City of New Orleans v. Smith Barney, Inc.

The City of New Orleans (city) (plaintiff), through its Board of Liquidation, City Debt (board) (plaintiff), issued general obligation bonds (GO bonds) to finance capital improvements throughout the city. The bonds were tax-exempt, which made them attractive investments for certain investors. Sometime after issuance of the GO bonds, interest rates fell, and the board wished to refinance the city’s debt. However, at the time, the GO bonds were not redeemable yet. Accordingly, the board sought to use a mechanism known as advanced refunding to accomplish a similar objective. In the advanced refunding, the board issued $180,000 of general obligation refunding bonds series 1991 (1991 GO refunding bonds), which were issued on a tax-exempt basis. The proceeds from the 1991 GO refunding bonds were used to purchase United States Treasury securities. The Treasury securities were placed in escrow accounts, and their proceeds were disbursed as needed both to pay the debt services on the refunding bonds themselves and to redeem the refunded bonds as they matured. The board hired BT Alex. Brown Inc. (BT) (defendant) and Smith Barney, Inc. (defendant) as financial consultants, whereby BT served as the underwriter and Smith Barney as the escrow provider. In August and September 1997, the Internal Revenue Service (IRS) issued letters to the city stating that the IRS made a preliminary determination that the 1991 GO refunding bonds could not be considered tax-exempt because they did not meet the IRS’s arbitrage rules, which required that treasuries purchased for advanced refunding purposes be purchased at their fair market values and that the yield in the escrow accounts could not exceed the interest payable on the refunding bonds. Specifically, the IRS claimed that Smith Barney and BT marked up the price of the treasuries purchased by the 1991 GO refunding bonds so that the yield on the treasuries would appear lower, a practice known as yield burning. The IRS also claimed that BT and Smith Barney shared in the excessive markups pursuant to a private agreement between themselves. The preliminary determination regarding the tax-exempt status of the bonds was not final and was subject to an ongoing investigation and a formal determination. Prior to any final determination by the IRS, the city and the board filed parallel lawsuits against Smith Barney and BT for a declaratory judgment that Smith Barney and BT were responsible for any determination by the IRS that the 1991 GO refunding bonds were no longer tax-exempt and that Smith Barney and BT should therefore indemnify the city and the board for all consequences arising from such a determination. Smith Barney and BT moved to dismiss.