WASHINGTON -
The IRS' allegations, which come as the Justice Department is investigating anticompetitive behavior in the municipal market, were revealed late Thursday in a proposed adverse determination letter disclosed by the Albuquerque-based Region III Housing Authority, which issued $27.71 million of variable-rate lease purchase revenue pass-through bonds in 2003.
The letter provides a wide-open look at the IRS' position in its audits of $1.065 billion of lease-to-own bonds sold by 19 issuers in 22 transactions between 1996 and 2005. Those audits are in various stages of development, but market sources indicated last week that the Region III Housing Authority's proposed adverse determination is not the only one issued recently.
CDR, the Beverly Hills-based investment and derivatives broker formerly known as Chambers Dunhill Rubin & Co., arranged the New Mexico deal's forward purchase agreement. SocGen's New York branch served as forward purchaser, liquidity provider, and investment agreement provider.
Greenberg Traurig LLP was the French bank's counsel and Hughes & Strumor Ltd. of Albuquerque was bond counsel. Chilton & Associates and RBC Dain Rauscher were co-managers, and Best Best & Krieger LLP of Riverside, Calif., was underwriter's counsel.
The Region III authority was created to provide quality housing for low-income families in Bernalillo, Sandoval, Torrance, and Valencia counties, but is facing scrutiny from the New Mexico State Investment Council after a default and allegations that bond proceeds were used for salaries, vehicles, and other expenses.
The IRS opened its audit of the Series 2003A bonds in 2005, according to Dewey Cave, a financial aide to Lawrence Rael, interim director of the authority.
In its April 7 proposed adverse determination, disclosed late Thursday with the nationally recognized municipal securities information repositories, the IRS told Region III that it was declaring the bonds taxable based on three issues. First, and perhaps most problematically, according to sources, is evidence that Société Générale "is making quarterly payments of $13,812 to CDR Financial Products out of the forward purchase fee for certain unidentified fees related to" the New Mexico sale, the IRS said.
CDR was paid $50,000 to structure the transaction's forward purchase agreement, which enhanced the bonds' credit. SocGen's fee as forward purchase agreement provider was treated as a qualified guarantee in computations of the Series 2003 bonds' yield, but since the "unrelated" payments that came from the fee were not for the transfer of credit risk and were not separately stated, as required by the tax code, the entire fee cannot be taken into account, the IRS said. Without the fee, the bonds' yield would have been 1.45% lower than the investment escrow's yield, which is well over the 0.125% excess permitted by tax code rules, violating arbitrage restrictions, the agency ruled.
"The service believes that the quarterly payments [from] Société Générale represent a deliberate diversion of arbitrage to CDR, and that Société Générale had an ongoing arrangement with CDR to promote similar abusive arbitrage devices," the IRS asserted. "CDR and Société Générale appear to have fixed pricing on financial products to facilitate the diversion of arbitrage."
In its second conclusion, the IRS told the authority that its bonds should have been issued as private-activity, single-family mortgage revenue bonds rather than governmental debt.
"The general structure of the transaction is no different than that of a general mortgage loan or bank loan ... [and] the bond meets the private loan financing test" of Section 141 of the tax code, the IRS said. "The authority chose to issue the bonds as governmental bonds to circumvent the rules and regulations Congress placed on the issuance of single-family housing bonds."
Finally, the IRS ruled that the authority could not have reasonably expected to loan 85% of the sale's proceeds within the required, three-year period.
Proposed adverse determinations of taxability become final if they are not appealed to the IRS Office of Appeals. Cave said the authority would not appeal the IRS' determination. Instead, it is attempting to negotiate a settlement agreement, under which it will likely have to pay a fee to protect the tax-exempt status of the bonds, he said. SocGen is rumored to have bought up nearly all the outstanding lease-to-own bonds, but a good portion of the Region III bonds is still outstanding.
Cave declined to comment further on those negotiations. Bond counsel Robert Strumor of Hughes & Strumor is representing the authority before the IRS but did not return a call for comment Friday. IRS officials declined to discuss the case.
"We have no comment on the IRS audit of the New Mexico issuer, but we are continuing to cooperate with various government authorities investigating the tax-exempt municipal bond market," SocGen media relations director Jim Galvin said Friday.
Galvin was referring to the wide-ranging investigations of alleged anticompetitive practices, including price-fixing, bid rigging, and collusion, in the market for muni bond-related investment contracts and derivatives. The Justice Department's antitrust division is conducting the criminal investigation, and the Securities and Exchange Commission is conducting a parallel civil probe. CDR was one of three investment brokers raided on Nov. 15 by federal officials, and SocGen confirmed earlier this month that it had received subpoenas from Justice and the SEC in conjunction with the probes.
"As in all lease-to-own transactions, [Region III's] was a unique, customized structured financing that was vetted and scrutinized closely by counsel as well as the issuer, with total knowledge by Freddie Mac, the designer of the program, along with all deal participants," CDR said in a statement Friday. "Further consistent with other lease-to-own deals, the credit enhancer was entitled to serve as a bidder. CDR's fees were paid by the credit enhancer for arranging for the forward purchase program."
"This program, as it was originated, had a very low rate of foreclosure and was impacted greatly by the lenders who pushed their clients into other programs away from lease-to-own," the firm said. "In the current climate of sub-prime foreclosures, the lease-to-own product is a great answer for Congress to help save the tens of thousands of homeowners that may lose their homes or can longer buy one."
