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August 19, 2003


The opinion of the court was delivered by: Barbara Jones, District Judge


Michael R. Lissack (the "Relator") brings this action to recover damages and civil penalties on behalf of the United States of America arising from allegedly false and fraudulent statements and claims made or caused to be made by Defendants, SMBC Capital Markets, Inc., successor by merger to Defendant Sakura Global Capital Markets, Inc. (formerly doing business as Mitsui Taiyo Kobe Global Capital, Inc.) (collectively "SGC"), in violation of the False Claims Act, 31 U.S.C. § 3729 et seq., as amended. The Relator's claims involve allegations of fraud in connection with certain municipal bond transactions. Relator originally filed a complaint against multiple defendants in the predecessor to this action in February `of 1995, but that initial complaint did not name Defendants SGC. The Government elected to intervene in these actions, and the parties subsequently entered [ Page 2]

into various settlement agreements resulting in the Government's recovery of over $200 million. Both the U.S. Attorney's Office and the Internal Revenue Service ("IRS") are parties to these agreements.

In May of 1996, Relator alleged for the first time that Defendants' conduct in its provision of ten forward supply agreements violated the False Claims Act. (See First Am. Compl., App. 2). On October 30, 2000, the Government declined to intervene in the Relator's action against SGC. (See Court Docket No. 82). Later, in March of 2001, Relator filed a Second Amended Complaint ("Compl.") against Defendants and listed five additional transactions in which Defendants allegedly engaged in fraud with respect to their provision of forward supply agreements.

Defendants seek the dismissal of Relator's Second Amended Complaint pursuant to Fed.R.Civ.P. 12(b)(1) for lack of subject matter jurisdiction. Alternatively, Defendants claim that the action should be dismissed for failure to state a claim upon which relief can be granted pursuant to Fed.R.Civ.P. 12(b)(6) and for failure to plead fraud with particularity pursuant to Fed.R.Civ.P. 9(b). [ Page 3]

I. The Transaction

Under § 103 of the Internal Revenue Code ("IRC"), interest on state and local bonds is excluded from taxable income, unless the bonds are private activity bonds, arbitrage bonds, or bonds not in registered form. 26 U.S.C. § 103. The alleged frauds at issue in this case stem from transactions in which municipalities refinanced outstanding, higher rate, tax exempt bond issues in advance of their first call dates with lower interest rate bonds. The bonds in such a refinancing are called "advance refunding bonds." To preserve the tax-exempt status of these bonds, municipalities must follow a set of rules established by the IRC and Treasury Regulations promulgated thereunder.

Under Treasury Regulations, a municipality must place all the proceeds from the sale of advance refunding bonds in an irrevocable "defeasance escrow" ("escrow"). 26 C.F.R. § 1.141-12(d)(1). This escrow is:

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.
26 C.F.R. § 1.141-12(d)(5). In other words, both interest and principal on the initially issued bonds are paid from the escrow account. To generate cash flow to pay this interest and principal through the call date, municipalities typically invest advance refunding escrows in Government securities for the entire [ Page 4]

defeasance period, selected on the basis of correspondence, at maturity, to the cash flow needed for debt service and, correspondence in maturity date, i.e.. Government securities are chosen that are scheduled to mature on a date as close as possible to the date debt service must be made. (Compl. ¶ 15). See generally 26 C.F.R. § 1.148-5. Under § 148(b) of the IRC, these escrow investments cannot yield more than the yield earned by the bondholders.*fn1 If the yield on the escrow exceeds the yield of the bonds, the bonds are considered arbitrage bonds and lose their tax-exempt status.*fn2 26 U.S.C. § 103, 148.

A component of the overall yield calculation is the yield that municipalities collect on forward supply agreements. In a typical forward supply agreement, the issuer, the provider and the escrow trustee execute an agreement that transfers to the provider the opportunity to earn the interest that the issuer would otherwise earn on the short-term investment opportunities arising in the escrow account. In exchange for this opportunity, the provider compensates the issuers, often in the form of a payment made at the time of the transaction's closing. (Compl. ¶ [ Page 5]

19). A municipality enters into a forward supply agreement with a provider, such as SGC, when there is a gap, or a "float period" between the time at which the Government securities mature and the time at which funds are needed to pay debt service. Forward supply agreements are generally entered into at the same time the escrow is established because the municipality knows in advance when the float periods will occur.

The purchase price received by the municipal issuer for a forward supply agreement is directly related to its yield. The more an issuer is paid for the forward supply agreement, the more its yield will increase. A municipality must be sure that its combined yield from the forward supply agreement and its yield from the escrow in general does not exceed the yield on the advance refunding bonds or those bonds will lose their tax exempt status. Since the tax exempt status of the bonds is inextricably related to the purchase price of the forward supply agreement, the Treasury Regulations establish a bidding process to secure a fair market value for the agreement. 26 C.F.R. § 1.148-5(d) ("The purchase price of a guaranteed investment contract and the purchase price of an investment purchased for a yield restricted defeasance escrow will be treated as the fair market value of the investment on the purchase date if [certain bidding conditions] . . . are satisfied").

