WASHINGTON -- Sales of lease-revenue bonds and other popular forms of debt secured by municipal appropriations in Virginia have come to a halt because of a recent state supreme court ruling, leaving underwriters and bond attorneys alike in a fog of confusion.
The ruling -- which holds that debt belongs to a county if the county's funds pay off the bonds -- is also causing ripples outside the state.
"The court decision in and of itself is casting a cloud over the market," said Parry Young, a senior vice president for Standard & Poor's Corp.
In Virginia, the ruling also could jeopardize appropriations-backed bonds issued by state agencies to meet housing, transportation, and other important needs, according to bond lawyers and rating agency officials.
"Nobody knows for sure what's in and what's out," said George Leung, vice president and managing director of state ratings at Moody's Investors Service.
What is clear is that the municipal leasing business in Virginia is reeling. "The court certainly put into question what you need to do to issue a tax-exempt lease in Virginia," said Neil Atterman, vice president and manager of municipal research at Kidder, Peabody & Co. "The market has to wait and see."
The 6-to-1 ruling, issued in April, invalidated a $330 million revenue bond issue proposed by Fairfax County to finance completion of a 35-mile parkway that county leaders had billed as their top highway project.
The Ruling
The Northern Virginia District Transportation Commission was to have been the issuer. That was supposed to free Fairfax from seeking voter approval, as the state constitution requires counties to do when issuing long-term debt.
But, because the bonds would have been repaid out of county tax receipts, the court ruled that the debt would still be the county's and that therefore the voter requirement still applied.
The decision was a victory for Marcia Dykes and her husband, Ted, cofounders of a group of county taxpayers who challenged the county financing plan and pursued their fight after losing in a lower district court ruling. A large chunk of public debt would have to go before the voters before it could be put on the books.
But the ruling has underwriters, commercial banks, state and local government officials, and business groups in the state worried that all types of municipal debt secured by regular appropriations are in jeopardy.
They are asking the court to reverse itself or to clarify the decision in a way that permits municipal leasing to continue. Failing this, investors holding outstanding debt want a safe-harbor ruling that makes sure they are not left with a lot of worthless paper.
No one knows exactly how much paper is at risk. Standard & Poor's recently estimated that there are 19 uninsured state and local lease transactions outstanding with a par value of $506 million, plus another $150 million in uninsured deals. While the rating agency did not say the deals might be worthless, it did say it will no longer rate leasing transactions in Virginia until the state supreme court clarifies its position.
The move followed a statement from Moody's that investors in lease revenue bonds and certificates of participation could be in trouble. Both have become increasingly popular forms of financing in Virginia and elsewhere as municipalities seek to overcome limits on GO bond issues or voters' resistance to increased debt.
The municipal leasing market may total from $8 billion to $10 billion in new issues, said John Petersen, chief economist for the Government Finance Officers Association. Mr. Petersen and Percy Aguila Jr., are coauthors of a book titled, "Local Government Finance: Concepts and Practices," to be published soon by the GFOA.
The growing success of the market enabled Kidder Peabody, the financing subsidiary of General Electric Corp., to package and sell nearly $150 million of municipal leases last November as tax-exempt asset-backed securities. IBM Credit Corp. soon followed with a similar offering of $302.8 million.
James Falk Jr., the lawyer who represented Mrs. Dykes and others in the court challenge, said he believes the constitution and existing case law give the state clear authority to sell appropriations-backed bonds and that the high court's ruling only affects municipalities. "I think somebody is blowing smoke on this, and I don't know why."
Fears about outstanding state and local issues are unfounded because under the law they are safe, Mr. Falk said. Moreover, he stated, from a practical point of view municipalities and bondholders have no interest in challenging done deals.
Officials, the state is taking the position that all of its issues are safe. "We don't think any state financings are involved," said Paul Timmereck, state secretary of finance.
But some bond lawyers and underwriters who looked at the problem are not so sure. Although the high court seemed to make a point of continuing to allow bonds repaid by tolls and other clearly defined streams of revenue, that still leaves open the question of appropriation-backed bonds issued by state agencies, they said.
