WASHINGTON - A Harrisburg, Pa., authority was pushing forward yesterday with a complex transaction under which it would issue $780 million of tax-exempt refunding bonds and taxable bonds to finance a hydroelectric power plant and other projects, but some lawyers and federal officials say the deal could violate tax laws.

"Based on what we've heard about the transaction, there appear to be very serious concerns that the ~refunding' bonds may actually be taxable hedge bonds," said one federal official who did not want to be identified.

Critics contend that the transaction would basically be a hedge bond deal protecting the city or future borrowers from rising interest rates, and that the tax law generally prohibits the issuance of hedge bonds.

However, the tax law also contains an exception for refundings. The deal's participants argue the tax-exempt bonds would be refunding bonds because they would be used to pay off the debt service of a prior issue.

Another concern, the federal official said, is that the transaction is the latest of a series of refundings and remarketings of pre-1986 Tax Reform Act tax-exempt bonds that generated huge arbitrage profits for harrisburg but were never used for the proposed hydroelectric power plant and dam.

"All of this comes one week after the General Accounting Office told Congress that the Internal Revenue Service is not doing enough to enforce the tax-exempt bond laws and regulations," the federal official noted.

But participants in the transaction insist it would not violate any tax laws. They say it has been structured to avoid arbitrage earnings and will merely preserve financing for the hydroelectric project and dam and provide funds for other city projects. They insist the hydroelectric power plant will be built.

In the transaction, which was masterminded by C. Willis Ritter, special tax counsel and a lawyer with Ritter & Eichner in Washington, the Harrisburg Authority would issue $390.1 million of tax-exempt refunding bonds and $390.1 million of taxable bonds. Both borrowings would be backed by guaranteed investment contracts that would, in effect, cross over in about three years, according to the bond documents.

The tax-exempt bond proceeds would be used to redeem the $390.1 million of refunding notes the authority privately placed with Pittsburgh National Corp. last month to redeem a 1986 bond issue that was to finance the hydroelectric project and dam.

The escrow that had been in place for those notes, combined with an unspecified amount of money from the city, would be used to acquire a short-term GIC that would serve as security for the tax-exempt bonds for three years. The yield of the GIC would be restricted to the yield of the bonds.

The taxable bonds would be used to acquire a long-term GIC that would provide interest for the taxable bonds for three years.

At the end of the three-year period, the short-term GIC backing the tax-exempt bonds would cross over and be used to retire the taxable bonds. The long-term GIC backing the taxable issue would cross over and be used as security for the tax-exempt issue and to provide funding for the hydroelectric power plant, the dam, and other city projects. Participants of the transaction were not able to identify which projects might be financed under the program.

In fact, no money would be available for projects during the first three years after issuance, while participants of the transaction would reap sizable fees from the spread between the yields of the short-term taxable bonds and the long-term GIC. Ritter said that under the tax law, bond proceeds would not have to be spent during the three years if they were invested below the bond yield.

Though complex, the transaction would basically be a hedge bond deal that protects the city or future borrowers from rising interest rates, observers say.

Ritter maintains the tax-exempt bonds would be refunding bonds because they would be used to pay off debt service on a prior issue. The bond issue clearly meets the regulatory definition of a refunding, he says.

Several federal regulators and bond lawyers, however, say that while the bond issue may literally meet the definition of a refunding, it does not in substance appear to be a refunding. They say the transaction is more like a new-money issue disguised as a refunding because it is to be used to finance city projects that were never part of the original bond issue.

"The purpose of the financing has changed from the hydroelectric facility to a lot of unnamed facilities," said a bond lawyer who is familiar with, but not involved in, the transaction.

Even if the case can be made that these are refunding bonds, the bonds do not appear to qualify for the refunding exception to the hedge bond prohibition, the lawyers and federal officials said.

One of three criteria for the refunding exception is that the average maturities of the refunding bonds would not exceed the average maturities of the bonds being refunded. That means the tax-exempt refunding bonds, which would have a stated maturity of 2015, could not have maturities that exceeded the maturities of the refunding notes that were issued last month.

Most city officials and market participants believe the authority issued 90-day notes last month. Several city officials interviewed by The Bond Buyer said the city council only agreed to a 90-day loan. The preliminary official statement for the pending transaction refers to the refunding notes issued last month as "revenue refunding bond anticipation notes."

Robert H. Long Jr., a lawyer with Rhoads & Sinon in Harrisburg, co-bond counsel on the note issue, stressed last month that the notes had a stated maturity of 2025 and could be reset every three months.

But the federal officials and lawyers said that even if the notes had stated maturities of 2025, they may substantively have been 90-day notes.

The pending transaction raises other troubling questions, several market participants said. If the city claimed in the past that it needed $390.1 million of bonds to finance the hydroelectric projects, they asked, how could it make funds from this latest $390.1 million bond issue available for other projects and still finance the hydroelectric projects?

An adviser to the city said funds borrowed for other projects would eventually be replaced.

Market participants also want to know how the city will be able to finance the project if it is approved by federal and state officials during the next three years, since the bond proceeds would be locked into the GIC during that period. But the adviser said the city could obtain interim financing.

Meanwhile, at least one of Harrisburg's city council members was angry yesterday after learning that a syndicate of bond firms led by Commonwealth Securities and Investments was trying to sell the bonds. O. Frank DeGarcia, a long-time member of the city council and chairman of the public works committee, said he had been assured the tax-exempt bonds would not be sold until he holds a public hearing on the transaction on Monday and until the city council approves it. Participants in the deal, however, said city council approval is not needed for the bond issue.

There was confusion over the date the bonds would be issued. Ritter said it would be later this month. Another participant said the bonds would be issued today. But bond firm officials pointed out that the syndicate of bond firms was trying to sell the bonds yesterday.

In a related matter, state officials said the state's Environmental Hearing Board has just issued an order alerting the city that it would have to seek a water quality permit from the state. The state already has denied the city a dredge and fill permit for the project. The city appealed that decision, but officials with the state's Department of Environmental Resources have vowed to fight the project through the state courts if the decision is overturned.

The project is also opposed by other state agencies, federal agencies, and environmental and recreational groups, state officials said.

Some state officials and many observers contend the hydroelectric power project was never feasible because of the opposition and because the projected power costs were too high to be competitive.

The city of Harrisburg first issued bonds for the hydroelectric power plant and dam in 1985. In 1986, the city issued more bonds for the project. The 1986 issue was remarketed in 1988 and 1991 and refunded last month.

In the latest transaction, co-bond counsel is Rhoads & Sinon and Stevens & Lee in Reading and Harrisburg. Devon Capital Services in Harrisburg is financial adviser. Dauphin Deposit Bank and Trust Co. in Harrisburg is trustee.

Long of Rhoads & Sinon, trustee officials, and project manager Dan Lispi did not return phone calls for comment on the bond deal and hydroelectric project. David Vind, a lawyer with Stevens & Lee refused to comment on the transaction.

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