Lissack v. Sakura Global Capital Markets

• Decision Date: 03 August 2004
• Docket Number: No. 03-7977.,03-7977.
• Citation: 377 F.3d 145
• Parties: UNITED STATES of America ex rel. Michael LISSACK, Plaintiff-Appellant, v. SAKURA GLOBAL CAPITAL MARKETS, INC. and Mitsui Taiyo Kobe Global Capital, Inc., Defendants-Appellees.
• Court: U.S. Court of Appeals — Second Circuit

377 F.3d 145

UNITED STATES of America ex rel. Michael LISSACK, Plaintiff-Appellant, v. SAKURA GLOBAL CAPITAL MARKETS, INC. and Mitsui Taiyo Kobe Global Capital, Inc., Defendants-Appellees.

No. 03-7977.

United States Court of Appeals, Second Circuit.

Argued: May 14, 2004.

Decided: August 3, 2004.

Appeal from the United States District Court for the Southern District of New York, Barbara S. Jones, J William B. Pollard, III, Kornstein, Veisz, Wexler & Pollard, LLP, New York, New York (John R. Phillips, Erika Kelton, Phillips & Cohen, LLP, Washington, D.C., Marc Marmaro, Jeffer, Mangels, Butler & Marmaro, LLP, Los Angeles, California, on the brief) for Appellant.

John K. Carroll, (James D. Miller, Christopher Joralemon on the brief) Clifford Chance U.S. LLP, New York, New York, for Appellees.

Before: FEINBERG and CABRANES, Circuit Judges, and KRAVITZ, District Judge.^*

KRAVITZ, District Judge.

The relator in this case, Michael Lissack ("Lissack"), acting on behalf of the U.S. Government, sued the defendants ("Sakura") under the False Claims Act for damages arising from alleged false statements and claims made by Sakura in connection with a "yield burning" scheme involving tax-free municipal bonds. The False Claims Act authorizes private citizens to sue on behalf of the United States to recover treble damages from those who knowingly make false claims for money or property upon the Government or who knowingly submit false statements in support of such claims or to avoid the payment of money or property to the Government. See 31 U.S.C. § 3729 et seq. However, the False Claims Act contains a proviso known as the "Tax Bar," which excludes from the Act's coverage all "claims, records, or statements made under the Internal Revenue Code of 1986." See 31 U.S.C. § 3729(e).

In a decision of first impression, the United States District Court for the Southern District of New York (Barbara S. Jones, Judge) held that even though Lissack did not seek to recover federal taxes, his claims nonetheless fell within the purview of the Tax Bar because the falsity of the claims at issue depended entirely upon proving violations of the Internal Revenue Code. We agree with Judge Jones's thoughtful and comprehensive treatment of the issues and affirm on the ground that the Tax Bar excludes Lissack's claims from recovery under the False Claims Act. Accordingly, we do not reach the other grounds relied on by the District Court for dismissing Lissack's claims.¹

I.

A. Background

This case presents a highly complex financial scheme involving tax-exempt state and local government ("municipal") bonds, and, more specifically, bonds known as advance refunding bonds. The description we provide of this scheme, which lies at the intersection between finance and tax law, relies heavily on Judge Jones's thorough opinion below, as well as on Lissack's Second Amended Complaint.

The Internal Revenue Code (the "Tax Code") allows municipal governments to issue bonds that pay interest which is exempt from federal taxation. See 26 U.S.C. § 103(a). When interest rates decline, as they did in the early 1990s, municipal governments often seek to refinance their tax-exempt municipal debt before it otherwise would become due by issuing what are known as advance refunding bonds. Typically, advance refunding bonds also qualify as tax exempt. They provide municipalities with funds, at lower interest rates, that are used to pay off the principal and interest due on previously issued tax-exempt bonds carrying higher interest rates.

Because the underlying debt on the original bonds cannot be retired until the call date of those bonds, municipalities must invest the proceeds from issuance of the advance refunding bonds so as to generate cash flows to meet the debt service requirements of the original bonds. The Tax Code tightly regulates the use and investment of proceeds from issuance of tax-exempt advance refunding bonds. Treasury Department regulations require municipalities to place all proceeds from the sale of advance refunding bonds in an irrevocable "defeasance escrow" account ("escrow account"), which can be used only to pay principal and interest on the previously issued bonds until the original bonds can be retired. 26 C.F.R. § 1.141-12(d)(5) (defining defeasance escrow as "an irrevocable escrow established to redeem bonds on their earliest call date in an amount that, together with investment earnings, is sufficient to pay all the principal of, and interest and call premium on, bonds from the date the escrow is established to the earliest call date").

