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Editor's note: This is the first story in a two-part series examining former Gov. Bill Janklow's lucrative but little-remembered sale-leaseback deal, which was struck in 1986 and expired last month. The articles are based on interviews, the Janklow Papers at the University of South Dakota, archived news stories, and financial documents obtained from state government. Part two will publish Monday.

As governor, Bill Janklow liked to “white-board” his ideas and would often end up standing in front of a jumble of arrows, circles, squiggles, words and numbers so dense that it was incomprehensible to everyone but him.

In the early 1980s, when the then-governor drew up his plan to reap a windfall for the state treasury by selling dozens of state-owned buildings, then investing the proceeds in an annuity and leasing the buildings for the state’s continued use — a transaction known as a “sale-leaseback” — he stumped even his own budget director.

“I said, ‘Huh?’” recalled Steve Zellmer, now of Rapid City. “It took me a while to get my head around it.”

It took Janklow several years, plus the passage of state and federal legislation, but he finally struck an extremely convoluted deal in 1986 just weeks before he left office. He’s now dead, but the deal lived on — and on, and on — until last month.

In simple terms, Janklow sold 118 state-owned buildings for $188 million, including the State Penitentiary in Sioux Falls, the Human Services Center and Correctional Treatment Unit in Yankton, the Custer State Hospital, and the State Veterans’ Home in Hot Springs, among others.

The state allowed underwriters to take a $4 million cut minus their own expenses and used part of what was left to buy a $172 million annuity, leaving state government with $12 million in leftover cash. The money was earmarked to build or repair 18 structures statewide, ranging from public-radio transmitter towers in rural areas to new buildings on Black Hills university campuses.

Later refinancings of the deal netted another $17 million, Janklow later reported, raising the state’s total take to $29 million.

For the past 30 years, ending in December, the state quietly used the biannual income from the annuity to lease the buildings while continuing to use and maintain them. Only now, with the last transactions complete, is ownership of the buildings reverting to state government.

If it all sounds confusing, that’s because it was, and still is. At the time, Janklow openly described the deal as selling buildings without really selling them. He variously referred to the deal as “trying to invent money” by “doing alchemy” through a “shell transaction.”

“All of this is fiction,” Janklow was quoted as saying in 1986. “We literally made money out of nothing.”

And yet, what was good for the state was bad for the nation. While South Dakota’s treasury filled with millions of dollars, the federal treasury lost untold millions in income taxes because investors in the sale-leaseback deal received tax-exempt interest.

That is why Congress ultimately outlawed similar deals, and why Janklow — ever the maverick — had to race and barter to get the deal done while deploying his trademark blend of persuasion and persistence.

Inadvertent loophole

The seeds of the sale-leaseback deal sprouted in 1981 when financiers across the country awoke to the lucrative potential of a loophole in federal tax law. The loophole was created, apparently unwittingly, by Congress when it passed the Economic Recovery Tax Act.

One section of the voluminous law was intended to allow companies with low tax bills to use sale-leaseback transactions to sell their tax breaks — including depreciation deductions for buildings and equipment — to other companies with higher tax bills. It was called “safe-harbor leasing,” because it protected the participants from scrutiny by the Internal Revenue Service.

The law was apparently intended to help only taxable entities. But enterprising underwriters realized that the law also made sale-leasebacks attractive for tax-exempt entities, including nonprofit organizations, cities and states.

Tax-exempt entities do not pay income tax and therefore receive no tax breaks on the buildings and equipment they own. The new tax law, with its loophole for sale-leasebacks, presented an opportunity to sell those unusable tax breaks to investors, merely by selling property for quick cash and leasing it back over a longer term.

Government sale-leasebacks began to pop up around the country. One of the earliest and splashiest deals was in Oakland, Calif., where the city sold a museum and auditorium to investors for $55 million.

In South Dakota, sale-leaseback discussions were struck up by a seemingly unlikely pair: a Republican governor and a Democratic financier.

Farm crisis spurs budget creativity

The Republican governor was Janklow, who trod a novel path to the office.

Janklow was born in Chicago and was only 10 when his father died of a heart attack. Janklow’s mother moved the family to her hometown of Flandreau, S.D., where the teenage Janklow, with his tough-talking Chicago accent and matching attitude, clashed with the locals. He got into trouble, dropped out of high school, served in the Marine Corps — which he later credited with turning his life around — and then reportedly talked his way into the University of South Dakota despite lacking a high school diploma.

