California School GO Structure Seen as Special Revenues
LOS ANGELES — California school districts meet the high bar Fitch Ratings says it set to consider whether pledged debt service funds are secure in a bankruptcy.
Fitch released a report Monday identifying six elements related to California general obligation school bonds that it says provide a sufficient level of comfort that special revenue status is unlikely to be challenged in a bankruptcy.
“The case for special revenues must be very clear, because a distressed municipality will seek to exploit any reasonable doubt in a bankruptcy proceeding,” said Amy Laskey, a Fitch managing director.
“The more complex the proceedings and the higher the stakes for other claimants, including a public employee pension fund, the more likely it is that the status as special revenue bonds will be disputed,” she said.
Fitch has assigned AAA underlying general obligation ratings to bonds issued by several California school districts with notably lower issuer default ratings. The higher underlying GO ratings reflect Fitch's opinion that the property tax revenues pledged to bond repayment would be considered pledged special revenues under the bankruptcy code.
The rating agency contrasted California school GOs with Chicago Public Schools, which in an effort to reassure investors about its junk-rated bonds, asserted in offering documents its belief that the bonds' pledged tax revenue stream could survive a Chapter 9 bankruptcy.
The high bar met by the California school districts is not met by the Chicago school bonds, according to Fitch, which rates Chicago Public Schools GOs B-plus with a negative outlook.
“I agree with the determination,” said Michael Ginestro, director of municipal research for Beverly Hills-based Bel Air Investment Advisors LLC. “I think the flow of funds in California demonstrates any other claimants or credits that would potentially go after revenues in the case of a bankruptcy or distressed situation would not be able to grab those revenues.”
In Illinois, under the local government reform act, there is a pledge of revenue that comes from the state that is escrowed to the trustee for school district bond issues, according to a Chicago bankruptcy attorney. It is pledged as the first lien superior to the rights of any other party, but it doesn’t have the language that the California statute has, he said.
In California, Senate Bill 222, which went into effect in January, provides a statutory lien for GO bondholders on property taxes levied to pay GO bonds.
California also has a longstanding statutory provision that the voter-approved ad valorem property taxes collected for school district GO debt by a county cannot be used for any other purpose than to pay that debt, which is not the case in Chicago, he said.
In Illinois, state aid can be directed to pay the bondholders, but it is not a mandate of a statute. If the state aid is not enough to pay the bond debt, then the ad valorem property taxes pay the debt, but they abate – meaning anything over the amount used to pay the debt would return to the taxpayers.
For five recent California school district bond sales, special legal opinions were provided to Fitch and the other rating agencies explaining why California school district property taxes would be considered special revenues in a bankruptcy, which was not the case in Chicago.
Peter Bianchini, a managing director in Mesirow Financial’s Institutional Sales & Trading Group, said some investors view California school GOs backed by ad valorem property taxes as being separate from school district operations. But other investors are still looking at school district operations when they purchase the bonds, he said.
Mesirow’s trading desk thinks there has been some benefit to California school district bonds from Fitch’s AAA ratings, but it is hard to say how much the higher ratings impacted pricing, he said.
“There are so many other factors,” Bianchini said.
The ratings might have helped to activate more retail buyers, who liked the fact there was that triple-A on it, and who tend to put more weight into how the rating agencies view bonds than institutional investors do, he said.
In contrast, the legal framework supporting the property tax pledge of Chicago Board of Education's bonds creates more concern that a legal challenge might be successful, Fitch analysts said in the report.
Among the elements Fitch said are necessary to meeting its high bar are an express statutory prohibition on the use of any revenues from the taxes for operations of the issuer, and that bondholders do not have a claim on general revenues of the issuer, but are rather solely secured by the dedicated tax.
GOs supported by an entity’s full faith and credit will typically not meet the criterion, Fitch said.
Fitch’s review centers on one type of special revenue delineated in Chapter 9, which attempts to distinguish property, sales and income taxes that pay for project debt from the taxes funding district operations.
That category is “ambiguous and difficult to apply in practice,” Laskey said.
According to Fitch, there is much at stake in correctly determining whether special revenue bond status exists and delinking the security rating from the general credit of the municipality.
“If the status of the debt is disputed, not only is payment interrupted, but the lien on post-bankruptcy revenues can be lost,” the rating agency wrote.
Fitch will host a teleconference Wednesday at 2 p.m. EST to discuss the special report.