The Tax Code strictly limits the yields that municipalities can earn on their escrow accounts so as to prevent municipalities from engaging in what is known as "arbitrage" — that is, investing the proceeds of the tax-exempt advance refunding bonds in higher-yielding taxable securities and thereby profiting from the tax-exempt status of the bonds. As the Treasury Department's regulations explain:

Under section 103(a), interest on certain obligations issued by States and local governments is excludable from the gross income of the owners. Section 148 was enacted to minimize the arbitrage benefits from investing gross proceeds of tax-exempt bonds in higher yielding investments and to remove the arbitrage incentives to issue more bonds, to issue bonds earlier, or to leave bonds outstanding longer than is otherwise reasonably necessary to accomplish the governmental purposes for which the bonds were issued. To accomplish these purposes, section 148 restricts the direct and indirect investment of bond proceeds in higher yielding investments and requires that certain earnings on higher yielding investments be rebated to the United States. Violation of these provisions causes the bonds in the issue to become arbitrage bonds, the interest on which is not excludable from the gross income of the owners under section 103(a).

26 C.F.R. § 1.148-0.

Under the Tax Code, if the yield on the escrow account is greater than the yield earned by the holders of the advanced refunding bonds, the bonds are considered "arbitrage" bonds and are no longer tax exempt. 26 U.S.C. § 103(b)(2) (excluding arbitrage bonds from tax exemption provision). "[T]he term `arbitrage bond' means any bond issued as part of an issue any portion of the proceeds of which are reasonably expected (at the time of issuance of the bond) to be used directly or indirectly(1) to acquire higher yielding investments, or (2) to replace funds which were used directly or indirectly to acquire higher yielding investments." Id. § 148(a). "Positive arbitrage" refers to situations where the combined yield on the escrow account is higher than the yield on the bonds, with the amount of positive arbitrage defined as the difference between the two yields.

Typically, escrow accounts consist of U.S. Treasury securities that are scheduled to mature on a date as close as possible to the date on which a debt service payment is due on the original bonds. Often, however, it is impossible to arrange the timing of payments on the Treasury securities in the escrow account to coincide exactly with the due dates of payments on the originally issued municipal bonds. This results in a gap period, known as the "float period," which can extend for several days or even a month or more. To keep the escrow account fully invested even during float periods, municipalities bridge the float periods through a financial product known as a "forward supply agreement." Forward supply agreements are contracts that give their purchasers the right to invest the cash flows generated by the escrow account in short-term securities at specified future dates. These agreements are arranged at the time the escrow account is established, since the dates and duration of the float periods can be determined at that point. What cannot be determined at that point, however, are the specific reinvestments contemplated by the forward supply agreement, because they will occur in the future. As a consequence, providers of forward supply agreements (the "provider") structure them so that they pay municipalities a sum certain for the right to reinvest future escrow cash flows during float periods. Through these agreements, municipalities derive the funds they will need to bridge the float periods; in return, the provider of the forward supply agreement receives the right to retain the proceeds derived from reinvesting the cash flows in the escrow account at specified future dates. A market exists for these forward supply agreements, which are commonly used in both public and private transactions that involve timing gaps in portfolios.

Because the price of the forward supply agreement is determined by assessing the return the provider expects to earn from reinvesting cash flows in the escrow account during float periods, a forward supply agreement provider can exaggerate its investment costs in order to understate its expected return and thereby pay less to the municipality for the opportunity to invest the escrow account's cash flows. In order to prevent this fraud, the Internal Revenue Service ("IRS") has established a bidding process to ensure fair market values for forward supply agreements. 26 C.F.R. § 1.148-5(d)(6)(iii).

Due to the restrictions against arbitrage discussed previously, municipalities must ensure that the combined yield on both the securities held in the escrow account and the amounts earned from the forward supply agreements do not exceed the yields paid to holders of the advance refunding bonds. Because the amount realized from the sale of the forward supply agreements must be included when calculating the yield generated by the escrow account, the more a provider of a forward supply agreement pays the municipal issuer, the higher the yield of the escrow account, and vice-versa. If a municipality determines that the combined yield of the securities held in the escrow account and forward...