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‘Yield burning’ agreement praised

‘Yield burning’ agreement praised

Cities and counties are feeling more financially secure since the government agreed to a settlement in a "yield burning" case involving a number of local
  • Written by Stephen Barlas
  • 1st July 1998

Cities and counties are feeling more financially secure since the government agreed to a settlement in a “yield burning” case involving a number of local governments and underwriter Meridian Securities. The company (bought in 1996 by Corestates Financial Corporation) and one of its former executives agreed to pay $3.7 million in fines to settle the case, which involved underwriting bonds that were then sold by local government entities in Pennsylvania and West Virginia.

The settlement marks the first time a financial institution has agreed to shoulder the blamefor fraudulently marking up the prices of bonds. Corestates did not acknowledge wrongdoing in the case; it merely agreed to the settlement to resolve tax questions arising from a number of municipal bond refinancing deals.

Deals like the one that prompted the settlement were common in the 1990s. When interest rates dropped, local governments refinanced older bonds with higher interest rates by issuing new bonds. The proceeds of those refinancings were put in escrow accounts stocked primarily with Treasury bonds that were then bought by the underwriters.

Ultimately, the price of the Treasury bonds was artificially inflated, allowing the underwriters to lower the yield for IRS reporting purposes. The practice threatened the tax-exempt status of those municipal bonds and left open the threat of huge federal penalties. For the past four years, the IRS has been threatening a never-specified number of cities and counties with having to pay millions of dollars in back taxes, arguing that the bonds they sold did not qualify as tax-exempt. Local governments had always argued that, not only did they do nothing wrong, they were in fact the victims of the practice.

Arthur Levitt, chairman of the Securities Exchange Commission, acknowledged as much in the settlement. “[It] is a fraud perpetrated against local governments and taxpayers,” he noted. As part of the settlement, the SEC, along with the Treasury and the Justice departments agreed to halt further yield burning investigations against local governments.

“It’s a potential landmark template agreement,” says Frank Shafroth, director of policy and federal relations for the National League of Cities. “But we’re not doing anything until the fat lady sings. A week after the settlement, the director of the Baltimore regional IRS office announced he was sending out 200 additional notices of investigation.”

The problem, according to Shafroth, is that the wrong people are making the decisions. Treasury Secretary Robert Rubin, the former CEO of underwriter Goldman Sachs, was forced to recuse himself, leaving somewhat of an intellectual vacuum. “There’s no one in charge who can say to the IRS, ‘Put a lid on it until we figure out the policy, so we’re all singing out of the same hymnal,'” Shafroth says. “Right now, each regional office is making its own rules.”

Oklahoma City Councilmember Mark Schwartz praised the settlement, which he had worked on last year as president of the NLC. “We are pleased to see this agreement to achieve restitution to all levels of government and to assure protection for cities and municipal bondholders,” Schwartz said in a press conference following the announcement of the settlement. “We hope it will lead to an effort to develop a joint team approach on this issue.”

Schwartz noted that NLC had asked repeatedly about working with the SEC and the departments of justice and the treasury to reach some consensus. Turf wars and spats between the three, however, prevented serious discussions. “There still has been no effort to get back to us,” he says. “Hopefully, this agreement will clear the way.

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