WASHINGTON - Crystal City, Texas has reached an agreement with the Internal Revenue Service to settle tax rule violations and preserve the tax-exempt status of interest already paid on $13.94 million of jail bonds issued by an authority in 2003 and now in default.
The IRS found the bonds were taxable private-activity bonds because they were used to finance the acquisition and new construction of a prison that had excessive private use and private payments. The IRS concluded the bonds were not "qualified" or tax-exempt PABs because of contracts the authority had with a private operator and the federal government.
The city disclosed the settlement or closing agreement in an event notice filed recently on the Municipal Securities Rulemaking Board's EMMA system. The case has led the IRS to pursue other prison or jail financings, sources familiar with these issues have said.
The settlement agreement stipulates that the tax-exempt status will remain for bond interest that was paid from Jan. 28, 2003 to and including Jan. 2, 2013. Any interest paid after that will be taxable, but the issuer said no interest has been paid on the bonds since Jan. 2, 2013. The bonds have been in default since 2012 when the U.S. Marshals Service withdrew federal inmates because of misconduct and security problems. The jail facilities have been shut down.
Bond counsel for the deal, Jackson Walker LLP contributed about $400,000 toward the settlement as well as attorneys' fees for Nixon Peabody attorneys, who were hired to help settle the tax dispute with the IRS, said W. James Jonas, Crystal City's manager and attorney. Geisler Smith Associates, Ltd., which did the feasibility study, also contributed several thousand dollars toward the settlement, Jonas said.
Now that the dispute with the IRS has been settled, the city plans to vigorously pursue litigation and arbitration against participants in the transaction, including the underwriters, Jonas said.
The city and the authority it created to issue the bonds, the Crystal City Public Facility Corp., filed an amended lawsuit in March in the state's District Court for Zavala County, Texas, against transaction participations including underwriters Municipal Capital Markets Group, Inc. and Herbert J. Sims & Co., as well as the former operators of the prison facilities, Correctional Properties of Texas, Inc. and BRG Security Services, both of which are private companies.
The suit charges the defendants with alleged fraud, negligence, breach of fiduciary, duty breach of contract, and negligent misrepresentation. It asks for unspecified actual, consequential, and punitive damages, as well as attorneys' fees, costs and forfeiture of fees received.
The city had included Jackson Walker and Geisler Smith in its original suit, which was filed in December 2012, but dropped them from the most recent amended version after they contributed money toward the settlement agreement.
Jonas claims the financing was one of a series of sham prison deals done for small cities in South Texas by the same group of firms. "We believe that by 1993, there was a group of insiders that were selling these deals that didn't even make sense," said Jonas. "We hope this case will hold Municipal Capital Markets Group, Inc. and others responsible for the train wreck they created here and elsewhere."
"These people did bad things and it's time they were held accountable for their acts of omission. They sat back knowing these deals would not work," Jonas said.
Charges Denied
But lawyers for the underwriters and prison operators strongly deny the allegations, saying the problems with the bonds were tax-related and that the firms had nothing to do with the tax issues.
They also say all of the transaction participants agreed to a court order to abate the lawsuit on April 10, 2013 and resolve the city's complaint through arbitration. The bond purchase agreement between the authority and underwriters compel the city to arbitrate any claims.
The BPA states: "Any and all controversies, disputes or claims between the underwriters or the corporation and affiliates or controlling persons thereof arising out of or relating to this agreement will be resolved by arbitration in Dallas, Texas, in accordance with the rules then observed by the National Association of Securities Dealers," now the Financial Industry Regulatory Authority. The BPA says any award rendered will be "entered" by the court of jurisdiction.
The city has not filed any arbitration claims, Jonas conceded, adding, "We believe we have some claims that go beyond arbitration," he said.
Transaction participants said Jonas' claims are not valid.
"The new claims by Mr. Jonas are groundless, and Municipal Capital Markets rejects them," said Tom Vander Molen, a lawyer at Dorsey & Whitney in Minneapolis who is representing MCMG. "The Crystal City Detention Center had years of successful operations until it ran into various difficulties after the IRS examined the 2003 bonds. The facility was built to provide jobs for the local community, and it did so. MCMG will vigorously defend the claim in arbitration. The project was designed in good faith and there is no merit to the claims against MCMG."
