WASHINGTON — The Government of the U.S. Virgin Islands and the Virgin Islands Public Finance Authority filed a lawsuit this week against their former bond counsel and financial advisor, alleging they were negligent when they advised that $219.49 million of bonds issued in 2006 would be tax exempt.
The Internal Revenue Service found in an audit that there was an over-issuance of the 2006 bonds because some of the proceeds were used to refund some 1999 bonds issued for working capital and the authority had already committed to redeem the 1999 bonds with surplus revenues each year from 2005 to 2009. The authority did not redeem any of the bonds with surplus revenues, violating its covenant.
The IRS also found that the 2006 bonds, which were issued based on the conclusion that the government was suffering an ongoing deficit, should not have been tax-exempt because the government had a cash surplus, according to the complaint.
After negotiations, the IRS said that $80 million of the 2006 bonds should not have been issued as tax-exempt. The PFA and the GVI paid $13.6 million to settle the tax dispute and maintain the tax-exempt status of the bonds.
The lawsuit names as defendants bond counsel Buchanan Ingersoll & Rooney PC and financial advisor Bank of America and related entities collectively referred to as "BoA." It also names as defendants "Does 1-10" who are employees of the other defendants that have not yet been identified, and "XYZ Corporations 1-10," which are other companies involved in the bond issuance that have yet to be identified.
All of the defendants are being sued in U.S. District Court of the Virgin Islands for negligence. Additionally, Buchanan and BoA are being sued for breach of fiduciary duty and breach of contract. Buchanan is also being sued for legal malpractice. The plaintiffs are seeking a jury trial and are asking the court to award them compensatory and punitive damages, prejudgment interest and attorneys' fees and costs.
"The Government of the Virgin Islands has been financially penalized as a result of the poor advice of our former advisors," John de Jongh, Virgin Islands governor and PFA chairman, said in a news release. "We have brought this lawsuit to ensure that the burden of this result is shouldered by those responsible and not by our local taxpayers."
David Stone, lead counsel for the plaintiffs and an attorney at Stone & Magnanini LLP, pointed out to The Bond Buyer that the government employees didn't have sophisticated expertise in issuing tax-exempt bonds and, as a result, had to rely on their advisors.
Buchanan generally does not make comments on claims, but its spokesperson Randy Vulakovich said the firm is confident that "the U.S. legal system will verify the integrity of our trusted role in providing sound counsel to our clients." A spokesperson for Bank of America said it has no comment on the lawsuit.
The PFA is an instrumentality that was created to help the GVI perform its fiscal duties and raise capital for essential public projects. In 1999, when the Virgin Islands was "struggling with severe fiscal deficits," the PFA and the GVI issued $299.88 million of series 1999A tax-exempt revenue bonds to finance the territory's working-capital cash deficit, according to the lawsuit. In three separate agreements, the GVI and the PFA agreed to pay off those bonds if the territory had a surplus, according to the complaint.
The Virgin Islands PFA hired Buchanan for bond counsel services in 2000. Under its contract, Buchanan was supposed to provide services relating to financing and refinancing public debt, economic recovery and legislation and other matters.
The authority hired Bank of America in 2002 to be its financial advisor. BoA was supposed to help manage the Virgin Islands' finances and help with efforts to develop revenue enhancement and expenditure reduction initiatives. As a result, the authority and the GVI regularly gave BoA financial data that could be used in reports to provide the plaintiffs with guidance on spending and investment issues and structuring bond transactions, according to the complaint.
The territory's financial condition improved from 2000 to 2005. In 2005, underwriter UBS Securities LLC proposed that additional bonds be issued. BoA and Buchanan supported the new issue. BoA and Buchanan advised the PFA and the GVI that they could issue tax-exempt working capital bonds again because the territory was in a cash deficit position, according to the complaint.
In September 2006, PFA issued $219.49 million of tax-exempt revenue bonds. More than $175 million of the proceeds were to be used to refund the 1999 bonds, $27 million were for termination of a swap option agreement, and $14 million were to be used for capital projects. The rest was used for reserves and to pay the cost of issuance.
Buchanan gave an opinion that the bonds were tax-exempt because they would finance a working capital cash deficit that the GVI continued to have from when the 1999 bonds were issued. It prepared a tax certificate and agreement that represented that the GVI had no working capital surpluses, according to the complaint.
But the law firm failed to realize that the GVI actually had cash surpluses in the three fiscal years preceding the bond issue that the territory had a projected surplus for 2006, the PFA and GVI said. BoA "misapplied rudimentary accounting principles to its revenue and surplus calculations, failed to recognize clear evidence, some of which it prepared, that GVI had cash surpluses for fiscal years 2003-2005 and a projected cash surplus for 2006, and misadvised the PFA and the GVI in sizing and structuring the Series 2006 bond issuance," the government and authority alleged in their complaint.
On March 1, 2012, the PFA was informed by the IRS that it was going to audit the 2006 bonds. Two-and-a-half months later, the IRS told the PFA that it had reviewed the GVI's financial statements from 1999 to 2008, and they showed cash surpluses from 2003 to 2006 rather than deficits.
In July 2012, the IRS determined the GVI did not comply with bond documents for the 1999 bonds because it didn't refund any of the 1999 bonds before 2006 even though it had cash surpluses starting at the end of fiscal 2003. The agency also determined that the 2006 bonds should be taxable because the GVI had a cash surplus, rather than a deficit, at the time the bonds were issued, according to the complaint.
Under Treasury Department regulations, bonds are taxable arbitrage bonds if they use an "abusive arbitrage device," such as overburdening the tax-exempt market. The IRS said that the portion of the 2006 bonds used to refund the 1999 bonds is overburdening the market because there should have been a tender offer on those bonds when there were surpluses. The agency added that the issuer "knew or should have known that there were surplus available revenues" because it had released financial statements for the fiscal years ending in 1999 through 2004.
Stone said BoA advised the issuer about its cash flows and that that there were liabilities in a cash-flow statement it prepared that aren't considered liabilities by the IRS.
The PFA and its counsel for the audit, Hawkins Delafield &Wood LLP, convinced the IRS to base the settlement payment on a conclusion that only $80 million of the 2006 bonds used to refund the 1999 bonds were not tax-exempt. In 2013, the PFA and the GVI settled with the IRS by paying it $13.6 million. To finance the payment, the PFA issued taxable bonds and loaned $14 million to the GVI, according to the complaint.
The GVI and the PFA said they suffered damages due to the defendants' conduct "including but not limited to the expense involved in connection with the IRS examination, the expense in connection with the $13.6 million payment and the expense in investigating and pursuing recovery from the defendants."
