Harbor Bancorp & Subsidiaries v. C.I.R.

• Decision Date: 06 August 1997
• Docket Number: No. 96-70037,96-70037
• Citation: 115 F.3d 722
• Parties: -2971, 80 A.F.T.R.2d 97-5667, 97-2 USTC P 50,532, 97 Cal. Daily Op. Serv. 4355, 97 Daily Journal D.A.R. 7299 HARBOR BANCORP & SUBSIDIARIES; Edward J. Keith; Elena Keith, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Ninth Circuit

Page 722

115 F.3d 722

79 A.F.T.R.2d 97-2971, 80 A.F.T.R.2d 97-5667,

97-2 USTC P 50,532, 97 Cal. Daily Op. Serv. 4355,

97 Daily Journal D.A.R. 7299

HARBOR BANCORP & SUBSIDIARIES; Edward J. Keith; Elena

Keith, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 96-70037.

United States Court of Appeals, Ninth Circuit.

Argued and Submitted May 6, 1997.

Decided June 10, 1997.

As Amended Aug. 6, 1997.

Mary Gassmann Reichert, Bryan Cave, St. Louis, Missouri, for petitioners-appellants.

Richard Farber (argued), Gary R. Allen, Edward T. Perelmuter, Tax Division, United States Department of Justice, Washington, D.C., for respondent-appellee.

Before MAGILL, ^* RYMER, and THOMAS, Circuit Judges.

OPINION

RYMER, Circuit Judge:

Taxpayers Harbor Bancorp and Edward and Elena Keith appeal from a decision of the Tax Court denying tax-exempt status to interest the taxpayers earned on bonds issued by the Riverside County, California, Housing Authority. The Tax Court determined 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 Tax Court had jurisdiction under I.R.C. §§ 6214, 7442, and 7460(b). ¹ We have jurisdiction under I.R.C. § 7482, and we affirm.

I

This is a complicated story involving two separate but substantially identical municipal bond issues of the Riverside County Housing Authority. There are two controlling questions, involving two pivotal events in the life of the bonds.

One question is whether 1985 or 1986 tax laws control. This depends on whether the bonds were issued in an irregular pair of closings on December 31, 1985, or instead were issued February 20, 1986 when actual dollars began to flow within the Housing Authority's financing plan. The second question is whether, given that a financial institution that took part in the bond financing plans misappropriated the bond proceeds and invested them, the Authority was obligated to pay the Treasury the spread between the yield on the bonds and the return on the unexpected investments if it wanted to preserve the tax-exempt status of the interest paid to the bondholders in this case.

A

The Riverside County Housing Authority is an arm of the County whose governing body is the County's board of supervisors. In 1985, the Authority wanted to finance construction of low- and moderate-income housing in the County with municipal bonds. After some deliberation, the Authority settled on a "conduit financing" plan. Conduit financing differs from the traditional "government financing" structure of municipal bond issues in which a public entity uses the bond proceeds to build public facilities. In conduit financing, the governmental bond issuer channels the funds to a private entity, such as a housing developer, to use for a public purpose. See generally J.R. Eustis, Jr. & D.M. Weiner, Raising Funds with Tax-Exempt Bonds, 240 PLI/Tax 141 (1986), available in Westlaw.

In late 1985, Riverside County approved bond issues and conduit financing plans for two housing developments, to be known as the Whitewater Garden Apartments and the Ironwood Apartments. One-fifth of the units in each development were to be for low- and moderate-income families. Whitewater was expected to have a total of 460 units; Ironwood was expected to have 312.

The conduit financing was designed to work as follows. The Housing Authority would issue the Whitewater and Ironwood bonds through two Wall Street underwriters--Donaldson, Lufkin & Jenrette Securities (DLJ) and Drexel, Burnham, Lambert, Inc.--with Interfirst Bank of Houston holding the proceeds as trustee for the bondholders. The Authority would lend the bond proceeds--about $18 million for the Whitewater project and about $12 million for Ironwood--to the respective developers, and assign each developer's note to the trustee, Interfirst. Each developer would hold the bond proceeds in an earmarked "developer loan fund" at a predesignated bank.

