TAHOMA, Calif. – A recent decision by the Washington Supreme Court has thrown a wrench into the use of a credit enhancement tool used on hundreds of millions of dollars in bonds.
The court earlier this month upheld a lower court ruling that contingent loan agreements – generally an agreement in which one government agrees to pay debt service for another in the event of a default - must count towards a municipality’s state constitutional debt limit of 1.5% of assessed property value.
The case was a result of Wenatchee, Wash.’s attempt to use a contingent loan agreement to help support a new issuance by a local public facilities district that had defaulted on its bond anticipation notes. The court ruled the agreement would put the city over its legal debt capacity.
“The conclusion is contingent loan agreements constitute debt,” said Roy Koegen, a partner at the law firm Koegen & Edwards and bond counsel to the city of Wenatchee. “The basis for the decision is the risk of loss is on the local government, is on the city, not on the bondholders.”
As a result of the decision, if a municipality is now over its non-voted debt limit when the principal of the debt backed by the contingent loan agreement is counted, the agreement is void.
The ruling has forced bond lawyers across the state to review deals done using the agreements.
“We are still trying to understand all of the implications,” said Jay Reich, a partner at Pacific Law Group in Seattle. “We are going to have to review the contingent loan agreements out there just to confirm there was debt capacity.”
No one interviewed for this article knew yet of any issuances that may be in trouble from voided agreements, but the general consensus is that a few may surface, if any, since it is typically issuers with good credit quality and debt capacity that lend themselves to these agreements.
Lawyers are also still poring over the Supreme Court decision since only four of the nine justices signed onto the opinion that arrived at a new legal analysis of municipal “indebtness.” a majority of the justices joined in the result, but not in the court’s written opinion.
As a result, said Bill Doyle, a public finance partner is Orrick’s Seattle and San Francisco offices, the case will be challenging to interpret and apply.“ The decision provides guidance for bond lawyers in an area where previously there was little,” Doyle said.
Many city and counties in the state have used contingent loan agreements, particularly to help public utility districts build regional projects, such as an arena, or to help housing authorities issue debt to build low-income housing.
The court’s decision could cool those types of deals.
“The real issue going forward is if you have a city or county with just modest extra debt capacity, will they be willing to tie up some of that debt capacity providing a contingent loan agreement with a housing authority or public facilities district,” said Hugh Spitzer, a partner at Foster Pepper LLC in Seattle. “That is the real impact.”
Earlier this year, Moody’s Investors Service warned following the lower court’s ruling that many municipalities in Washington had come under pressure because of the guarantees on debt they have made for financially weak public facility districts.
As a result, the rating agency downgraded several city ratings, including Wenatchee and Kent, Wash.
Public facility districts are municipal corporations that under state law have an the ability to levy a sales tax, and are typically formed to build projects that benefit a region such as convention centers, arenas and museums.
Many of the public facility district projects arrived during boom years of the last decade, using rosy revenue growth projections that have since proved misguided when issuing bonds.
According to Moody’s, 18 public facilities districts in the state have a combined $482 million of outstanding debt.
The most infamous example of the recent problems caused by a contingent loan agreement is in Wenatchee.
In December, the Greater Wenatchee Regional Event Center Public Facilities District, which was formed in 2006 to build and operate the Toyota Town Center arena in Wenatchee, defaulted on $42 million of bond anticipation notes backed by a contingent loan agreement with the city, which pledged to make interest payments on the notes if the district was unable.
Before the default, the city had tried to get a new contingent loan agreement approved for an issuance to help pay off the BANs.
But a state superior court invalidated the proposed agreement, deciding it constituted debt and would exceed the city’s limit.
Last week, the state Supreme Court upheld that decision.
The facilities district includes two counties and eight other municipalities, but Wenatchee, with a population of 30,000, is its largest city. Unable to use the contingent loan agreement, the district and the Wenatchee voters approved a tax increase that was used to support a new issuance to pay off the debt.
Wenatchee is not alone.
Moody’s last month downgraded Kent’s limited tax general obligation bond rating to Baa2 from A1 in part because it had a contingent loan agreement on bonds issued by a struggling public facilities district formed to support a city arena.
The city had been paying debt service – more than $3 million annually - on the district’s bonds and had been covering operating losses, according to the ratings agency.
Kent’s finance director, Robert Nachlinger, said the city will show an addition $61 million in outstanding debt, doubling its burden, under the decision but will still have more than $40 million of capacity left before it reaches the constitutional debt limit.
“We happen to agree with the State Supreme Court on their decision,” Nachlinger said in an email in response to questions. “If there is a contingent loan agreement, the exposure should be shown on the books of the guarantor, in this case the city.”
