The Ghost of Scandals Past

Previous "creative financing" debacles should haunt city officials who've approved a risky $1 billion lease of Muni streetcars

I was sitting in a smallish, undecorated conference room with a city bureaucrat, discussing a plan to lease the city's fleet of light-rail cars to private investors, when the walls came alive with ancient spirits. I saw images of former government officials from Nevada County to Pittsburg, from Tehachapi to Palm Springs. Their legs clanked with the shackles of creative municipal financing deals long ago gone sour; they moaned in voices deeper than the deepest city coffer: "Everybody's doing it. It's standard industry practice."

I had arrived at the offices of the Municipal Railway to ask Muni Deputy Manager for Finance Gigi Harrington about a Cayman Islands shell company that will be the city's go-between in an offshore corporate tax shelter involving a complex lease/leaseback of the city's 118 Breda streetcars.

"Tell me everything you know about Premier International Funding Corporation," I said, referring to an entity that will handle more than $1 billion in Muni money over 27 years, an entity that takes its mail in care of QSPV Limited, which is -- apparently unbeknownst to Harrington -- a subsidiary of the same Cayman Islands law firm that set up the "LJM Cayman" shell companies that played a role in ruining Enron.

"They exist, as I understand it, for purposes of, um, the payment, and they're, uh," Harrington said, before pausing to start over again. "I don't know. When we went to procure the surety, and the, um, debt portion of the transaction, all these components were bid together, so the entity in the Caymans is part of FSA, who bid on this proposal." Harrington's voice trailed off into an unfinished haze of inaccurate statements, then she abruptly said she had another meeting to attend.

And that's when the ghosts entered the room.


It's only trivially relevant that Maples and Calder, the Cayman Islands law firm that owns QSPV Limited and set up Enron's Cayman Islands shell firms, appears to be involved in Muni's shell firms, too. But it's deeply troubling to me that Muni's finance director doesn't seem particularly interested in knowing who we're dealing with in this complex plan to lease, and then lease back, city rail cars, or what, exactly, the 2-inch-high pile of contracts that she's recommending the city enter into will commit the city to do.

Harrington's attitude, shared by other Muni officials and advisers, seems to be underpinned by a type of logic that has driven financial fads through time, whether tulips or Internet stocks or junk bonds: As long as everyone else is doing it, ignorance is bliss. In this case, the attitude says that it isn't important whether Muni bureaucrats truly understand the details of a deal (approved Monday by the San Francisco Board of Supervisors) that has Muni leasing its Breda light-rail cars to wealthy investors, who will lease them right back to the city, in the process gaining what they hope will be the privilege to write off on their federal tax returns tens of millions of dollars of streetcar wear and tear, or depreciation.

What matters most, Muni officials have said in interviews, in testimony before the board, and in documents summarizing the leasing transaction for the public, is that Muni will receive $33 million in immediate benefit from the deal; that 60 other transit systems have already completed similar deals; that many elements of the Muni deal are "standard industry practice"; and that neither the public nor its elected representatives ought be concerned with facts beyond these.

But there are facts, and risks, that can't and shouldn't be ignored.

This series of contractual agreements, which ties Muni to the aforementioned Cayman Islands shell companies, to a group of foreign banks, to their trusts, their trustees, and their lawyers, appears to place the city in a truly amazing situation, even by the high-wire-act standards of creative municipal financing.

The agreements make the city legally responsible for guaranteeing private investors a perfect tax shelter, one that must consistently pass muster with the IRS, one that must not fall apart in a few years, one that does not contain details that will somehow cause investors to achieve less of a tax write-off than they had initially hoped for. If, for a laundry list of reasons spelled out in the agreements, the IRS does not allow the investors as big a tax break as they had planned, these contracts explain in excruciating detail how we, the taxpayers of San Francisco, must pay the investors enough money so that their balance sheets read as if they did have the perfect tax shelter they had hoped for. If the tax shelter fails, and the investors take the IRS to court, we pay their legal fees. If the investors claim their tax write-off is faulty, and we don't believe them, we are specifically prohibited from examining their books.

In signing these agreements, the city has entered a legal house of mirrors. If the IRS determines that the great Breda lease/ leaseback is purely a tax shelter of the type prohibited under the U.S. tax code (and there is at least one recent IRS ruling running in that direction), the Breda deal will become less of a tax shelter for investors, and taxpayers will, apparently, have to pay the investors enough to offset the increased taxes the investors will owe. And "enough" could wind up being tens of millions of dollars.

