Wednesday, October 1, 2008

Safety in the Numbers You Pull out of a Hat

Who among us would consider it safe to come up with fictional numbers to present to the IRS?

I am thinking about this because I was reading another attorney’s anonymously offered justifications for the transcendently artificial stratagems currently being used to divert public moneys to the financing of sports venues like Yankee Stadium. In connection with this it seems that some rather fictional numbers were submitted to the IRS. It is doubtful that the numbers are any more substantiated than if they were simply pulled out of hat.

Federal Stadium Financing Hearings

The anonymously offered justifications appeared in Foul Ball: Congressional Committee Criticizes New Yankee Stadium Deal, by Brian Baxter which appeared in The Am Law Daily, September 21, 2008. The article was about hearings Congressman Dennis Kucinich, chairman of the House Oversight and Government Reform Committee, is holding concerning the tax-exempt financing of Yankee Stadium, about which there is much to criticize and much to investigate.

The Yankee Stadium financing presents an excellent example of what is wrong with sports stadium and arena financing in the country in general and in New York in particular. The proposed Atlantic Yards Nets arena is on obvious analog and cousin to the Yankee Stadium financing. I was led to The Am Law Daily by a post in Atlantic Yards Report, (Monday, September 22, 2008, An architect of the Yankee Stadium deal was an IRS insider), which picked up the information in the AM Law article that a primary architect of the Yankees's financing strategy, Bruce Serchuk, a Nixon Peabody law firm partner, worked in the office of tax policy at the Treasury Department and in the IRS's chief counsel office.

Artificially Inflated Statement of Land Value to Issue Tax-Exempt Bonds

Congressman Kucinich and New York State Assemblyman Richard Brodsky are alleging what is pretty clearly true, that the Yankees and the city deliberately inflated the ostensible value of the city parkland where the new stadium is being constructed. The reason for doing this was to issue far more tax-exempt bonds than would otherwise have been permitted. Among other things, the New York City Department of Finance provided a $275 per square foot assessment for the parkland so they could tell the IRS that the land under the new stadium was worth $200 million, while the state was told it was worth just $21 million. (A Daily News analysis showed nearby property was valued at $25 per square foot: Yanks land deal ain't fair ball, September 12th 2008.) Think about the number of multiples (almost 10 times or possibly even more) by which the correct valuation of the land was overstated and you can conceive the proportionate quantity of bonds issued that should never have been sold as tax-exempt. There is a greater challenge in figuring out how overstated the land valuation is since the New York City government, ducking the issue, didn’t send officials to testify at the hearing. (See: Wednesday, September 17, 2008 In Brodsky’s report slamming Yankee Stadium deal, major questions implied about Atlantic Yards arena plan and Saturday, July 26, 2008 Was Yankee Stadium value "gamed" to issue PILOTs? Congressional probe could affect AY.)

Anonymous Justification Litany

Though no New York City officials showed up in Washington to defend the financing at the Kucinich hearings, perhaps there was solace for the die-hard stadium acolytes when The Am Law Daily quoted justifications for the financing from that anonymous lawyer.

Public finance is a very small industry so I probably know the lawyer who was being quoted. I can understand the impulse to speak out on behalf of industry colleagues though I don’t agree with him. (I have often counseled that public finance is such a small community that what goes around comes around far faster than in other industries.)

The anonymous lawyer dutifully recited the standard litany of industry rationales for these devices that plunder taxpayer funds to further enrich the superwealthy. (Were the Yankees really going to move to Connecticut?) Those justifications have been so comprehensively refuted I will not take space to restate the refutations here. If you want a quick reference to my point of view, see my More Money for the Very Rich: An Unsporting Pursuit? March 17, 2008.(This Huffington Post piece appeared just days before a massive increase in the cost of the Nets arena was announced, so though the principles are correct, the already huge numbers are understated.)

“Many, Many Lawyers”

What interested me was the anonymous lawyer’s description of the multiple lawyers working on the transaction:

"We're talking about many, many teams of lawyers working with the IRS, which issued a private letter approving the structure because it was grounded in established law," the lawyer says. "The federal government was fully involved in approving this transaction, which couldn't have been more public."

The comment was likely meant to reassure the reporter or his Am Law Daily readers. Indeed, a lot of lawyers do work on municipal bond financings.

