Some people would say there is an interesting parallel going on today. The legislature is bought off with the mother's milk of politics-campaign contributions. The police and firemen are controlled by wage negotiations; judges, while increasingly independent, are still the products of a political machine that lives on campaign contributions. So what could rein in a plague that is mortgaging the whole state to a level that could not be paid off? Why, our friendly IRS of course, along with some extra help from the Securities and Exchange Commission (SEC).
And what is the crime that has brought in the federal sharpshooters? The crime is for a municipality to issue tax exempt bonds for one purpose and then use the money for something else while the bondholders in good faith declare the interest payment they receive as tax-free on their income tax.
Two legal cases are paving the way for reform of these practices. In the first case the SEC alleges that a bond underwriter advertised and sold municipal bonds that were in fact not investment grade, that they misrepresented the improvements to be made and failed to disclose that the developer was undercapitalized and could not complete the project. The court is being asked to hold that the defendants in this case (the bond underwriters) must "return all ill-gotten gains plus interest" and to "impose civil penalties." While this may appear to be a very small step in cleaning up the municipal bond market, in fact it goes to the very root of the problem; the bond underwriters promoting supposedly investment grade bonds that through misrepresentation and misappropriation turn out to be junk bonds.
The second case involved the Riverside County Housing Authority and the issuing of $30 million in bonds to build 772 apartment units in two projects, each reserving 20 percent of the units for low and moderate income families. While the normal government financing structure of municipal bonds is for the government to use the proceeds for public facilities, an alternate plan was used called conduit financing. This is where the government channels the bond proceeds to a private entity, such as a housing developer, to use for a public purpose instead of the government just building the project itself. Where things go awry is when some of this money is used for other purposes than what the bond issue was advertised to do-and especially if the diverted funds should make more interest than scheduled and this interest is kept from the ultimate bond buyers or specifically the IRS. The Ninth Circuit Court of Appeals said on August 6, 1997 that "(1) the Riverside County bond issues were subject to the Tax Reform Act of 1986 because the bonds were issued after December 31, 1985, and (2) the interest on the bonds is taxable because they are 'arbitrage bonds' under the 1986 Act, in that (a) the proceeds were used, without the Housing Authority's permission or knowledge, to make 'nonpurpose investments' with a return higher than the interest rate on the bonds, and (b) the Housing Authority did not rebate the excess earnings, or arbitrage, to the U.S.Treasury."
The result is the bond holders for the past eleven years must file amended tax returns with penalties and interest on an illegal deduction. This is a very far reaching case and will encourage bond issuers to maintain tight control over proceeds, and will protect federal taxpayers from having to subsidize unapproved non-governmental uses of tax-free state and municipal obligations.
If you are wondering what these bonds were called when they started out, they were called Redevelopment bonds, and because they were used in variance to what they were issued for, a lawsuit is now possible for the bondholders to sue the underwriters, the Redevelopment Agency and the county Board of Supervisors or city council as the case may be, to be "made whole again." This says that for government bonds to be tax-free, the proceeds must be used for the stated purpose. This will be particularly troublesome for many cities who have been issuing bonds for projects and then using some of the money for agency operations (overhead).
It took the IRS to bring down Al Capone and it just may be that the IRS will bring down the robber barons of Redevelopment.