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INVESTIGATION: State Agency Error Jeopardizing $183M in Bonds with IRS

Thursday, December 20, 2012


A state agency has been accused of violating IRS rules that restrict the amount of money it can earn on $183 million in bonds it has issued, risking potentially millions of dollars in penalties.

The quasi-public agency, the Rhode Island Student Loan Authority, is attempting to negotiate a settlement with the IRS, rather than get into a costly and protracted battle with federal authorities.

The IRS rule in question prohibits nonprofit, state-based student lenders like RISLA from collecting more than a 2 percent yield on bonds that are tax-exempt, according to Jennifer DePaul, a reporter for The Bond Buyer who has been covering the issue nationally. When the lenders earn more than 2 percent, they are supposed to rebate the money to the IRS. But the IRS is concerned that nonprofit lenders have been trying to skirt those rules by tying higher-yield student loans to higher-yield bonds, DePaul said.

Such practices enable those agencies to collect more interest than permitted on the bonds, which is an abuse of the tax exemption granted to the bonds, according to the IRS.

“It’s a big issue because the IRS is cracking down,” DePaul said.

At stake is hundreds of millions of dollars in bonds that RISLA has issued in order to fund the student loan programs it provides to local students. Originally, the principal of the affected bonds stood at nearly a billion dollars—at $950 million, to be exact—according to Noel Simpson, the deputy director and chief financial officer for RISLA. Now, $183 million remains of the original amount.

Millions in penalty payments

Any penalty payments could cut into the amount of funding RISLA has available to forgive student loans for future borrowers, according to Simpson, who maintains that his agency has done nothing wrong and has not really violated IRS rules as it interprets them.

Simpson declined to say how much his agency has offered to pay to the IRS as part of any settlement agreement.

But other settlement agreements offer a window into just how much RISLA may have to pony up. In November 2011, the Pennsylvania Higher Education Assistance Agency agreed to $12.3 million in voluntary penalties to “protect” an estimated $250 million in tax-exempt student loan bonds, according to a Bond Buyer report.

If RISLA ends up being saddled with a similar penalty payment, it could affect consumers, according to Shelley Honeycutt, the owner and College Planning Director at COACH2college, a full-service college planning and advice firm. “From a consumer standpoint, it could affect the cost of loans,” Honeycutt said.

All told, 16 state-based nonprofit lenders have entered into settlements with the IRS through a voluntary closing agreement program, also known as VCAP, according to DePaul. The IRS established the program last March.

Without the VCAP program the tax-exempt status of the bonds issued by those lenders could have been at risk, according to Vince Sampson, president of the Education Finance Council, a national trade association that represents nonprofit student lenders. “It does create market disruption,” Sampson said. “That’s not a good thing.”

Whistleblower says violation ‘raises alarms’

The violation of IRS rules raises questions about the way RISLA has been conducting business, said Peter Kerwin, the former chief of program development for the Rhode Island Higher Education Assistance Authority who says he was wrongfully terminated last April after raising concerns about a potential merger between RISLA and his agency.

“I think it kind of raises some alarms about what’s going on,” Kerwin said.

Kerwin suggested that RISLA has exhibited a pattern of hiding information from the public.

Last Friday, the state Attorney General’s office found that RISLA had willingly or knowingly violated the state Open Meetings Act by holding a meeting on June 26 without posting a meeting notice 48 hours in advance, as required by state law. Attorney General Peter Kilmartin has filed a complaint against RISLA in Rhode Island Superior Court. If the court sides with the Attorney General, RISLA could face a $5,000 fine.

During that June 26 meeting, RISLA went into a nonpublic session to discuss matters pertaining to “litigation,” according to the minutes.

Yesterday, Simpson revealed that during that closed-door meeting, RISLA staff briefed the agency’s board on the possibility of entering into a settlement with the IRS. He said RISLA chose to hold the meeting behind closed doors because it was a “new subject” for the board.

But Kerwin suspects that the real motive behind the closed-door meeting lies elsewhere. “It seems to me that RISLA violated OMA [Open Meetings Act] in order to avoid having their potential liability to the IRS get out,” Kerwin said.

Kerwin also faulted the state agency for making an incomplete disclosure on the matter to the Municipal Securities Rulemaking Board, an independent regulatory agency. He contrasted RISLA’s disclosure with another agency that had provided more information about its dealings with the IRS.

“If you make a mistake, you make a mistake. Take your medicine,” Kerwin said. “But to go to these lengths raises the question, ‘What else are you hiding?’”

Nonprofit student lenders under fire

Kerwin’s concerns rest with the kind of loans that RISLA issues, which an August 2012 report from the federal Consumer Financial Protection Bureau has compared to the housing loans that were offered on the “subprime mortgage market.” Prospective students and their parents, Kerwin said, may not realize that the loans available from RISLA do not have the same consumer-friendly protections that federal loans have.

In general, federal student loans have more protections and benefits than others, especially for students who have faced economic hardship, according to Honeycutt. She said student borrowers normally are advised to exhaust their federal loan options before seeking other kinds of loans. RISLA, she said, provides a valuable service in making loans to those borrowers who have run out of options elsewhere.

But Kerwin fears that student borrowers and their parents instead may be turning to agencies like RISLA first—and assuming that their loans have the same protections as federal loans because RISLA is affiliated with state government. “So you think it’s a government thing it’s got to be OK, but it’s not,” Kerwin said.

Simpson declined to comment on Kerwin’s accusations about the lack of transparency. But he did reject the federal report’s blanket statement about private student loans. “We think it’s a misnomer because RISLA never engaged in subprime lending,” Simpson said, adding that RISLA has a 2 percent student loan default rate.

RISLA official denies any real wrongdoing

Simpson insisted that RISLA had complied with IRS rules and was not guilty of any infractions.

“I wouldn’t characterize it as a violation,” Simpson added. “I would think it’s more of a difference of opinion.”

The difference of opinion, as Simpson described it, is over the interpretation of IRS rules on how student loans are allocated from bond proceeds and how excessive interest is calculated.

Even though he maintains his agency’s innocence, he said the board decided to seek a settlement rather than engage in a protracted battle with the IRS. Plus, there is added pressure to settle, he said, because the IRS put the burden of proof on issuers to prove that they had not engaged in practices that involved collecting excessive interest, known as “arbitrage” in tax finance jargon. Unless issuers can prove that they did not engage in arbitrage, they are presumed to be in violation, Simpson said.

He said that RISLA has complied with regulations on earning excessive interest by making rebate payments to the federal government on any earnings it has made over the 2 percent cap. Since the mid-1900s, he said the agency has made a total of $4.7 million in such rebate payments. RISLA’s books show a potential liability of $11.4 million in rebate payments it may have to make in the future when its existing bonds mature, he added.

“We feel like we complied with their requirements,” Simpson said.

Simpson said RISLA indeed has transferred student loans from one bond to another, but not in an effort to make more money and sidestep IRS rules. He said such transfers had been done in order to comply with various investor and rating agency requirements. He said the transfers also were necessary to reduce the amount of debt RISLA issues and to continue to offer loans at low interest rates.

If successful in striking a settlement with the IRS, the agency will have to agree not to do any more transfers in the future, Simpson said.

So far, RISLA has not received any word on whether the IRS will accept its application for a settlement. “We haven’t heard back from them yet so we’re just waiting for the process to unfold with them,” Simpson said.

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