay off the bonds rather than as a true guarantor for the bonds," said another New York lawyer who had reviewed the bond documents and is familiar with such deals.

Some of the people on the buy-side of the deal were also on the sell-side, raising conflict-of-interest questions such as whether the purchase proce of the marina facilities or the price of the insurance premium represented fair market values under the tax laws, the industry and federal officials said.

The $3.9 million junk bond issue was sold to finance the port authority's acquisition and improvement of a small marina complex on 2.65 acres of land near Demopolis, Ala., a town with a population of about 7,800. The marina is located one mile from where the Tombigbee River meets the Black Warrior River and is the only full-service marina for a stretch of about 300 miles between Mobile and Pickensville.

Mostly used for pleasure boats, the marina also provides fuel for commercial tow boats. The marina facilities include a duck with 76 boat slips, a marine lift, fuel facilities a metal maintenance building, a general store, and a small restaurant.

When the bonds were sold, the Internal Revenue Service had seized, and was threatening to sell, some of the facilities because the private owners owed the IRS almost $100,000 in back withholding taxes for employees.

The port bonds were zero coupon bonds, with yields ranging from 13.90% to 14.4% and maturities from 2005 to 2019, according to bond documents. More than half were noncallable under any circumstances so that, even if there was a default and the marina folded, the bonds would continue to remain outstanding for years until they matured.

Debt service on the issue, none of which was due until the bonds matured or were redeemed, would be $138.5 million, according to an arbitrage analysis done by BDO Seidman of Oklahoma City, which has since become Grant Thornton.

The authority sold the bonds to Blount Parrish Roton Inc., a broker-dealer in Montgomery, Ala., which in turn sold the bonds to AROD Holdings, the bond documents say. AROD, which appears to have been set up specifically for the deal and held the bonds for less than 48 hours, paid Investors Guaranty an insurance premium of $12.75 million.

Investors Guaranty, using the premium and some of its own funds, paid $14.5 million for U.S. government-backed bonds, which were put in an insurance trust fund held by the Bermuda Trust Co. Ltd., a subsidiary of The Bank of Bermuda Ltd., to secure the junk bonds, according to the arbitrage analysis and participants.

AROD then resold the bonds as insured to Blount Parrish and Prudential-Bache Capital Funding. The bonds were rated AAA by Standard & Poor's Corp. and sold to investors at premiums ranging from 12% to 32% above their par or principal amount for a total of $20.5 million. The yields on the reoffered bonds ranged from 7.20% to 7.30%. The insurance trust funds were invested at a yield of about 8.66% to earn enough arbitrage to cover the $138.5 million debt service, according to the arbitrage analysis.

Blount Parrish and other parties to the junk bond deal such as Rushton, Stakely, Johnston & Garrett P.A., the bond counsel, received a total of $405,000 in fees and an underwriter's discount -- more than 10% of the face amount of the issue, according to the bond documents.

Participants in the $20.5 million reoffering, which included the two broker-dealers and two special tax counsel firms, refused to disclose their fees, but said most of the money went to AROD. The special tax counsel firms were Fagin, Brown, Bush, Tinney & Kiser of Oklahoma City and Haskell Slaughter & Young of Birmingham, Ala.

Most of the participants of the bond issue and the reoffering claim that these were separate transactions and that neither was subject to arbitrage restrictions. One party that helped structure the reoffering, however, said the underwriters had warned they could not sell the junk bonds unless they were credit enhanced.

Theodore Jackson, a lawyer with Rushton Stakely, said the junk bond issue was not subject to arbitrage restrictions because the authority spent the proceeds within six months to acquire and improve the marina. Under the tax laws, most governmental issuers are exempt from rebate if they spend the bond proceeds within six months.

The participants in the reoffering said that it was not subject to arbitrage restrictions because it was a secondary market transaction that involved private parties, not the authority.

However, William Slaughter and Robert Shattuck Jr., lawyers from Haskell Slaughter, one of the special tax counsel firms, said they concluded that some yield restriction was necessary under a "belts-and-suspenders" approach that relied on a more conservative theory.

They found the insurance trust funds should be yield-restricted, but not below the yield of the reoffered bonds. They said that the insurance premium could be treated as a "qualified guarantee."

Rebate rules issued by the Treasury Department in 189 allow issuers to treat credit enhancement that meets certain criteria as a "qualified guarantee" that can be used to adjust the bond yield upward to allow for a higher investment yield. The idea behind the concept is that credit enhancement lowers interest costs and, therefore, should be treated as an interest payment or expenditure.

But the lawyers and industry and federal officials who reviewed the deal said the premium paid to Investors Guaranty did not meet the criteria for a qualified guarantee because it was unreasonably high and because it was used for a primary rather than secondary source of funding for debt service.

The federal tax laws do not set standards to show what constitutes a reasonable premium. But according to credit enhancement experts, municipal bond insurers typically get premiums of less than 1% of debt service. The few credit enhancers that insure junk bonds rarely charge premiums of more than 3% or 4% of debt service, they said.

Investors Guaranty's premium was roughly 10% debt service and three times the size of the face amount of the junk bonds. These experts also said that bond insurers typically insure bonds on the basis of their credit rating and assume some risk that the issue might default. But Investors Guaranty had no rating and little capital and took virtually no risks because the securities it put in the trust fund would pay debt service.

Participants of the transaction argued that Investors Guaranty did take a risk because it used some of its own money for the trust funds; however, they refused to reveal that amount. They said the primary source of payment of debt service was the marina revenues, not the trust funds. An appraisal, they said, concluded that the revenues of the marina facilities would be sufficient to pay the $138.5 million of debt service.

