Taxable Refunding Of Utah Pool Raises Reissuance Concern For Treasury, IRS

WASHINGTON -- Bond firms and lawyers said they refunded part of a 1988 tax-exempt hedge bond pool to make the pool work, but federal officials say the refunding may have triggered a reissuance that threatens the pool bonds' tax-exempt status.

At issue is a recent $53.86 million taxable refunding of part of a $200 million tax-exempt hedge bond pool that was sold in July 1988 for the Utah School District Finance Cooperative -- an emerging kind of transaction that industry officials said could become popular if not for the Treasury's concerns.

Some of the participants in the deal -- which included Kirchner Moore & Co. and the law firm of Arter Hadden Haynes & Miller -- said it was designed to produce subsidies to encourage school districts to obtain loans from the 1988 pool.

No loans have been made from the pool because, with falling interest rates, it could not compete with other lenders. School districts would have to borrow from the pool at a rate of about 8.75%, when they can get loans from other lenders at rates of between 6% and 7%.

The refunding produced a $523,306 fund to subsidize borrowers, as well as $500,000 for a new administration building for the issuer, in part because the underwriters were able to sell the issuer Treasuries at below market prices for the defeasance portfolio.

"We changed a program that didn't work to one that has economic benefit," said one source close to the deal who did not want to be identified.

"You've got a lot of these pools out there," said another such source. "These pools have high interest rates, and they are worthless to everybody."

He added that deals like this "at least make these pools usable."

But federal officials said they are concerned that the deal -- in which the underwriters purchased some of the 1988 bonds, increased their value through the taxable refunding and then sold them for a profit -- may have triggered a reissuance that threatens the tax exemption of the 1988 bonds.

"Treasury and the Internal Revenue Service are very concerned about this transaction and are looking into whether or not a reissuance has occurred," a Treasury Department official said this week.

"The bondholders, which in this case were the underwriters that purchased the bonds, made a payment to the issuer," the official said. "That payment has the economic effect of reducing the interest costs on the issue to the issuer. We are concerned that the change in the interest rate to the 1988 bonds may be a material modification of the terms of the 1988 bonds."

"It is not normal for a bondholder to make a payment to the issuer, other than when he buys the bonds or is paying accrued interest," he added. "The bondholder is, in effect, paying the issuer to do something that he otherwise would not do" such as changing the security of the bonds.

The payment results from the underwriter's sale to the issuer of Treasuries at below-market prices. The security for the $53 million of bonds, which had been an investment agreement from Swiss Bank Corp., is now the defeasance portfolio of Treasuries. Under the tax code and IRS rulings, a reissuance occurs whenever there is a change in the terms of the bonds, such as a change in the rights and remedies of the bondholders.

If the taxable refunding did cause the 1988 bonds to be reissued, they would no longer be tax-exempt because the portion of the guaranteed investment contract backing the taxable bonds was not invested at or below the yield of the reissued bonds, according to Treasury and industry lawyers.

The 1988 pool had been underwritten by Kirchner Moore, then a subsidiary of Drexel Burnham Lambert, and Boettcher & Co. Earlier this year, they offered to buy the 1988 pool bonds from investors at premium prices. They were able to buy about $53 million of the bonds.

In July, the trustee bank, Key Bank of Wyoming, held a lottery to determine which of the $200 million of pool bonds would be subject to annual mandatory sinking fund redemptions beginning in 1993. Of the $53 million of bonds purchased, almost $44 million would not be called before 1998.

In August, the school district cooperative issued $53.86 million of taxable refunding bonds to refund the $53 million of bonds held by the underwriters. The proceeds were used to buy the Treasuries to defease the bonds.

Participants in the deal said the value of the refunded bonds increased by 500 to 600 basis points from the change in security. The lottery also may have added to their value by establishing which bonds would be called before 1998. The underwriting firms sold the bonds to investors, at premium prices ranging from 104.4% to 113.5% of the principal amount, for a huge profit.

Besides the profit from the purchase and sale of the bonds, the firms got an underwriter's discount of $550,606. They also may make additional money from remarketings of the taxable refunding bonds, which are subject to mandatory tender purchases in 1992 and 1993, and from any loans made with subsidies.

Bond documents say the cooperative "recognizes that certain professionals such as underwriters, lawyers, and others contributed to the issuance of the bonds" and "reserves the right to deny any application for a subsidy if the application does not utilize the professionals the governing body [cooperative] assigns."

The underwriters included Kirchner Moore, a division of George K. Baum & Co., and Boettcher & Co., a division of Kemper Securities Group Inc. Chapman & Cutler was bond counsel, and Arter Hadden was underwriter's counsel. Lawyers from Arter Hadden refused to comment on the deal. Officials from Kirchner Moore did not return several phone calls.

Other participants of the Utah deal said they were confident there was no reissuance problem. "We feel very, very comfortable with all of the legalities relating to the issue," said one lawyer involved with the deal, "We spent months and months dealing with the legal issues."

But market participants said the Treasury's concerns could put a damper on these kinds of deals, which are being pushed in the market.

"A lot of people are trying to do the same thing," said one industry official. "There are investment bankers who are inventive. They don't have enough new deals so they get creative with the existing ones. They want to know, how can I make some dough? How can I take advantage of these tax-exempt rates?"

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