The Internal Revenue Service believes that the bidding for a forward-float contract in a Colorado Springs 1991 utilities deal was “questionable” because the winning bid was made 10 minutes after bids were due, and the escrow and bond yields were nearly identical, according to an agent’s report.The IRS determined earlier this fall that the city was underpaid for the float agreement, which it entered into in conjunction with $345 million of Series 1991A utilities system refunding revenue bonds. The city late Tuesday responded to inquiries, likely from bondholders, about the Sept. 5 preliminary adverse determination, releasing the document in a material event notice filed with the nationally recognized municipal securities information repositories. The disclosure included the determination’s six-page report from an IRS field agent detailing the agency’s case.Municipal issuers use forward floats to cover gaps in cash flow between the time securities in advance refunding escrows mature and the time funds are needed to pay debt service on the related bonds. In Colorado Springs’ case, on Jan. 27, 1992, George K. Baum & Co. solicited bids for the float agreement. Bids were to be faxed by 11:30 that morning for a contract with a net price of $1.54 million. The city planned to award the contract based on the shortest reinvestment period, it said.French bank Societe Generale offered to provide a contract that would run through July 14, 1994. Morgan Guaranty, now JPMorgan, bid for July 28 of that year.Ten minutes after the 11:30 deadline, Mitsui Taiyo Kobe Global Capital, now SMBC Capital Markets Inc., bid for July 12, 1994, according to the report.Colorado Springs has told the IRS that it complied with the tax code’s “safe harbor,” which requires compliance with about a dozen requirements related to competitive bidding for an investment contract to be considered fair market value. When such contracts are undervalued, they lower the investment escrow’s yield and allow the investment provider to collect excess profits above the bonds’ yield.But the IRS argues that the safe harbor requirements were not met, since the winning bid came in late and the escrow yield generated from that bid is very close to the bond yield.“Because of the miniscule difference between the bond yield and the escrow yield, one has to wonder whether an arm’s length bidding process took place,” the report said. “Any reasonable person should have, and would have, questioned the bid and the bidding process instead of taking it at face value.”The IRS believes the forward-float contract was undervalued by as much as $894,341. It said in the report that the subsequently lower escrow yield allowed MTK, later known as Sakura Global Capital, to collect excess profits, making the bonds arbitrage bonds.Attorneys who read the full preliminary adverse determination — such documents are rarely disclosed by issuers under audit — said it confirms that the IRS is using the float valuation methodology it developed for a voluntary closing agreement program. Some also asserted that the determination shows that the agency’s case is shaky.“If you’re going to challenge the bidding process, you have to have something fairly significant,” said former IRS tax-exempt bond office director W. Mark Scott, a partner with Vinson & Elkins LLP. “Reading through the letter, I don’t see it. If this is all the IRS has, it is going to be a difficult case for them.”“The reason it came in so close was that they bid it that way,” said one attorney who wished to remain unidentified. “They said 'we’ll tell you what the price is, and we’ll take the earliest maturity.’ It was set up as a fixed-dollar bid, so it came in just under the bond yield. That isn’t suspicious at all.”The 1991 bonds have been retired since Nov. 11, 2001, and the statute of limitations is thought to have expired, but the city has said there is a chance the IRS could challenge the tax-exempt status of $300.79 million of Series 2001A bonds and $117.45 million of Series 2004A bonds, which refunded the 1991 debt. James P. Lane, the Sherman & Howard LLC attorney representing the city before the IRS, could not be reached for comment Wednesday.The city said earlier this month that Sherman & Howard and Kutak Rock LLP had issued opinions stating that if the IRS declares interest earned on the 2004 bonds taxable, the bonds’ standby bond purchase agreement will not immediately terminate. The city noted that current and prospective bondholders had also inquired about the matter. Sherman is Colorado Spring’s bond counsel, and Kutak is counsel to Dexia Credit Local, which provided liquidity for the 2004 bonds.
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