O.C. School Accounting Under Scrutiny by SEC

The U.S. Securities and Exchange Commission has questioned many Orange County school officials whether local districts improperly inflated their projected deficits last spring to increase the amount of money they could borrow and up their stakes in the county’s high-yield investment pool.

Apparently at the urging of a financial adviser and bond lawyer, many local school districts passed resolutions last spring to restrict money they expected to have left over from the budgets they were operating under at the time, so those funds would not be taken into consideration as they calculated their budget forecasts for the year to come.

Restricting such surplus funds helped circumvent an IRS rule that limits the amount of tax-exempt debt a governmental entity can issue. By reducing the amount of cash on hand, the fund restrictions effectively increase any projected deficit the debt issuance is designed to cover.

“It may well come down that the restriction of the ending balances is not something we should have been doing,” said one school finance officer, who spoke on the condition he not be named. “We’ve learned a lot of things out of this whole mess.”

John Nelson of the Orange County Department of Education is one of several school officials throughout the county who said they were asked about the issue during interviews with the SEC, which is conducting a wide-ranging probe in the aftermath of the county’s Dec. 6 bankruptcy filing.

“People are asking questions. Obviously, people are looking at it closely,” Nelson said. “The bond counsel and financial adviser told us this was within the rules--you pay good money for this advice. We did not think we were doing anything wrong.”

SEC officials in Los Angeles and Washington declined to comment on the issue because the agency has a policy prohibiting them from discussing ongoing investigations.

Several people familiar with the situation wondered whether the SEC would actually have jurisdiction over the matter. The school districts would more likely face problems with the IRS, since the strategy appears to stretch the provisions of the federal Tax Code.

A spokesperson for the IRS at its Laguna Niguel office also declined to comment.

Schools districts and other government agencies routinely issue Tax and Revenue Anticipation Notes (TRANs) to cover expenses in the dry months before property taxes roll in. TRANs proceeds are invested and earn interest until they are spent, with the investment proceeds considered a side benefit.

With larger issues of TRANs, districts could reap more in interest earnings--particularly in Orange County, where the investment pool typically earned yields several percentage points higher than the cost of borrowing.

“It’s a loophole that counsel found that we could do,” said John Edinger, acting director of business services for the Orange Unified School District.

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Though Edinger described himself as too conservative to use the fund-restriction strategy, he said he understands his colleagues’ motivations.

“If the laws allow you to do it, and it gives you more money, you do it. If you’re trying to find more money for your school district, you do whatever you can,” Edinger said. “It’s so hard for school districts to get more money--this is one avenue you can use.”

Officials at several districts said they passed resolutions restricting their surplus funds at the suggestion of Ken Ough of Rauscher Pierce Refsnes--financial adviser for the $299-million issue of TRANs the county floated on behalf of 27 school districts last June--and Jean Costanza, a lawyer with LeBoeuf, Lamb, Greene and MacRae, who served as bond counsel for the issuance.

Ough first mentioned the idea at a January, 1994, meeting at which officials from throughout the county had gathered to discuss the prospects for pooling their TRANs issuances, according to several people at the meeting.

Later that spring, officials said, Costanza drafted a model resolution for restricting the funds and sent it to school boards.

“Bond counsel had obviously felt it was something legal to be done--that’s why we pay bond counsels,” said Charleen Wing Chandler, assistant superintendent for business services at Capistrano Unified, which restricted a $14.6-million balance before issuing $28 million in TRANs.

“These are the legal eagles that we count on for their expertise,” added Robert Giritz, controller at Santa Ana Unified, which restricted $18 million and issued nearly $34 million in TRANs.

Taylor Briggs, a LeBoeuf, Lamb partner in New York, acknowledged that Costanza had approved the fund-restriction strategy and authored the resolutions.

“You restrict your ending balances for a number of reasons,” Briggs said. “You have to have a legitimate business reason to do it and we advised them with respect to that.”