If you are not familiar with public finance it may be hard to imagine how many lawyers are involved in these transactions. (If you saw the film Michael Clayton, an interesting corporate morality tale, the roomful of people in the scene showing the law firm closing a deal looked much like a tax-exempt bond issuance closing. Sometimes it can take not one room but two or three.) A crowd of professionals milling around dotting i’s and crossing t’s can give everyone a collective feeling of safety and assurance that all is within the realm of the condoned. There may be a feeling of safety in numbers, but it is not that simple.

Individual Responsibilities vs. the Herd

Current Wall Street events underscore the herd mentality and group-think to which the Street is susceptible. That includes not only runs on banks but also unjustified complacency about what is right in the first place. Notwithstanding, I have been in situations when the emperor is declared to have no clothes. I have seen that a single individual expressing himself can still bring to a halt a deal that is flawed by lurking vice. Further, when you come down to it, though there were probably “many, many teams of lawyers” working on Yankee Stadium, only a very few individuals would have been responsible for misrepresentations about the land valuation numbers. The individuals most responsible for any misrepresentations were probably not even lawyers.

However large the crowd, the responsibility when municipal bonds are issued is sliced and diced in almost as many separate pieces as the mortgage-backed securities which are carved into the multiple tranches and derivatives that are now perplexing Wall Street. Slews of different opinions and certificates are signed by different parties. That doesn’t mean that you can blithely ignore the unreliability of other transaction participants. Almost everyone is held to a standard of being responsible for what they “knew or should have known” to be inaccurate or unfounded. General “due diligence” responsibilities are distributed throughout the parties to the transaction. (BTW, “due diligence” it is cracked, is the “diligence that is due.”)

Assurance from Bond Counsel

When tax-exempt bonds are issued, bond counsel plays the key role of blessing that the transactions are being executed properly. The role of bond counsel was created when the railroad-building boom collapsed in the late 1800s. During that boom period government officials were cavalier in the issuance of huge amounts of debt. (Sound familiar?) With the ensuing bust, (the Panic of 1873) bond holders were jilted when the cavalier transactions were disavowed as the acts of irresponsible government functionaries acting without due authority and proper formality. (It happens.) Ergo, Wall Street law firms stepped in and afterward debt was no longer issued without an established and reliable law firm soberly opining that sufficiently binding legal procedures had been properly observed. To this day, this is one of the legal opinions that bond counsel still issues.

More recently, the role of bond counsel for tax-exempt transactions has grown and bond counsel now issues another separate opinion specifically directed to the validity of the thinking pursuant to which interest paid on the bonds will be considered exempt from federal income tax. The tax specialist lawyers who offer the thinking as to why the bonds should be tax-exempt do not provide the facts necessary to support the conclusion; they rely on certifications from the government officials and private parties involved in the transactions, though they are supposed to be alert for falsifications.

Infallible Lawyers?

Bond counsel lawyers assure against fallibility, but they are fallible human beings themselves. The most famous example perhaps is that John Mitchell, once one of the best known bond counsel to the New York State finance authorities, entangled himself in Nixonian politics and became the first United States Attorney General ever to be convicted and imprisoned for illegal activities. (Recent events with respect to the appointment of a special prosecutor indicate that Alberto Gonzales may become the second United States Attorney General to achieve this dishonor.) If there is ever a time to discover human fallibility, you will probably find it most easily at the end of boom cycles; it is so hard to let principle restrain you when those around you seem to be cashing in on risk without negative repercussion.

Tax-exemption of bonds is predicated upon abstract premises plus facts and numbers which are supposed to be real. In the case of the Yankee Stadium financing, the theory of the tax exemption was a pretty ploy in itself for which a limited number of tax lawyers working on the transaction must vouch. Fewer individuals had the responsibility to see that the numbers that plugged into that theory were accurate.

Club for Safety Speaks Louder

Is there ever safety in numbers? Yes, sometimes that is exactly how it works with respect to getting legal theories accepted. I remember as a young lawyer near the beginning of my public finance career being quite bewildered as I studied a section of the tax regulations: The better I thought I understood them the clearer it seemed to me they didn’t say anything actually comporting with the way those regulations were interpreted in the industry. It was then that one of my favorite tax lawyers asked me whether I hadn’t heard of the “103 Club.” (When I put up this post it will be the first time that “103 Club” Googles.)

My friend and colleague explained that the “103 Club’ was the term by which municipal bond tax lawyers from the city’s different firms referred to themselves when they periodically met for lunch to discuss the tax code and regulations. “103" refers to the section of the IRS Code pursuant to which most tax-exempt bonds attain their tax-exempt status.