Next, under the plans, the Whitewater and Ironwood developers would obtain letters of credit by mortgaging the property where each project was to be built. The bank that issued the letter of credit in exchange for the mortgage would then sell that mortgage for cash to a predesignated institution, then use that cash to buy a guaranteed investment contract (GIC) with sufficient returns to pay the interest and principal on the bonds. The bank would pledge the GIC to the trustee, Interfirst, to secure the bonds. The goal was that, in exchange for fees to various financial institutions, each bond issue would be backed by an investment-grade instrument, the GIC, as well as by the developer's note. One downside was that the developers would carry extra debt. The developers were expected to pay off their notes and mortgages with the rental income from the projects.

SBE Development, Inc., which had been active in California's construction industry for more than a decade, was chosen as the primary developer for each project. As the designated "letter of credit provider" for the Whitewater project, the County selected Mercantile Capital Finance Corp. No. 47 (MCFC 47). The letter of credit provider for Ironwood would be Mercantile Capital Finance Corp. No. 30 (MCFC 30). As the "mortgage purchaser" for both Whitewater and Ironwood, the County selected Unified Capital Corp. The two MCFCs were controlled by James J. Keefe, who was also one of three people who controlled Unified Capital. Unified Capital's eventual diversion of the bond proceeds would start the chain of events that has led to this case.

The principals involved in preparing the Whitewater and Ironwood bond issues knew of changes in the tax laws that would apply to municipal bonds issued after December 31, 1985, so they believed it was important to complete the issues by the end of the year. Yet by mid-December, after the County supervisors had approved the bond issues and after certain financing documents had been executed at a pre-closing, both Wall Street firms whom Riverside expected would underwrite the bonds pulled out. An investment banker at DLJ arranged to install Matthews & Wright, Inc., another Wall Street firm, in their place. Matthews & Wright was a well-known underwriter of municipal bonds, and DLJ itself was preparing an initial public offering of Matthews & Wright's stock. However, the County wasn't told of the substitution of Matthews & Wright at this time.

In order to beat the end-of-year tax deadline, DLJ had planned to have another institution "warehouse" the bonds--that is, to buy them before January 1 and hold them until they could be rated by a bond agency and marketed. Matthews & Wright now took over the warehousing arrangements. On December 29, 1985, Matthews & Wright informed its lawyers and counsel for Interfirst that Commercial Bank of the Americas, a corporation headquartered in the Northern Mariana Islands (and not at that time chartered as a bank), would buy the bonds and warehouse them. An Interfirst executive did a limited one-day check on Commercial Bank's bona fides by confirming that it was listed in a directory of international banks. Unknown to Interfirst, the founder, operator, and sole shareholder of Commercial Bank was an executive of Matthews & Wright.

Two days later, on New Year's Eve 1985, the parties held what appeared to be closings of the Whitewater and Ironwood bond issues at Matthews & Wright's New York offices. These closings, which were among dozens done by Matthews & Wright in much the same way on the same day, were casual affairs considering the amounts of money involved. No representative of Riverside County or the Housing Authority attended. The law firm representing Matthews & Wright as underwriter's counsel sent an associate. Interfirst sent an employee who was in New York on other business but who knew little about the bonds or the financing plans and who followed step-by-step directions from her headquarters during the transactions.

At the closings, counsel for Matthews & Wright, apparently acting on behalf of bond counsel for Riverside, handed temporary Whitewater and Ironwood bond certificates to Arthur Abba Goldberg, vice president of Matthews & Wright. ² In exchange, Goldberg handed Interfirst's representative drafts for the face value of the bonds. These drafts (the equivalent of checks) had been prepared from starter kits for new accounts at a credit union that Goldberg himself controlled. The accounts on which the drafts were nominally drawn didn't exist. In closings that same day, Matthews & Wright wrote 24 drafts on Goldberg's credit union for a total of some $750 million, or about 15 times the credit union's assets. Interfirst had accepted large checks from underwriters in the past, however, and it had no reason to think the credit union drafts could be dishonored upon demand for payment.

The drafts were never cashed. Upon receiving them, Interfirst's representative by prearrangement endorsed over the drafts "without recourse" to buy two investment contracts from Commercial Bank of the Americas. ³ The general manager of Goldberg's credit union acted as the signatory for Commercial Bank in the sale of the investment agreements, although he later testified that he knew nothing about Commercial Bank, which in fact was a shell with no material assets. (Prior to the closings, Matthews & Wright--which at this point in the deal was the bondholder for whom Interfirst was acting as trustee--had agreed to hold Interfirst harmless for investing the proceeds of the issuances with...