Market Lauds Davis Decision

WASHINGTON - Market participants hailed yesterday's long-awaited but widely expected Supreme Court decision that upheld 42 states' preferential tax treatment of their bonds as a "resounding victory" for the municipal securities market.

The near-unanimous support for the 7-to-2 decision in Department of Revenue of Kentucky v. Davis - from fund managers, attorneys, state officials, and industry groups alike - reflected the dire consequences for the market had the high court ruled differently.

"It's a resounding victory for the existing structure of the municipal bond market," said Len Weiser-Varon, an attorney at Mintz Levin Cohn Ferris Glovsky and Popeo PC in Boston, who wrote a friend-of-the-court brief on behalf of the National Federation of Municipal Analysts, which didn't take either side in the case but highlighted the dramatic upheaval that would have occurred if the court ruled against Kentucky.

"The court decided to give the states a long leash on this issue, principally because it's been this way for decades and all 50 states have said, 'This is fine by us.' The majority also made it clear that the court doesn't want to do anything that might be disruptive to the municipal market," he said.

The court in effect upheld the status quo in the muni market by overturning a Kentucky appeals court's 2006 decision that said the state's long-standing practice of taxing the interest on bonds issued out of state while exempting from taxation the interest on bonds issued in state was unconstitutional. Forty-nine states filed friend-of-the-court briefs in support of Kentucky, a factor that appeared to weigh heavily on the court's thinking.

Among other things, yesterday's ruling saves states from having to consider as much as $3 billion in potential tax refunds, said Christopher Trower, the solo practitioner who argued the case before the Supreme Court on behalf of Kentucky.

G. Eric Brunstad of Bingham McCutchen LLP, who argued on behalf of the married couple, George and Catherine Davis, who sued Kentucky for trying to tax the interest from their out-of-state bond holdings, could not be reached yesterday.

Even though the ruling was widely expected, fund managers said they were relieved because it would not force a fundamental reshaping of the roughly 450 state-specific mutual funds, which held about $156 billion of munis as of May 31, 2007, according to the Investment Company Institute. In a brief statement, ICE said it welcomed the ruling.

John Mousseau, a vice president portfolio manager at Cumberland Advisors in Vineland, N.J., said the decision alleviated one more potential problem in a market that has weathered enough turmoil in a short amount of time.

"Here's a market that's been banged up beyond recognition," Mousseau said. "We have been assaulted by failed auctions, hedge funds going under, bad [variable-rate demand notes], bond insurers getting downgraded, and no liquidity, so this was just one more thing hanging over the market."

"It's nice to see some clarity - even if it was something that was expected," he added. "Most people felt that the court would probably head in this direction and had no desire to upset a capital market that usually works very well, especially since states exempting their own bonds [from tax] is something that has worked for more than 100 years."

Dan Loughran, senior vice president and portfolio manager at Oppenheimer Funds, agreed, saying: "Our market has had a stream of bad news over the last nine months and it just removes one major uncertainty that has been overhanging the market."

"If it had gone the other way, there would be no reason for state-specific funds to exist," said Michael Smith, a shareholder at Butzel Long here, who wrote a friend-of-the-court brief on behalf of 13 single-state funds urging the court to overturn the Kentucky court's decision.

Tom Spalding, senior investment officer at Nuveen Investments in Chicago, said the decision validates the heftier price tag investors pay for specialty states, and should allow them to continue to outperform the national market now that a cloud of uncertainty is gone.

"Now the specialty state market will go along just like it was ... the New Yorks and New Jerseys, and North Carolinas will command a premium price in the market place," he explained. Typically, specialty paper from high-taxed states, such as New York and New Jersey, trades 10 to 15 basis points higher in price than non-specialty state paper, according to Spalding.

Demand for these bonds weakened in recent months as investors awaited the outcome of the case, according to Spalding, who added that trading should resume its normally healthy pace.

Had the decision favored the Davises, "we would have changed the matrix on how we traded" specialty and non-specialty states. "Bonds in states that have out-traded the national market would have given ground and we would have had some new spread relationships that we have never seen before," he explained.