The purpose of the 103 Club was to discuss what the tax code and regulations said and what they should be declared to say. The tax code and regulations don’t always say what they perhaps meant to say. The IRS is understaffed, the provisions are complex and certainly hard to write. When they don’t say what they mean or are sufficiently vague as to require interpretation, the industry lawyers can steer the IRS by agreeing upon what the IRS should be told the provisions mean. Enough industry lawyers communicating that they interpret something a particular way will generally persuade the IRS to agree unless the tax code provisions are explicitly contrary in both word and spirit to what the IRS meant to write. This approach naturally also applies when it appears that discovery of a loophole might be exploited. By definition, a loophole is when the spirit of a law can be evaded. So, you see, getting your way with the IRS is not only about hiring away from the IRS someone who one worked for them as was noted above.

I should observe that this kind of industry input is probably little different in other heavily regulated industries.

The last time I checked, not all that long ago, the 103 Club was still at it. Though I can’t think that its business would ever become unimportant, I can’t swear to you that they still refer to themselves using the “103 Club” term. After all, it is not a formally chartered group.

Poor IRS

This then is background when you consider the anonymous lawyer’s statement that "the federal government was fully involved in approving this transaction.” He is no doubt referring to how an IRS letter ruling was obtained providing comfort for the use of a loophole to evade the spirit of the law that Congress passed prohibiting sports stadium and arena financing. The poor IRS. The letter ruling was a stretch in itself, but when it was not satisfactory, based upon available facts, fictitious numbers were supplied to bootstrap it into workability.

Declaring Bonds Taxable: A City Expense

Noticing New York previously addressed itself (Friday, September 19, 2008, Contrivance in the service of creating blight, real blight- Listen again- REAL blight) to speculation that the tax-exempt bonds that have been issued for Yankee Stadium (and certainly any similar bonds) may be declared taxable based on the misrepresentations made to the IRS in obtaining private letter rulings from the IRS. (See also Atlantic Yards Report: Friday, September 19, 2008, At Congressional hearing, criticism of Yankees deal and stadium funding; IRS says final regulation coming soon.)

The bonds would almost certainly be declared taxable retroactively to the date of issuance, which would mean that taxes would be owed by bond holders not only going forward but for past years as well. Because the IRS ruling would be invalidated due to the contrived fictions of city government officials, it is envisioned that the city would be called upon to step in with payments to financially compensate the aggrieved bond holders. As I noted earlier, some individuals are more responsible than others for certain things even if a roomful of lawyers was involved.

Bond counsel on the transactions are probably predicting that the IRS would seek to negotiate a compromise. There is a persuasive argument that the IRS might just want to collect money straight from the city rather than having to chase down and reopen the tax returns of multiple bond holders. Maximum liability to the city might be somewhat circumscribed to the extent that the bonds can be made subject to an early call, with or without paying an early call premium. As we noted before, though the payments required from the city could be very substantial; this is not to say that they wouldn’t be proportionate to the arrogant carefreeness with which officials were willing to contrive fictive data at the expense of the public.

Away with Fictions, Scot-free?

Let me return again to the theme with which I began this essay: When there is money to be grabbed, do public finance and development professionals feel it safe to act with corporate collectivity to present fictions to the IRS? Forest City Ratner, thoroughly in the habit of making misrepresentations about Atlantic Yards and Nets Arena to the press and public, seems to have considered it safe to extend the habit to misrepresentations it is willing to make to the IRS. Much like the Yankee Stadium situation, other professionals (including officials with the city and state) seem willingly complicit or unwilling to due diligence information coming from FCR. The New York City Industrial Development Agency and the Empire State Development Corporation wrote a May 8, 2008 letter to the IRS urging that federal government allow R-TIFC PILOT (“Return Total Intercepted For Costs-Payment In Lieu Of Taxes” ) financing be used for the planned Atlantic Yards arena. In a July 14, 2008 letter to the IRS, Develop Don’t Destroy discredited that May 8th letter for its inaccuracies and fictive slant. (See: Monday, July 21, 2008, Asking feds not to approve tax-exempt bonds for AY arena, DDDB criticizes city/state letter.)

If the standard is not truth, but what can be gotten away with, do all these professionals feel safe presupposing that the IRS will tolerate their misrepresentations?

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