Linda Pomerantz, a spokeswoman for Dallas-based Rauscher, said generally that her firm had done nothing wrong, but was unable to respond to specific questions about the fund restrictions Thursday or Friday. “The people I need to get the answers from are simply not here. I can’t get to them,” Pomerantz said.

Several local officials and outside experts said the fund-restriction strategy was a subtler, less risky way to achieve the same objectives sought by five local districts that borrowed a total of $250 million last year solely to increase their investments in the county pool that collapsed last December.

Those agencies--Newport-Mesa Unified, Irvine Unified, North Orange County Community College District, the Orange County Department of Education and Placentia Yorba-Linda Unified--each issued about $50 million in taxable notes on top of their regular TRANs borrowings. Ough, the Rauscher broker, handled the taxable note issuances for four of the five districts.

As with the taxable-note deals, districts that increased the size of their tax-exempt TRANs could potentially expand their interest earnings by having larger sums deposited in the investment pool.

School officials, financial advisers and bond counsels not involved in the Orange County deal said that the IRS code does not prohibit restricting unspent funds, and allows for restricted monies to be left out of the calculations used for determining the total dollar value of the TRANs issues.

But funds are typically restricted for a specific purpose. The resolution Costanza wrote for Orange County districts was far more vague, simply restricting the funds without saying to which use they were being restricted.

Some officials who used the restrictions said they did so to set aside reserves in case the state decided to cuts its school allocations after the start of the school fiscal year.

“In light of the current economic situation, the predicted State budget deficit, and the potential impact on the District’s revenues, all general fund balances, as of the end of fiscal year 1993-4, shall be restricted by Board action on June 30, 1994,” reads the resolution passed by several local districts. “Such restricted fund balances shall not be spent for any purpose without the approval of the Board.”

Patrick Keegan, director of school business services for the state Department of Education, said “the question is whether they did it for a legitimate purpose.”

“If they were setting aside funds for building a building or purchasing a computer system, that makes sense,” Keegan said. Otherwise, he added, “that doesn’t appear to me to be an appropriate way to do your cash-flow analysis.”

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California Debt Advisory Commission Executive Director Peter Schaafsma said he “doesn’t know whether it violates any laws or regulations,” but that the fund-restriction strategy “doesn’t seem consistent with the spirit of the rule.”

Gary Downs, a Los Angeles lawyer specializing in public finance, said Orange County districts appear to have been “a little bit aggressive” with the Tax Code. “It’s definitely something that moves into the gray area,” Downs said. “It’s not common, but I’ve seen it done.”

It is unclear how many local districts restricted their balances because officials at some districts did not respond to telephone inquiries from The Times this week.

But a change in IRS rules between 1993 and 1994 typically would have reduced the amount of TRANs a district could issue if it found itself in identical economic predicaments in each of those years. However, 15 of the 27 Orange County districts involved in the pooled TRANs had larger issuances in 1994 than 1993.

“Our feeling was that [unspecific restrictions] would probably not be right,” said John Pappalardo, business services manager at the Fullerton Joint Union High School District. “It’s not within the spirit of the law that lets us actually issue TRANs.”

Some who did restrict funds acknowledge that the main objective was to increase interest earnings.

“If all of a sudden you’ve got a way to maximize the TRANs, then it seemed like the logical thing to do. We would maximize the net interest for the district,” said Giritz of Santa Ana Unified, the county’s largest school district. “There’s no doubt that if you restrict the cash balance, it has a direct impact on your projected deficit.

Higher earnings, Giritz said, “was certainly the effect that was anticipated. It was the expected result.”

But officials at several districts that restricted the funds insisted that they had relied on professional advice and obtained the proper legal approval before restricting their funds and sizing the TRANs issuances.

“There’s a lot being made about it now, like many other things since Dec. 6,” said Chandler of Capistrano Unified. “But at the time, nobody thought there was anything unusual about it at all.”