Chicago District Cites Another BAB Audit

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WASHINGTON — The Metropolitan Water Reclamation District of Greater Chicago has disclosed that the Internal Revenue Service is examining $600 million of Build America Bonds it issued in August 2009 — the second IRS audit of BABs announced in less than a week.

The district’s material-event notice disclosing the audit, published late Friday on the Municipal Securities Rulemaking Board’s online EMMA system, also noted that the bonds are subject to a Securities and Exchange Commission inquiry.

The bonds were issued to finance construction projects under the triple-A rated water district’s capital improvement program. The IRS notified the agency of the audit in a Sept. 24 letter.

The district is in the process of responding to the IRS request, according to Harold Downs, its treasurer.

Bradley Waterman, the tax-controversy attorney representing the issuer before the IRS, declined to comment.

The disclosure marks another public acknowledgment of an IRS audit by a BAB issuer.

Last week, San Antonio disclosed that the IRS is examining $375 million of BABs it issued in May 2009 to finance capital improvements to its CPS Energy system. The city was notified of the audit on Oct. 18.

Clifford Gannett, director ot the IRS’ tax-exempt bond office, said in an interview Friday that his team is auditing between 15 and 20 BAB deals. He said that, depending on what agents find, the service could audit more BABs as part of a targeted IRS initiative.

Both issuers received information ­document-request forms from the IRS, asking them to provide documents and information about their BABs, including how they were priced when sold and who purchased them.

One of the questions that has drawn particular interest from lawyers asks if any of the BABs were sold to governmental pension funds. This has caused some market participants to worry that the IRS is concerned about issuer employees participating in pension plans that buy the issuer’s BABs.

One investment adviser on Tuesday wondered if the IRS is trying to figure out how many tax-exempt investors are buying BABs, to more accurately gauge the cost of the taxable stimulus bonds to the federal government.

However, the IRS did not indicate in either case that it was looking for a specific violation.

Gannett said the audits are “for the most part” random.

The Metropolitan Water Reclamation District also has responded to a query from the SEC in April about the pricing of its BABs due to the level of investor profit-taking in secondary market trading that immediately followed the initial sale, according to an article published in May by Bloomberg LLP.

Though the deal — which resulted in a true interest cost of 3.72% once the 35% direct-pay BAB subsidy was factored in, resulted in savings over a traditional tax-exempt deal — Bloomberg claimed in its analysis that the agency paid $8 million in unnecessary interest when compared to similar taxable deals done at the time.

Downs said Monday that the water district has not heard from the SEC since June when it provided pricing and other information from the deal. “We’ve heard nothing back at all,” he said.

Chapman and Cutler LLP and Pugh, Jones, Johnson & Quandt PC served as co-bond counsel on the issue.

The bonds were underwritten by a team led by Mesirow Financial, Inc., with co-senior manager Loop Capital Markets, LLC. Other underwriters were George K. Baum & Co., William Blair & Co., Blayock Robert Van LLC, Cabrera ­Capital Markets LLC, Jefferies & Co., Melvin Securities LLC, Bank of America Merrill Lynch, Podesta & Co., Samuel A. Ramirez & Co., and Siebert Brandford Shank & Co.

The disclosure of the water agency’s audit comes as it is preparing to issue more BABs before the end of the year. The district is in the process of evaluating proposals from underwriting firms that came in Friday for another BAB deal, according to Downs.

Up to $500 million of BABs could be issued as part of the deal, but some portion of those bonds could end up as tax-exempts, he said.

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