The Securities Industry and Financial Markets Association applauded the ruling, saying it "benefits both state governmental entities and [their] citizens."

Ohio Treasurer Richard Cordray also welcomed the ruling, which he described as “good news for America’s troubled economy.”

“A different ruling could have disrupted a multi-trillion dollar financial market and upset the expectations of countless investors,” Cordray said. ““I am pleased that the Court has preserved a critical source of funding and prevented states from having to cut public services, cancel projects, and increase taxes.”

From a legal perspective, several attorneys noted that the decision reflected the court's thinking in its 6-to-3 decision last year in another case involving the dormant commerce clause, United Haulers v. Oneida-Herkimer Solid Waste Management Authority, in which the court expressed a willingness to allow governments to exhibit a preference for themselves over out-of-state private competitors. The dormant commerce clause suggests that only Congress can erect barriers to interstate trade.

In the United Haulers case, the court found that a New York county could force private waste haulers to use a publicly owned processing facility, even if the haulers could use a private facility in another state for a lower cost. The court found that a government could show preference to itself if it serves a public good.

"This ruling strengthens the prior United Haulers decision in recognizing that state governments may create a preference for the benefit of public entities fulfilling governmental purposes," said Kenneth Roberts, a partner at Hawkins Delafield & Wood LLP in New York, who co-authored a friend-of-the-court brief by the National Association of State Treasurers in support of Kentucky.

Roberts also noted that yesterday's decision is noteworthy in light of the high court's 1994 ruling in Carbone v. Clarkstown, which struck down as unlawful an ordinance requiring delivery of locally produced hazardous waste to a privately operated processing facility.

This shows a solid majority stating that government preferences for the benefit of government activities should be treated differently than preferences for private business interests, he said.

Weiser-Varon said that the court appears to have essentially “punted” on the issue of private-activity bonds – which make up 20% of all bond issuance and are issued by municipalities on behalf of private owners, sometimes through conduits. In a footnote, the court said the arguments over private-activity bonds were not well developed and never pressed by the Davises.

“Accordingly, it is best to set this argument aside and leave for another day any claim that differential treatment of interest on private-activity bonds should be evaluated differently from the treatment of municipal bond interest generally,” the footnote said, noting also that “we cannot tell with certainty what the consequences would be of holding that Kentucky violates the Commerce Clause by exempting such bonds; we must assume that it could disrupt important projects that the states have deemed to have public purposes.”

“The court has no motivation to do anything that might be disruptive to the market,” Weiser-Varon said.

Some attorneys who had closely followed the case wondered why it has taken so long to decide, noting the ruling came out 196 days after oral arguments were held on Nov. 5. Some speculated that additional time may have been necessary given that yesterday's majority was fragmented - only Justices John Paul Stevens and Stephen Breyer consented to the full opinion, which was written by David Souter, while Chief Justice John Roberts and Justices Ruth Bader Ginsburg and Antonin Scalia agreed with it only in part, and Justice Clarence Thomas filed a separate opinion concurring with the judgment.

Still, none of the justices adopted any radically new positions, several attorneys said.

"My guess is it just went on the backburner because they had other cases to get out first," Weiser-Varon said.

Though 196 days is an unusually long time for the court to decide a case, the court actually took six days longer to rule on another decision that it released yesterday concerning child pornography laws. And there's a money laundering dispute for which the court heard arguments Oct. 3 that has still not been decided, said Alan Viard, a resident scholar at the American Enterprise Institute here.

Viard co-wrote a friend-of-the-court brief advocating a ruling against Kentucky and was one of the few to express disappointment with yesterday's ruling. Though Viard had predicted the court would rule in favor of the state, he has argued that preferential tax exemptions are a net financial loss for state governments. He said yesterday that existing tax schemes are an outmoded barrier to interstate trade that curtails a free, national market.

"This is an anachronistic style arrangement, from when 19th century communications and transportation necessitated that borrowers and lenders had to be close to each other," Viard said. "They don't completely shut down interstate trade, but they are still a pretty substantial obstruction of interstate commerce."

Ted Phillips, Christine Albano, Yvette Shields, and Michael Scarchilli contributed to this story.

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