"It's laid out in text that the City and County of San Francisco is expected to indemnify all the trust holders and the equity investors from this risk, and that doesn't make any sense," says Greg Dorbeck, a financial consultant who specializes in leases, and who reviewed the contracts in question at SF Weekly's request. "This whole deal is predicated on an authority [the IRS] that hasn't given its blessing to the transaction. Someone has to get a ruling that the trust will work, and it's incumbent on the investors to do so. It's not the city's problem."

But the pile of contracts Muni is poised to sign say it is the city's problem. Our city officials don't appear to understand, or be willing to admit, this risk to taxpayers. Everybody else is doing these kinds of deals, they say. It's standard industry practice.

But standard industry practice has a history of biting the practitioners.


Sitting in the bleak conference room after Harrington excused herself to leave, I recalled the last time California embarked on a creative-municipal-financing craze, the so-called "dirt bond" boom that peaked in 1990. I recalled how financial advisers told municipal officials that it was perfectly reasonable to shackle themselves in risky business partnerships with private investors they knew very little about. I remembered how, during the next seven years, $317 million worth of these "Mello-Roos" bond-financing deals went sour, and how by the late '90s municipal bond analysts had described a "default line" consisting of 29 failed special-financing entities that roughly paralleled the San Andreas fault.

I remembered how my former father-in-law, California real-estate-tax-shelter-limited-partnership king Michael Montross, bankrupted Nevada County in a 1990 fraudulent dirt-bond scheme, then went on the lam. I recalled how the U.S. Securities and Exchange Commission next launched a California-wide inquiry in which municipal officials from Nevada County to Antioch, along with their San Francisco financial advisers, were called to task for entering into risky, complicated municipal financing deals without having a clear idea what they were getting themselves into.

The dirt-bond craze differed in important ways from the lease-leaseback transactions that have recently beguiled officials in San Francisco and elsewhere. Dirt bonds depended on the profitability of real estate developments; lease-leasebacks rely on the effectiveness of corporate tax shelters. But both types of transaction are alike in that they put the fate of millions of dollars in government assets in the hands of private investors, creating a situation where municipalities may lose control of their own destinies. These transactions have another important trait in common: Defenders of both types of deal have lured municipal officials by using the "everybody's doing it" justification, and the "this is standard industry practice" rationale that underpins many a dubious creative-financing boom.

I spoke to Walter Borny, who was Montross' top salesman before becoming a whistle-blower and joining a class-action lawsuit against Montross' firm, to ask if he also saw any ghosts emanating from this week's Muni-Breda leaseback deal. Borny is now a registered representative at Whitehall Parker Securities in San Francisco, and he is familiar with the lease-leaseback tax-shelter deals that cities such as San Francisco have been entering into during recent years.

"When you are giving control away to other people, it's not something the government or municipalities should be involved in. It creates the temptation or the risk of potential corruption," Borny said. "These municipalities are doing this to attract funds by investors, but it's probably going to end up in a similar mess that we've seen since the mid-'80s with Mello-Roos bonds, of loss of control, and perhaps even the loss of the equipment itself, to the parties that do control it."


The last time I'd given a thought to Michael Montross was five years ago, when he was awaiting a 100-count securities fraud trial in San Mateo. His once-sprawling real estate empire now existed only in the memory of myriad court files.

Twelve years ago he had imagined a grander future. Back then, he was chasing the possibility of creating housing-tract gold out of dirt in the Sierra Nevada foothills, in a scheme that became infamous in New York finance circles. In 1990, Montross proposed that Nevada County designate a 286-acre property he had bought as a special, Mello-Roos tax district, named for the California lawmakers who sponsored legislation allowing such districts in 1982. Under that legislation, a developer could borrow money by selling bonds; the developer and home buyers (as they moved into the new subdivision) were expected to pay off the bonds through special property taxes.

But if a developer failed to complete a subdivision, or went bankrupt, then the county that had authorized the bonds might be left with no way to repay the debt.

Nevada County supervisors hired a San Francisco investment bank to underwrite the bonds and the vice president of another San Francisco investment banking firm to act as financial adviser, and issued $9 million in Mello-Roos bonds. According to SEC files, Montross lied to officials and advisers about his supposed personal ownership of the land. He said he was an experienced real estate developer, when he wasn't. Montross' statements to Nevada County suggested he had enormous financial worth when, in fact, by 1989 his firm was nearly broke. Montross failed to complete the subdivision, filed for bankruptcy, and left the county up a financial creek.

He went on the lam for two years before he was arrested in Southern California for trying to obtain a phony passport. He was subsequently sentenced to state prison on securities fraud charges related to his collapsed limited partnerships.