"There is absolutely no truth to Mr. Jonas' comments, " said Thomas F.A. Hetherington, a lawyer with Edison, McDowell & Hetherington LLP who is representing Herbert J. Sims. "This is a case where mismanagement by the original manager of the Crystal City Correctional Center caused a decline in census and a payment default in 2012 - nine years after the deal was originally underwritten. Furthermore, primarily because of the way Crystal City decided to contract with the jail manager, the IRS determined the bonds to be taxable in 2011. The IRS found no culpability on the part of any of the parties underwriting the bonds in connection with the taxability determination."
"My clients aren't really involved in this mess," said Tony Schaffer, a lawyer with Sessions & Schaffer, PC who is representing the former operators, CPOT and BRG.
The controversy is rooted in a prison facility that existed in the 1990s called the Crystal City Correctional Center, which was financed at least in part by Zavala County, according to bond documents. The prison, which was located about 90 miles from San Antonio and 47 miles from the border with Mexico, had many problems. It was opened then periodically closed and opened again. It was subject to lawsuits. CPOT bought it in 1998 and cleaned it up, according to Schaffer. CPOT leased the facility to the city and BRG (Bobby Ross Group, Inc. at that time), which operated it, according to bond documents.
In 2002, Crystal City, a town with a population of about 7,190 in 2000 located on 9.43 kilometers of land, formed the Crystal Public Facility Corp. to issue the $13.94 million of bonds to finance the acquisition of the facility from CPOT and to construct 48 new isolation beds, which would bring the total beds to 515. The following year the bonds were issued. The corporation was to lease the facility to the city, which in turn entered into a management contract with to operate the facilities.
The underwriter's discount was $836,100 and issuance costs were $565,370, according to the official statement.
The city had hired GSA to do a feasibility study and that study concluded, "It is feasible to continue operating this facility." But its conclusion was based to a great extent on the fact that the city had an intergovernmental agreement with the U.S. Immigration and Naturalization Service for federal inmates that would be incarcerated in the prison. The study also anticipated the U.S. Marshals Service would also provide inmates. The study also noted that BRG would manage and operate the facility under a 15-year contract with the facility.
The contracts with the federal agencies and BRG created private use. Under the tax law, bonds are private-activity bonds if more than 10% of the projects they finance are used by private parties and more than 10% of the debt service is paid by private parties. PABs are only tax-exempt if they are "qualified," meaning they are used to finance projects in certain categories, none of which include prisons.
IRS Audit
The IRS began auditing the Crystal City bonds in 2010 and believed it to be so egregious that it spurred other audits of prison bond deals, according to municipal market participants familiar with the transaction. In July 2010, the IRS sent the issuer a notice of proposed issue that concluded the bonds were taxable because of violations of the laws and rules governing private-activity bonds.
The IRS' concerns were two-fold, according to bond-related documents. First the IRS took issue with the management contract the city had with BRG, under which the net profits were split between the two. The IRS argued this compensation structure suggested "an equity interest in the operation of the bond-financed facility," creating a private use and payments problem.
In addition, the IRS noted the prison had contracts with federal agencies to take in federal inmates and that from 2008 to 2010 about 90% of the inmates in the prison were federal. Federal agencies and inmates are considered private, not public, parties under the tax law. The IRS contended that the economics of the prison would not work without substantial federal use, creating private use and payments. The federal government tends to pay more for incarceration of its inmates that state or local governments, sources said.
In June 2011, the IRS sent the issuer an adverse tax determination notice, stating that about $9.85 million of the bonds were outstanding at that time that had a tax exposure of $900,000 through the end of that month.
The tax issues were evident from the official statement for the bonds and the feasibility study. But Jackson Walker issued an opinion that the bonds were tax-exempt.
The city and underwriters stated they had no responsibility for the feasibility in the official statement for the bonds. "Neither the issuer, the city, nor the underwriters" have independently verified the statistical data or assumptions in the feasibility study and cannot give any assurances they are complete or correct," the OS states.
State district court judge Cynthia Muniz has scheduled a status hearing on the litigation for Jan. 6.
Jonas says he would like to revive the prison facilities, possibly working with Zavala County to do so. He said bondholders are working with the trustee to see if the prison could become operable, but sources who were either involved with the financing or litigation don't think that will ever happen.