He graduated from the USD law school in 1966 and went to work as a legal aid attorney on the Rosebud Sioux Indian Reservation, where he earned a reputation as a winning trial lawyer. In 1974, he was elected the state’s attorney general, and in 1978 he won his first gubernatorial race at the age of 39.

Janklow’s first term as governor coincided with the onset of the 1980s farm crisis, when plummeting crop prices and soaring lending rates turned some farmers financially upside down and sent many of them into foreclosure. The farm crisis was a drag on the state budget, which depended largely on economic activity created by farmers to generate sales-tax revenue.

Janklow, whose motor never stopped, met the challenge of declining revenues with a flurry of ideas. He was a man so hard driving that when he died in 2012, his son, Russell, was surprised that the cause was cancer. Russell reportedly “always thought his dad would die of a heart attack, yelling at someone on the phone or something.”

The sale-leaseback idea was on Janklow’s mind as he cruised to a landslide re-election win in the fall of 1982, according to letters in Janklow’s private papers, which are now open to researchers at the University of South Dakota.

The letters flowed between Janklow, the brash Republican governor in Pierre, and Michael Dougherty, a Democrat and South Dakota native who had founded an investment banking firm five years earlier in Minneapolis.

Dougherty, Janklow similarities

Despite their contrasting political labels, Dougherty and Janklow had strikingly similar backgrounds.

Like Janklow, Dougherty suffered tragic loss as a boy. He was 7 when his mother died of cancer and 14 when his father died of a heart attack.

Dougherty’s older brother, Bill, became the de facto leader of the family and took over their father’s livestock commission business at the Sioux Falls Stockyards. Michael Dougherty went on to attend college but — like Janklow — got into trouble and was “asked to leave” for what he described as disciplinary and academic reasons.

Dougherty was soon drafted into the Army. Like Janklow, who had been transformed by the Marines, Dougherty came out of the military a changed man.

He went on to earn a degree in political science and history from the University of St. Thomas in St. Paul, Minn. Shortly after his graduation in 1966, the same year Janklow graduated from law school, Dougherty was hired as the campaign manager for South Dakota Democratic gubernatorial nominee Robert Chamberlin.

Chamberlin lost to Republican Nils Boe, and Dougherty left politics behind. But the Dougherty name lived on in South Dakota political circles, because Michael’s older brother, Bill, a fellow Democrat, served as the state’s lieutenant governor from 1971 to 1975. Bill Dougherty then transitioned into a longtime lobbying career at the state Capitol that included a close relationship with Janklow.

Michael Dougherty landed at a Minneapolis brokerage firm as a municipal bond salesman. He left that job in 1977 with three partners to found the investment banking firm of Dougherty, Dawkins, Strand & Yost.

Plan goes to legislators

By 1982, Dougherty was pitching the sale-leaseback concept to Janklow. Existing South Dakota law made sale-leasebacks impractical, so Dougherty assigned his lawyers to draft authorizing legislation. Janklow introduced the bill to the 1983 Legislature and convinced lawmakers to approve it.

The minority of legislators who cast “no” votes expressed a fear that a sale-leaseback would contribute to the federal government’s budget woes. They viewed sale-leasebacks as tax shelters, because the deals gave investors depreciation deductions to avoid higher income taxes.

Some of the legislators who voted with the majority, including influential Republican Sen. George Shanard, of Mitchell, had similar concerns but shrugged them off.

“Granted, there’s no question that it’s a loophole that robs the federal treasury,” Shanard was quoted as saying. “However, it is a loophole now available to and being used by private citizens, and by a couple of other governments.”

As it turned out, members of Congress were also talking about sale-leasebacks in 1983, and their attitudes were not so permissive.

Congressional resistance

In February 1983, while Janklow’s bill was making its way through the South Dakota Legislature, Congress was growing concerned about the revenue it was losing to sale-leasebacks.

A U.S. House Ways and Means subcommittee conducted a hearing that very month to learn more about the deals. Three months later, U.S. Rep. J.J. Pickle, a Texas Democrat, introduced a bill to make sale-leasebacks less attractive by tightening restrictions on depreciation deductions and making other changes to tax law.