In 1995 the SEC notified Nevada County officials and other deal participants that it was considering filing securities fraud charges against the county and its entire financing team. Following a three-year probe, the SEC reached a negotiated settlement with the county that resulted in a "cease and desist" order specifying that, even though Nevada County hired lawyers and experts, it violated U.S. securities law by failing to adequately supervise the creative-financing bond deal itself.

The San Francisco investment banking firm that underwrote the bonds agreed to pay $700,000 in penalties to settle a federal civil suit connected with the Montross deal.


If Nevada County tied its fate to that of Michael Montross, San Francisco is marrying its interests with those of a group of investors and trustees. In the case of Nevada County, sound city finances relied on the promise of a successful real estate deal. In San Francisco, our partners must build the perfect tax shelter.

The deal is supposed to work like this: Muni will lease 118 of the city's Breda rail cars to a group of private investors, mostly foreign firms. For the right to deduct the value of the cars' annual wear and tear from their federal taxes, the investors will lease the cars back to Muni -- at a $43 million discount. Muni will pay $10 million to lawyers and financial consultants, and keep $33 million for itself.

If the IRS somehow determines that the investors can't take the tax deduction they had hoped for, however, it becomes S.F. Muni's responsibility to make it whole, according to the Tax Indemnification Agreement Muni is entering into with CIBC, one of the investors. According to this agreement, the taxpayers of the City and County of San Francisco are liable for helping create the Breda tax break (or sham, depending on your point of view). If the IRS gets wise, and disallows the tax break, the agreement provides a laundry list of ways the decision might be considered Muni's fault. In such an event, the citizens of San Francisco must pay the investors what they say we have to pay, in taxes, because of the loss of the tax shelter -- and we won't even be allowed to inspect the investors' records to make sure they're telling us the truth. Theoretically, the city could be liable for millions, or even tens of millions, of dollars.

It would seem important, therefore, that Muni officials and their advisers achieve a solid understanding of how, exactly, the tax shelter is supposed to work, and who, exactly, we're dealing with.

Harrington, for one, did not seem conversant with these details during our meeting in the conference room, or in a subsequent half-hour conversation. To answer my questions, she looked up documents and read from them; she gave incomplete, misleading descriptions; she obfuscated in other ways. At the same time, however, she insisted that this tax shelter, which Muni has sold to the Board of Supervisors as a tax shelter, not be referred to in the press as a tax shelter.

Harrington told me she would take my request to speak with attorneys from Orrick, Herrington & Sutcliffe LLP, who advised the city on the Breda leaseback deal, "under advisement." In other words, she refused.

The city's financial adviser, Peter Ross, a principal of Ross Financial, seemed more knowledgeable about the transaction. Still, he parried questions about the tax shelter's details. "These are quite complicated, and the questions you raise are the ones you are very much aware of," he said. "It's a complicated aspect, and counsel for the investors have concluded that the transactions do comply with the tax code, and our counsel is satisfied that the tax risk is borne by the equity investor rather than Muni."

For Walter Borny, who during the early 1990s spent months poring over court and financial records trying to determine what, precisely, Montross had done with investors' money, the evasions and temporizing sound all too familiar: "Anybody who says, '"Everybody's doing this' -- those are buzzwords for '"Don't look into what we're doing.'"


Having scrutinized spirits past, I thought I'd visit ones from a possible future of lease-leaseback deals. I traveled by phone to Ontario, Canada, where the provincial government is drawing up municipal leasing guidelines after a lease-leaseback deal for a proposed sports complex in the city of Waterloo blew up into a series of lawsuits when a journalist determined last year that the deal would cost the city $228 million over 31 years, twice what officials first thought. As it happened, the tax shelter part of the deal fell through, and the city of Waterloo was liable for the money lost to investors.

Since then, several other government entities in Ontario have launched inquiries into troublesome lease-leaseback transactions similar to the Muni-Breda leaseback. The city of Toronto has hired leasing expert Greg Dorbeck to conduct a detailed review of a lease agreement involving $68 million of computer equipment.

"At the end of the day, we came to a conclusion that the best types of protections were to require the full light of day to be shone on these things as they were being entered into. You've got to have high levels of disclosure at the front end," said Dan Cowin, director of municipal finance for the Ontario Ministry of Municipal Affairs and Housing. "We want to require clearly that municipalities' treasurers and their councils come to grips with what a leasing policy ought to look like, how they're going to manage risk. All these things would be part of such a policy."

What's going on in Ontario might be of interest to S.F. officials who have been so eager to push through a multimillion-dollar lease of Muni's Breda light-rail cars that they seem to have closed their eyes to precisely whom or what they are getting involved with.

In the world of creative municipal financing, when one closes one's eyes, ghosts may appear.

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