But the appraisal, which was done in 1987 by American Appraisal Associates Inc. of Milwaukee, indicated that the only way marina revenues would cover debt service was if they were invested in a sinking fund at rates of 10% to 11%.

One party to the deal said that, even though the marina is operating at capacity today, it is bringing in far less revenue than what the appraisal projected would be needed for debt service.

The lawyers and industry and federal officials said the junk bond issue and reoffering were a single arbitrage-driven transaction and that Investors Guaranty had been used to set up a sinking fund that should have been yield-restricted, rather than to provide true insurance.

IRS officials refused to comment on the deal. But one federal official said the $20.5 million from the reoffering should have been considered either sales proceeds or sinking fund proceeds that should have been yield-restricted.

Special tax counsel defend bonds' tax status

Mr. Slaughter and Mr. Shattuck, the special tax counsel from Haskell Slaughter, disputed that view. "We strenuously defend the tax-exempt status of the bonds," Mr. Shattuck said.

Mr. Slaughter said, in a recent letter to The Bond Buyer, that lawyers often disagree over complex tax law issues. He also said that the "market's requirement of a brief, unqualified opinion in standard form" creates "special difficulties" for bond and tax counsel because it does not reveal their analysis of the tax issues in the bond documents.

Mr. Slaughter said Investors Guaranty was providing "a fairly common insurance device" used in Bermuda. Mr. Shattuck also said that the IRS, i a 1981 letter ruling, concluded that if an insurance company collateralized its obligations, the collateral was not subject to yield-restriction requirements.

But other lawyers with expertise in credit-enhanced transactions said letter rulings apply only to those that receive them. They said that the IRS probably would not have ruled so favorably in the 1981 ruling if, like the Marengo deal, the bond proceeds had been used for the collateral.

One participant who helped structure the reoffering defended it by claiming Investors Guaranty was filling a niche in the bond market by providing a "special insurance technology" to help municipal issuers get insurance for junk bonds that is not available from the big U.S. bond insurers.

But critics of the deal said that the insurance did not lower the port authority's interest costs, which are still accruing at rates of 13.90% to 14.4%.

Small-town relations versus conflict of interest

An official from one major bond insurer said he was offended by the transaction. "This is an arbitrage play; it's improper arbitrage," he said, adding, "We all have a vested interest in keeping the municipal bond industry clean and this is not something you would want to write home about."

Besides arbitrage concerns, lawyers and industry and federal officials raised conflict-of-interest questions about the deal. According to the bond documents, several port authority and investors Guaranty directors were part-owners of or were affiliated with the marina facilities and benefited from the bond financing.

William Blount, of Blount Parrish, and other participants denied there were conflicts of interest and said most of the relationships were disclosed in the bond documents.

Several lawyers who reviewed the documents, however, said conflicts of interest are not eliminated just because they are disclosed.

"Practically everybody in this deal is related to either the seller or the lender," said one of the lawyers from New York. "I understand this is a small town, but this is ridiculous."

Another lawyer in the Midwest agreed. "This certainly smells like conflict of interest," he said, adding that some of the officials connected with the authority "are taking the money that bails them out."

The chairman and president of the authority's board, Hugh Lloyd, was also a director and chairman of the board of Robertson Banking Co., a bank in Demopolis that had made loans to the marina that were paid by the bonds. T.M. Culpepper 3d, another director of the authority, was also a director of Robertson Banking Co. They abstained from voting on the bond issue, according to the bond documents.

W.W. Dinning Sr. and W.W. Dinning Jr., lawyers with Lloyd, Dinning, Boggs & Dinning, the law firm of Mr. Lloyd that represented the authority, had guaranteed notes to the marina that were paid with bond proceeds.

Both Dinnings and another authority director, R. Phillip Anderson, were minority shareholders in the restaurant that was acquired with bond proceeds. Mr. Dinning Jr. was also a minority shareholder of the marine lift. He was expected to serve as a consultant to the marina and to continue to represent the authority after the marina was sold, the bond documents said.

Mr. Dinning Jr. also denied there were conflicts of interest in the junk bond deal. "I can honestly say that no person I am aware of benefited one whit," he said.

D. Patrick McCoy, a director and minority shareholder of Investor Guaranty, was a past owner of, and a lender to, the marina. He also had a partnership interest in the marine lift. His loan was repaid, and he got money from the sale of the lift and fees for helping to structure the reoffering.

Douglas L. King, a director and minority shareholder of Investor Guaranty, also got fees for helping to structure the reoffering, the bond documents said.

Scott J. Brown, a lawyer with the Fagin firm, the co-special tax counsel, became a director of Investors Guaranty after the reoffering, according to the law firm in Bermuda that registered the company.

The junk bond issue and reoffering have come under scrutiny before; they were the subject of an investigation by the National Association of Securities Dealers.

That investigation, which focused on securities law issues rather than tax law issues, led the NASD last year to censure and fine Blount Parrish $50,000 and Prudential-Bache $90,000 for "significant failings in the due diligence conducted."

The NASD order said broker-dealers have an obligation to thoroughly investigate the financial capability of the issuer and the insurer as well as the reasonableness of insurance premiums and whether money is actually exchanged at each level when more than one transaction is involved.

Mr. Blount said the NASD fined the underwiters because they "did not do enough due diligence, beyond the rating agency, on the insurance company." He refused to elaborate. Officials from Prudential-Bache declined to comment.

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