Pickle seemed as stubbornly committed to stopping sale-leasebacks as Janklow was to participating in them. During a June 1983 hearing on Pickle’s bill, the congressman brought some colorful Texas flair to the fight.

Pickle said the burgeoning sale-leaseback industry was an “Alice in Wonderland world of off-budget finance” with tax breaks that served as a “carrot” to entice investors.

“I might add, this is no scrawny carrot, either,” Pickle said. “It is a big carrot. Bugs Bunny never had a bigger carrot in all his life.”

The Congressional Budget Office concurred. A CBO analysis of Pickle’s bill said the potential market for sale-leaseback deals involving tax-exempt entities was $2 trillion. That was the total value of property owned by nonprofits and state and local governments that was eligible to be included in sale-leaseback transactions. The only limit on the market, the analysis said, was the amount of money that investors could pour into it.

The effect on the federal budget was potentially severe, the CBO warned, because of the tax breaks investors received for owning tax-exempt property. Speaking hypothetically, the CBO calculated that if sale-leaseback deals totaled $2 billion in 1984, the federal government would lose $100 million in tax revenue; if the value of the deals increased to $10 billion by 1988, the government would lose $1.5 billion in revenue.

Pickle’s bill did not pass, but its language was incorporated into the broader Deficit Reduction Act of 1984. The section including Pickle’s sale-leaseback restrictions came to be known as the “Pickle rule."

Janklow and Dougherty watched Pickle’s efforts warily as they waited through 1983 and much of 1984 until federal law on the topic was finally settled.

Meanwhile, the South Dakota Legislature passed a bill in early 1984, before the Pickle rule was passed, that allowed cities to participate in sale-leaseback deals. That allowed Rapid City to speed ahead with a $40 million sale and leaseback of its civic center to fund an expansion, with underwriting in part by Dougherty’s firm. The term was 15 years, and Ray Woodsend, the city attorney at the time, recalled recently that it was paid off early.

The state's sale-leaseback deal was still a work in progress, and with the Pickle rule in place, Janklow went back to the white board.

Put in a 'Pickle'

Until the Pickle rule was adopted, South Dakota’s sale-leaseback plan was envisioned as a sale of state buildings to investors, who would benefit from depreciation deductions while the state invested the sale proceeds and spent the interest. The buildings were to be leased to the state for a nominal sum, and at the end of a contract term of possibly 15 years, the state would buy back the buildings with the original sale proceeds.

In response to the Pickle rule and its crackdown on depreciation deductions, Janklow and his brain trust hatched a Plan B that was based on a complex "arbitrage" transaction. That's a term describing the simultaneous buying and selling of investments in different markets to take advantage of a higher price in one and a lower price in the other.

Under the new plan, the state would sell its buildings to investors and pay them back at a relatively low rate of interest, which the investors would accept because the interest was tax-exempt. The state would use the proceeds of the sale to buy a higher-yielding annuity — a financial instrument that pays fixed returns over the course of the purchaser’s life.

The annuity would be tied to the lives of state employees in the state retirement system, only to stop paying out if all the employees died suddenly. And the state would accept lower future annuity income in exchange for receiving some of the returns upfront in a lump sum. That lump sum would be spent to build and repair state structures, while the future annuity income would be used to make lease payments on the buildings.

While it was technically a sale and leaseback of buildings, that aspect of the deal was really just the vehicle that allowed the state to borrow money from investors and then invest the borrowed money for a higher return.

Throughout 1985, Janklow and some of his staffers were quoted as saying they were close to getting the deal done. But something was holding them up — possibly the working out of complex details, and perhaps also the negotiation of various terms, fees and commissions, according to Harry Christianson, of Rapid City, who was among the horde of lawyers involved.

Christianson said Janklow negotiated from a strong position, because the underwriters involved in the deal had spent several years working on it and had a strong incentive to complete it, while Janklow could take it or leave it.

“Janklow was squeezing on what the underwriters got for a fee, and he squeezed them until they screamed,” Christianson said in a recent interview with the Journal.

Janklow was about to get squeezed, too, as Congress stepped forward with another legislative effort to squash sale-leasebacks. And this time, the Republican governor would turn to another Democrat for help.

Contact Seth Tupper at seth.tupper@rapidcityjournal.com

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