WASHINGTON — The Internal Revenue Service closed an audit without taking any enforcement action on $600 million of Build America Bonds issued by the Metropolitan Water Reclamation District of Greater Chicago that some market observers claimed had been mispriced.
The IRS’ decision to make no change to the subsidy payments the district gets from the federal government was disclosed in an event notice the district filed with the Municipal Securities Rulemaking Board’s EMMA system this week.
The BABs were issued in August 2009 to finance construction projects as part of the district’s long-term capital improvement program. The district, which encompasss Chicago and 125 suburbs, is responsible for treating sewage and preventing flooding for some 5.3 million customers.
After the BABs were issued, Bloomberg News reported they had cost taxpayers $8 million in unnecessary interest.
In addition, former Securities and Exchange Commission chair Arthur Levitt, a director of Bloomberg LP, wrote an opinion piece suggesting that taxpayers were “fleeced” by the deal. He charged the triple-A BABs were “priced worse than their equivalents.” The BABs due in 2038 were priced to yield 5.72%, but similar Johnson & Johnson bonds were trading at an implied yield of 5.22%, he said, adding district officials could have saved taxpayers $68.6 million over the lifespan of the bonds if they had borrowed at that lower rate.
Bradley Waterman, a tax-controversy attorney who represented the district before the IRS, declined to comment and district officials could not be reached. But the IRS was looking at whether the issue prices stated for the bonds was correct, sources said. BAB audits have been part of a targeted IRS initiative since 2010 due to concerns over issue price.
For BABs, the issue price is key to determining interest costs and the size of the subsidy payments the Treasury Department will make to the issuer. Currently, the Treasury Department pays issuers a subsidy rate equal to 35% of their interest costs.
Under IRS rules, the issue price for each maturity of bonds is the first price at which a substantial amount of them are sold to the public, with 10% considered to be a substantial amount.
IRS officials have been concerned that BABs and other bonds are initially issued at one price and then almost immediately begin trading at higher prices. They also are concerned that flipping occurs. Flipping is when bonds are issued at one price and are almost simultaneously sold to dealers or institutional investors at higher prices before being sold to retail investors at even higher prices.
Issuers and bond lawyers have questioned whether they should be expected to differentiate between investors who buy to hold bonds and investors who buy to flip them. Even though BABs are taxable, they must still comply with the same laws and rules as tax-exempt bonds, the idea being that if the issuer gets a subsidy it should not be able to earn arbitrage as well.
The district’s BABs, which were priced at par when issued, were traded by investors who flipped them to prices as high as 103 before the bond purchase agreement was signed by the issuer and underwriter, according to trade data on EMMA. The secondary market trades are not recorded until after the BPA is executed and then made public on EMMA.
The $600 million BAB issue was the district’s largest single sale of bonds, according to a 2010 presentation by Richard Lanyon, executive director of the district. He said the sale would save taxpayers $180 million that would have been used for debt servicing with traditional tax-exempt fixed rate bonds.
The IRS audit of the district’s BABS was only the second public announcement of a BAB audit. Soon after the announcement, the SEC began an inquiry of the BABs. The SEC investigation is still ongoing.