If a municipality determines that the combined yield of the forward supply agreement and escrow account will exceed the yield [ Page 6]

of the bonds, it can avoid arbitrage and retain its tax-exempt status by investing in United States Treasury State and Local Government Series ("SLGS"), which are zero interest Treasury securities available only to local and state borrowers. (Compl. ¶¶ 27, 29). In order to retain tax-exempt status, municipal bond issuers "must, in good faith, certify the issuer's expectations as of the issue date" that the yield restrictions have been met. Additionally, the issuer must state the facts and estimates used to make this certification. Treas. Reg. § 1.148-2(b)(2)(i).

II. The Allegedly Fraudulent Forward Supply Agreement

Relator claims that SGC caused several municipalities to violate the yield restrictions by providing forward supply agreements to municipalities that were fraudulently priced.*fn3 The [ Page 7]

Relator alleges that SGC engaged in a sham bid process in contravention of Treasury Regulation § 1.148-5, in which SGC obtained non-bona fide bids to assure that SGC would be the "winning" bidder. The Relator asserts that "the non-bona fide bids were below fair market value, as were [SGC's] `high' bids." (Compl. ¶ 45). According to the Complaint, SGC:

corrupted, and conspired to corrupt, the bid selection process by, inter alia, selecting non-competitive bidders to participate in the bid process; communicating "not to exceed" bid amounts to "losing" bidders; selecting fewer than three disinterested bidders to participate in the bid process; providing false or misleading information in order to cause legitimate bidders to submit artificially low bids; diverting portions of anticipated profits to pay off co-conspirators that solicited non-competitive bids or otherwise ensured [SGC's] selection as forward supply provider.
(Compl. ¶ 67) .*fn4

Relator further maintains that Defendants concealed the rigged bidding process that allowed SGC to provide an agreement [ Page 8]

below fair market value. Additionally, he contends that Defendants made false statements and misrepresentations in written documents to induce the issuers' and bond counsels to certify that the bonds "were priced consistent with federal law." (Compl. ¶ 52). Further, the Relator alleges that SGC paid undisclosed brokerage fees to co-conspirators that were responsible for the selection of SGC as the forward supply provider. The Relator asserts that, as a result of this fraud, Defendants caused the municipality to engage in bond arbitrage. He explains that because the forward supply agreement purchase price was fraudulently suppressed, the municipality reported an improperly low yield on its escrow. The result, the Relator contends, is that SGC "burned" excess yield earned by the escrows in violation of the IRC and that SGC's fraudulent profits equaled the dollar value of the yield it illegally burned.

If SGC had provided the fair market value, the combined yield would have exceeded the advance refunding bond yield.*fn5 Relator additionally alleges that to prevent losing their tax exempt status, the municipalities would have sought to keep their yield within the restrictions by investing in United States [ Page 9]

Treasury State and Local Government Series ("SLGS") securities, which are zero interest securities issued only to state and local borrowers. (Compl. ¶¶ 27, 29). Through the purchase of zero interest SLGS, the municipalities could ensure that "the federal Government (a) does not pay a higher overall yield on escrows than the municipality pays bondholders of the advance refunding bonds and (b) receives the positive arbitrage in open market escrows." (Compl. ¶ 30). The Relator claims that because the municipalities did not take this step, arbitrage occurred, and the Government was harmed in two related ways: the Government continued to pay the interest on the yield-bearing Treasury securities and it, correspondingly, lost the benefit of no cost borrowing "through which `positive arbitrage' — in the form of interest and principal paid on the escrow Treasury securities — is returned to the public [treasury]." (Compl. ¶¶ 31-32). The Relator claims that the U.S. Government is, thus, owed the arbitrage amount, as calculated either by the difference between the fair market value and the forward supply agreement purchase price or by the amount of interest that the Government should have saved through the issuance of SLGS.

III. Standard for Motion to Dismiss for Lack of Subject Matter Jurisdiction

On a motion to dismiss, the factual allegations of the complaint must be taken as true. Jaghory v. New York State Dep't [ Page 10]

of Educ., 131 F.3d 326, 329 (2d Cir. 1997). A court may not dismiss a complaint unless it appears beyond doubt that there are no set of facts the plaintiff can prove that would entitle him to relief. Still v. DeBuono, 101 F.3d 888, 891 (2d Cir. 1996). However, when a court considers a motion to dismiss pursuant to Fed.R.Civ.P. 12 (b)(1), it is appropriate to consider certain matters outside the pleadings, such as affidavits, documents and testimony. Phifer v. City of New York, 289 F.3d 49, 55 (2d Cir. 2002); Cargill Int'l S.A. v. M/T Pavel Dvbenko, 991 F.2d 1012, 1019 (2d Cir. 1993). Consequently, a court must "look to the substance of the allegations to determine jurisdiction." Cargill, 991 F.2d at 1019. The plaintiff bears the burden of proving that the court has jurisdiction. See Malik v. Meissner, 82 F.3d 560, 562 (2d Cir. 1996). Moreover, when considering whether subject matter jurisdiction exists, it is inappropriate to draw argumentative inferences in favor of the party asserting jurisdiction. Atlantic Mutual Ins. Co. v. Balfour MacLaine Int'l, 968 F.2d 196, 198 (2d Cir. 1992).

IV. The False Claims Act

A. Background

"The False Claims Act, 31 U.S.C. ยง 3729 et seq., as amended in 1986, empowers the United States, or private citizens on behalf of the United States, to recover treble damages from those who knowingly make ...

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