WASHINGTON - In a new development in the Internal Revenue Service's ongoing effort to crack down on the approximately one dozen zero-coupon bond issues that it thinks violate the arbitrage rules, the agency has started prompting bondholders to work with issuers to call the debt.
But the IRS' goal of getting the debt off the market may be difficult to achieve for several reasons, various officials said. Much of the debt currently is not callable and could become callable only if bondholders jointly vote to change the trust indentures. Retirement homes and other projects that were built with the bond proceeds may also find it difficult to pay off the debt.
Despite such hurdles, the IRS is hopeful that it will persuade a sufficient number of big investors to help remove the debt from the market because the bonds otherwise may become taxable, according to Charles Anderson, the agency's manager of bond field operations.
"There's been quite a bit of activity lately on the bondholder side with regards to the zero-coupon debt under audit ," Anderson said. "Bondholders are finally starting to wake up and realize that, 'Hey we have a problem here.' I'm meeting with various bondholder groups at the moment. They are anxious to have this resolved."
He would not identify any specific investors or bond issues, but said he has talked with approximately six mutual funds and some private individuals who own part of the debt.
Issuers that sold zero-coupon debt in the early 1990s that is now under IRS scrutiny include the cities of Bakersfield and Palm Springs, Calif.; the Colorado Health Facilities Authority; the Glen Cove, N.Y., Industrial Development Agency; the Illinois Development Finance Authority; the Knox County, Tenn., Industrial Development Board; and the Marengo County, Ala., Port Authority. Approximately five additional issuers remain undisclosed.
Anderson said he would like to see the debt removed from the market, because if it is not, any settlement that would try to maintain its tax-exempt status would be prohibitively expensive for issuers. The settlement process usually involves the issuer or other parties to a deal paying the IRS some share of what the agency believes the federal government would have collected had the debt initially been sold as taxable. Since much of the high-interest debt in question in this case will mushroom into immense amounts at maturity, the tax exposure is quite large.
For instance, in the IDFA's case, the IRS is questioning the tax-exempt status of three series of debt that totaled $13.1 million at the time of issuance as zero-coupon bonds, according to an IDFA official. That money is expected to grow to a total of $820 million upon maturity.
"If you don't call the bonds, there's not enough money in the whole world to settle this, because the future tax exposure is just huge," Anderson said. "There are two possible solutions. One is that we declare these bonds taxable, and another possibility is that we get them off the market and then we argue about settlement dollars. I see no prospect of settling for an amount of money and leaving the bonds on the market, because there is just not enough money to settle in that manner ."
"Bondholders realize that we need to get the bonds off the market," Anderson added. "I think the key is to have the issuers and bondholders work together so we can find a way to get the bonds off the market."
One possible way to do that, he said, is for issuers and bondholders to agree to waive the covenant that prevents calling the bonds. That is an uphill battle, he acknowledged, since state laws governing this differ, and also because unanimous consent among bondholders may often be required by the bond covenants.
Brad Waterman, a lawyer defending the bonds issued by the Colorado authority, said that calling the debt "may be a means to see the conflict resolved. We're looking at it."
But Gary Gleba, an attorney with Lytle, Hitchcock, Blaine & Huber, pointed to an additional reason it may be difficult to call the bonds. "It may not be feasible for all of these bonds because of the amounts of money that would be needed to do that," said Gleba, who represents the Glen Cove agency but talked generally about the zero-coupon bond issues under audit.
The projects paid for with the initial debt -- retirement-housing facilities in several cases -- "may not have the economic resources to buy the bonds back," he said. "That could be very problematic for some of them. It might be more wishful thinking on the part of the IRS."
He could not say at this time whether it would be a problem for the Glen Cove project.
Gleba added he does not think the IRS has yet been in contact with the investors of the Glen Cove bonds.
Richard Chirls -- the Orrick Herrington & Sutcliffe bond lawyer who is representing UBS PaineWebber Inc. in its effort to settle the cases that it inherited when it bought J.C. Bradford, which underwrote many of the bond issues --would not comment on the IRS' effort to involve bondholders and get the debt off the market.
Some sources said that the IRS' new effort seems to indicate that its negotiations over the past year with PaineWebber may have stalled. But Chirls said the talks are ongoing.
"PaineWebber continues to work with the IRS, issuers, and other parties to achieve a settlement in order to preserve the tax exempt bonds," Chirls said, echoing earlier statements.
