Overpricing of municipal escrow purchases: yield burning issues and potential liabilities.

• Author: Phillips, John
• Position: Case involving the Los Angeles County Metropolitan Transportation Authority

Based on expert studies showing investment providers' systematic overpricing of advance refunding investments, the Los Angeles County Metropolitan Transportation Authority's legal action against its former financial advisor alleges that one of its escrow purchases was overpriced by approximately $3.6 million.

The Internal Revenue Service's (IRS) Revenue Procedure 96-41 delineates a closing agreement program for issuers to protect the tax-exempt status of advance refunding bond issues affected by escrow overpricing. Issued July 19, 1996, Revenue Procedure 96-41 is cause for enormous concern for any state or local issuer that purchased open market investments for an advance refunding defeasance escrow. This is the federal government's first broad-scale response to charges that Wall Street investment providers illegally overpriced advance refunding escrow investments. The Revenue Procedure provides that state and local governments may preserve tax exemption provided that they pay to the IRS the amounts by which Wall Street investment providers' escrow investment prices exceeded market "spot" prices. Thus, the procedure, in essence, holds issuers who were the victims and vehicles of Wall Street's illegal practices accountable for the overpricing.

Between 1990 and 1995, it is alleged by industry insiders and observers that Wall Street investment providers systematically and illegally overpriced advance refunding escrow investments. The potential profits illegally taken from these transactions is staggering - industry observers estimate that between 1990 and 1995, Wall Street's overpricing of advance refunding escrow investments could be as much as $1 billion. Overpricing advance refunding escrow securities may cause multiple violations of federal and state laws: it is a potential violation of - among others - security pricing and disclosure laws, tax-exempt financing regulations, and state and federal false claims law. For this reason, the Securities and Exchange Commission (SEC), IRS, and U.S. Justice Department, among others, have overlapping enforcement authority over tax-exempt advance refunding escrow pricing practices.

Yield Burning Defined

The overpricing of open-market investments purchased for tax-exempt advance refunding bond escrows is commonly referred to as yield burning. Federal law places yield restrictions on the investment of tax-exempt bond proceeds that expressly prohibit overpricing practices. The fair market valuation of investments purchased with bond proceeds is integral to the yield-restriction regulations. Federal yield restrictions require that an issuers' refunding bond proceeds may be invested in escrowed securities that earn combined yields that are no higher than the combined yields earned by bondholders of the new advance refunding bonds. In the case of advance refunding bond escrows, the yield-restricted rate may be achieved in one of two ways. First, escrow funds may be invested entirely in the U.S. Treasury's State and Local Government Series (SLGS) securities at the precise yield-restricted rate. Second, escrow funds may be invested in open-market Treasury securities. Because open-market yields generally exceed tax-exempt yields, the yield-restricted rate may be achieved by blending the higher yield open-market securities to the restricted yield by the purchase of special zero-interest SLGS for the final period of the escrow. Investment in zero-interest SLGS is the means by which the Treasury recovers the "positive arbitrage" (i.e., the yield in excess of the restricted rate) in the tax-exempt refunding transaction.

When a Wall Street investment provider adds unjustified markups to the price of advance refunding escrow securities, the refunding escrow's yield is artificially depressed below what it would be had the investments been fairly priced. Such yield burning wrongly diverts to the investment provider positive arbitrage that would otherwise be owed to the federal Treasury. As a result, overpricing of positive arbitrage refunding escrows directly damages the federal Treasury. In addition, in negative arbitrage cases (i.e., where the escrow's yield is below the restricted rate) investment overpricing is paid directly by the issuer.

Revenue Procedure 96-41 makes no accommodation for the facts that the issuers did not profit from these escrow sale transactions, that issuers relied on professional financial advice and market price certifications, and that issuers were deliberately misled by their Wall Street investment providers. The Revenue Procedure, in other words, exposes public issuers to potential combined liabilities of $1 billion on essentially a strict liability basis. Moreover, issuers that choose not to enter closing agreements may be subject to IRS enforcement action and, thus, run the risk that their advance refunding bonds will be declared taxable arbitrage bonds. Revocation [TABULAR DATA FOR EXHIBIT 1 OMITTED] of tax exemption would, in turn, expose public agencies to even greater potential liabilities to bondholders.

Although some proponents of the closing agreement program suggest that issuers may later proceed against investment providers to collect overcharges paid by issuers, this may be done only at great expense. The transaction costs would be immense. There would be an explosion of litigation pitting financially strapped municipalities against legal resources purchased by the wealthiest businesses in the...