Excessive fees paid to swap brokers and other parties in swap transactions are quickly becoming a significant focus of Internal Revenue Service enforcement efforts, according to top agency officials.
Mark Scott, director of the IRS tax-exempt bond office, and Charles Anderson, field manager of the division, said yesterday that the agency is growing more concerned about underwriters or swap brokers integrating sky-high fees into transaction costs to increase bond yields. The effect is similar to that of yield burning the tactic diverts arbitrage that otherwise would be payable to the federal government, they said.A swap adviser or broker can earn a fee for services provided in a swap transaction, and in some cases those fees are far above market rates.
The typical basis-point charge would be in the six to 10 range [but] weve seen swaps at 50 basis points and higher, Scott said. Lets say you charge 50 basis points for a swap and the competitive market rate would have been six basis points. The [issuer has] to pay you, on their leg of the swap, a higher interest rate than they would have otherwise paid.
If the underwriter or swap provider then integrates the higher rate into its investment costs for arbitrage calculation purposes, it could run afoul of the IRS.
There are some questions as to the reasonableness of those amounts of fees paid to swap providers, Scott said. If its being paid for out of arbitrage profits, in essence through a higher yield on the bonds, we would have an issue with that.
While the IRS has looked at swaps in many different sectors, most past investigations have concentrated on what Scott called the two-hat problem, where arbitrage otherwise due for rebate to the federal government was diverted via a contract.
In theory, a swap broker could arrange to burn the yield on invested bond proceeds through marked-up investments, overpayments of credit insurance, or bidding irregularities on guaranteed investment contracts, which would create arbitrage on the front end of a deal as funds escape the arbitrage rebate process, Anderson said.
A swap could occur later, as a separate transaction, and then an excessive fee to the swap provider could be a form of kickback for arranging the original arbitrage diversion. In other words, someone wearing a hat on each transaction gets a payment from something seemingly unconnected, Anderson said.
When the swap provider or some related party is also entering into the GIC or the credit enhancement contract, then there is another whole list of potential problems, Scott said. Thats generally most of our cases to date.
Another variation, Anderson said, occurs when participants in swap transactions receive large fees to repay favors from other, unconnected deals.
Former J.P. Morgan Securities Inc. managing director Charles LeCroy was convicted of fraud in Philadelphia this year after admitting to making a payment to a bond lawyer for the attorneys work on an unrelated deal. The IRS has seen similar payments made to divert arbitrage, Anderson said.
In general, most of the situations the IRS is concerned about involve negotiated transactions where swap fee amounts were unusually high, or competitive transactions with bidding that appears unfair, Scott said.
Unlike bond deals, swap transactions are not regulated by the Securities and Exchange Commission.
Fees paid to swap brokers are all over the board but generally in the same range as those paid to GIC vendors, according to Scott. Sometimes it was zero and sometimes it was hundreds of thousands of dollars, for basically the same work, he said.
At this point, Scott said, the IRS plans to look at many more swap deals in the future. Its a growing area for us in enforcement, he said.
He would not comment on which firms would be the subject of the stepped-up examinations, but said the IRS would examine cases in which there are excessive payments for swap advisory services, or those in which a swap was less than what it should have been and was not integrated into the deal.
Word of the IRS new enforcement initiative comes after questions were raised years ago about fees paid to swap advisers in deals done in Jefferson County, Ala., a major holder of swaps and other derivatives. LeCroy, who has been serving jail time since early June, worked with the county on several swap contracts and brought J.P. Morgan millions of dollars in fees.
