MTA, Agencies Must Pay Up to $2.5 Billion to U.S., IRS Rules
An Internal Revenue Service ruling, vindicating a municipal bond market whistle-blower, means that the Los Angeles Metropolitan Transportation Authority and more than 100 local agencies nationwide will have to pay the federal government as much as $2.5 billion within a year or risk even more dire consequences.
The ruling has to do with an alleged scheme in which major Wall Street brokerage firms inflated the prices of Treasury securities sold to state and municipal agencies, thereby pocketing money the agencies otherwise would have had to pay the U.S. government in taxes.
The ruling also is expected to lead to a spate of lawsuits by local governments and agencies against the brokerage firms to recover the money plus interest.
Judging from a 1995 report commissioned by the MTA, its share is likely to be much more than $5 million.
In its ruling, the IRS threatened that if the municipal agencies did not pay up within a year, it would declare their tax-exempt municipal bonds taxable, which could lead to mammoth lawsuits by investors. Investors who bought municipal bonds because the interest paid on them was tax-exempt could suddenly be liable for taxes.
Catherine L. Spain, a director of the Government Finance Officers Assn. in Washington, called the ruling “shocking.” She said the organization may ask the Treasury Department to overturn it. She says it holds the government agencies responsible for wrongdoing that was mainly the fault of the brokerage firms.
The municipal agencies generally were unaware that they were being overcharged, Spain said. Some may not have been vigilant in checking the prices they paid because they would have been unable to keep any of the profit anyway.
Lawyers interviewed Tuesday said the IRS apparently concluded that under federal tax law it didn’t have the authority to directly penalize the brokerage firms. However, the Securities and Exchange Commission has been conducting an independent investigation of the firms and could impose its own penalties.
The IRS ruling, issued Friday and first reported in The Bond Buyer newspaper, has to do with an illegal practice known as “yield burning,” first publicized by whistle-blower Michael Lissack, a former municipal bond executive with Smith Barney Inc.
Federal law forbids state and local governments and agencies to invest the money they raise from tax-exempt municipal bonds at a profit. Any profit earned is supposed to be forfeited to the IRS in taxes.
For example, if a municipal agency raises $100 million from a bond issue on which it has to pay investors 4% interest and invests the proceeds temporarily in U.S. Treasury securities that pay 5%, the 1 percentage point difference is supposed to be paid to the IRS.
Under yield burning, the brokerage firms that sell the local agencies the Treasury securities deliberately overcharge them, selling them the securities at significantly above the market price. As a result, the municipal agencies don’t earn a profit on the investment, and no money goes to the IRS.
But this means that the brokerage firms pocketed the money that would have gone to the federal government. It’s called yield burning because, by overcharging, the brokerage firms are reducing the yield, or return, the municipal agencies receive on the Treasury securities they buy.
The Times reported in June 1995 that the MTA’s former financial advisor, New York investment house Lazard Freres & Co., appeared to have overcharged the agency on Treasury securities sold to the MTA as part of complicated municipal bond refunding transactions meant to help the agency take advantage of falling interest rates. The MTA commissioned a report by an independent consulting firm, which found that the MTA had been overcharged by $7 million by Lazard in four transactions in 1992 and 1993 and by $1 million in a 1991 transaction with Goldman, Sachs & Co.
Lazard and Goldman have strongly denied that they overcharged the MTA.
Of the total $8 million allegedly overcharged, about $3.6 million came directly out of the MTA’s pocket; the rest would have been owed to the IRS. As reported, the MTA in May joined in a whistle-blower lawsuit filed by Lissack, seeking to recover the $3.6 million from Lazard, plus treble damages as allowed under the California False Claims Act.
On Tuesday, Ronny J. Goldsmith, the MTA’s chief financial officer, said that because of the IRS ruling, the MTA’s lawyers are now considering whether to seek recovery both from Lazard and Goldman Sachs of the additional money that would have gone to the IRS. That amount, plus interest, is estimated at much more than $5 million.
Micah Green, executive vice president of the Public Securities Assn., the trade organization of government securities dealers, denied that there was any widespread conspiracy among firms to cheat the federal government and municipal agencies.