The Virginia Commonwealth Transportation Board, for example, has issued $200 million of bonds to build Route 58 across the southern flank of the state, with another $400 million planned. Similar financing is under way for the Route 28 transportation district in northern Virginia.
In other instances, the state has a more indirect role in bond issues that could be subject to legal challenge. The Virginia Housing Development Authority and the Virginia Resources Authority both issue bonds that have recognized sources of revenue -- on the surface making them safe -- but issues from both agencies rely on reserve funds that carry a moral obligation from the state to make up any deficiency.
"I don't think the court realizes what it has done," said Harry Frazier, senior bond attorney for Hunto & Williams in Richmond. The firm estimates that more than $2.3 billion of outstanding state and local issues are supported in whole or in part by obligations subject to appropriation. About three-quarters of the paper is estimated to be held by Virginia residents.
Hunton & Williams has filed an amicus brief with the high court on behalf of a group of underwriters, banks, and businesses supporting a petition for rehearing that was submitted by Fairfax County and the Northern Virginia Transportation District. The underwriters and banks distribute large amounts of state and local bonds in the state and serve as advisers to issuers.
"I think the general feeling is that this decision was not a particularly good one," said Mike Roe, managing director of Crestar Investment Bank, one of the investment banking firms that is asking the court to reverse itself. Crestar serves as trustee in many leasing deals and has cited the business in an application it has before the Federal Reserve Board to expand its underwriting powers.
Whether the Virginia Supreme Court will agree to review its decision in Marcia Dykes v. Northern Virginia Transportation District Commission remains to be seen. The court is scheduled to consider the matter this week and issue an order one way or the other on June 10, according to a court spokesman.
'Practical Effect' Doctrine
In its ruling, the court said the county recognized that failure to make an annual appropriation to pay off the proposed revenue bonds would be a "disaster [that] would never be permitted to occur."
Therefore, the court reasoned, the county "implicitly acknowledges that the bond issue would have the practical effect of a long-term debt binding the county."
Opponents of the court's reasoning argue that the "practical effect" argument represents a new legal doctrine that goes beyond current law. Chief Justice Harry Carrico, sole dissenter in the ruling, commented, "It might be obvious to the majority that he county would be bound to make annual appropriations of sufficient funds to finance the bonds, but it is not obvious to me."
Justice Carrico, who correctly warned that business and financial communities in the state would be riled by the majority's decision, said the Fairfax County bonds should only be invalidated if there was a clear and unconditional commitment to continue making appropriations to pay off bondholders.
However, one bond lawyer said, the court ruling is sophisticated about how the bond market works. The rating agencies consider leasing obligations in evaluating a local government's creditworthiness, but in practice the deals are excluded from long-term debt calculations.
On the other hand, the agencies acknowledge the risks inherent in leasing deals and assign them lower ratings than GO bonds, which are triple-A in the case of Fairfax County and Virginia.
Courts in other states have wrestled with the legalities of leasing and have generally issued rulings favorable to the industry, so it also remains to be seen whether the Virginia case will have any spillover effects elsewhere. Florida, Georgia, North Carolina, Oregon, South Carolina, and Washington have all upheld lease-backed contracts, said Mr. Young of Standard & Poor's. New Mexico has ruled the deals invalid.
In North Carolina, the state supreme court ruled in January that lease-purchase debt was valid under the state's constitution, a decision that freed up about 50 deals that had been put on hold following a challenge brought by a citizens group.
In Florida, a state supreme court ruling last year validated $412.5 million of lease-purchase deals done by Sarasota, Collier, and Orange counties school districts.
"This is not the first time these arguments have been raised," said William McBride, a partner with Hunton & Williams. "The great majority of states find these financings or a similar type of financing acceptable." Moreover, said Mr. McBride, what happens under Virginia law does not necessarily have much meaning in other states. "It really is a state-by-state issue."
And, said James Dearborn, senior analyst at Moody's, no one can be sure how the state supreme court will respond to the petitions for a rehearing. "Supreme courts make their own rules."
