By Boris Ladwig, The Republic
bladwig@therepublic.com
An electric cooperative that provides power to 800,000 Hoosiers, including more than 40,000 in Bartholomew, Jackson and Decatur counties, has filed a lawsuit to fend off bankruptcy due to a convoluted financial arrangement that a judge said is likely a "sham."
Hoosier Energy, which provides power to 17 Indiana rural electric cooperatives in 47 counties, has filed a lawsuit against insurance giant John Hancock because it faces the prospect of having to pay $120 million as a result of a tax-shelter deal.
The deal, according to court documents, included a "several-hundred-million-dollar transaction" involving the Merom Generating Station in Sullivan County, and a tax shelter known as "SILO," short for "Sale in, Lease out."
In 2002, Hoosier Energy leased parts of the Merom power plant to John Hancock for 63 years, received $300 million, and immediately leased back those portions of the plant.
The deal, which, according to court documents, was detailed in about 4,000 pages of fine print, allowed John Hancock, for tax purposes, to claim to be the plant's owner.
The SILO provided Hancock "the right to hundreds of millions of dollars of tax benefits" that Hoosier, as a nonprofit cooperative, could not take advantage of, court documents show.
The deal also required Hoosier to obtain a credit default swap, essentially an insurance, to provide Hancock with $120 million if Hoosier could not meet its lease payments. The deal also required that the lease payment guarantor, New York City-based financial services company Ambac Assurance Corp., retain its credit worthiness.
If Ambac's credit rating fell below a certain threshold, Hoosier would find a new credit default swap or similar guarantee within 60 days or a default could occur, which would "allow Hancock to terminate its involvement in the transaction and demand payment of more than $120 million from Hoosier," according to court documents.
As a result of the credit crisis, Ambac's credit rating fell below the agreed upon minimum threshold, resulting in Hancock declaring that Hoosier had defaulted and asking Hoosier to pay $120 million.
'Tortured finance'
The New York Times' Gretchen Morgensen, in a column, called the transaction "a deal that only a Wall Street contortionist could love" and "a veritable trifecta of tortured finance."
SILOs were allowed by federal agencies in the early part of the decade and primarily were used by transit authorities in large cities to generate cash without using taxpayer funds.
David F. Hamilton, chief judge of the U.S. District Court for the Southern District of Indiana, concluded that, "The entire Merom SILO transaction appears to have been an abusive tax shelter, a sham with little or no economic substance."
"This case provides a case study of some of the worst aspects of modern finance," Hamilton wrote.
"The case arises from an elaborate transaction that combines the sometimes toxic intricacies of credit default swaps and investment derivatives with a blatantly abusive tax shelter," Hamilton wrote.
"Investment bankers and lawyers," Hamilton wrote, "made more than $12 million in fees for putting together the paper transaction."
"(And) although all parties have been making all payments required under the contracts, the transaction is now in crisis because credit rating agencies have downgraded the credit ratings of one of the parties," Hamilton wrote.
Among regulated Indiana power generators, SILOs involving power plants are rare: IURC could recall only one such deal was struck, in the late 1980s by Indiana Michigan Power.
Chris Tryba, a spokesman for Hoosier Energy, said that the SILO was a legal transaction when Hoosier Energy entered into it. Such deals provided certain nonprofit entities an opportunity to record a financial gain through a tax credit that they otherwise could not have taken advantage of.
Since the deal was struck, however, challenges by the IRS have resulted in equity investors in SILOs, such as Hancock in the Hoosier deal, not being able to receive the SILOs' tax benefits.
Tryba said the IRS simply changed its perspective on such deals.
Because Hancock has lost the deal's potential benefits, it "is now attempting to shift the burden of this adverse tax result to Hoosier," Hoosier argues in the lawsuit.
John Hancock General Counsel Jonathan Chiel said the company still is hoping that the transaction can be salvaged.
He said the default event, Ambac's credit rating falling below the threshold, occurred in June, and that under the terms of the contract, Hoosier Energy had 60 days to find a replacement swap.
However, by October, 30 days beyond the contractual deadline, Hoosier Energy still had not finalized a replacement, Chiel said, and requested another 90 days, at which point John Hancock declared that a default had occurred.
"We don't want to prevent people from getting electricity," Chiel said.
John Hancock also does not want to drive Hoosier Energy into bankruptcy, he said - but it also does not want to put its investment at risk.
Bartholomew County REMC General Manager Jim Turner referred questions to Hoosier Energy.
On appeal
Hamilton on Nov. 25 issued a temporary restraining order preventing Ambac from paying $120 million to Hancock, as it would have resulted in Ambac requesting the same sum from Hoosier, resulting in Hoosier's bankruptcy.
Hamilton also wrote that he "questioned the legality and enforceability" of the credit default swap, and that he worried that the outcome of the case "would be inequitable if John Hancock were able to terminate the transaction and walk away with the improper tax benefits it sought, while leaving Ambac and Hoosier Energy behind to pick up the pieces of this abusive transaction."
The case is on appeal at the U.S. Court of Appeals, 7th District, in Chicago. Oral arguments were made Jan. 5.
The court had not made a decision as of Monday , but Hoosier's attorney, Reed Oslan, partner of Chicago-based Kirkland & Ellis LLP, said a ruling could be issued any day.
He said an adverse judgment could lead to Hoosier filing for bankruptcy.
"This is a scenario that's possible - not certain," he said.
If the appeals court upholds the injunction, Hoosier would not have to pay unless it lost the lawsuit, the resolving of which likely would take years, Oslan said.
If the judge overturns the injunction, lots of things could happen, Oslan said, including Hancock receiving $120 million from Ambac, which would ask for $120 million from Hoosier, which also would result in a lawsuit.
"We have no intention of paying them either," Oslan said.