Kentucky Files Davis Case Brief

WASHINGTON — Forcing over 40 states to eliminate preferential tax treatment for their bonds would have dire consequences for investors and issuers alike, attorneys for Kentucky warned the Supreme Court in a brief filed late last week. The state’s brief comes two months after the court agreed to review a high-profile municipal bond dispute, Kentucky v. Davis, in which a married couple successfully argued that the state’s policy of taxing interest on out-of-state issued bonds while exempting the interest on their own debt violated the so-called dormant commerce clause of the Constitution. That clause stipulates that only Congress can erect barriers to interstate trade. Highlighting widespread interest in the case, eight market groups, representing a wide swath of the municipal market — from state treasurers to mutual fund managers — filed friend-of-the-court briefs in support of Kentucky. The briefs were filed by: the Securities Industry and Financial Markets Association; the National Association of State Treasurers; North Carolina Attorney General Roy Cooper on behalf of all state attorneys general except for Kentucky; the Government Finance Officers Association on behalf of eight other state and local groups; the Multistate Tax Commission; Dupree Mutual Funds; the Aquila Group of Funds on behalf of 13 state-specific mutual funds; and Nuveen Investments Inc. Another group, the National Federation of Municipal Analysts, filed a “neutral” brief because its board was split on the issue, but still voted to highlight the dramatic upheaval that would occur if the court upholds the Davis ruling, according to NFMA chairman Tom Weyl. “We had people on both sides of the issue, but we wanted the court to understand the full market impact of the case. There’s a lot of money at risk,” he said. Kenneth B. Roberts, a partner at Hawkins Delafield & Wood LLP who co-authored the NAST brief, noted that all 50 states — including those that do not currently have an income tax — filed documents in support of Kentucky, a fact that he hoped would help sway the court. “Where there is evidence of unanimous support among the states and among the groups that are involved with state and local governments [for taxing interest on out-of-state bonds but not in-state debt], I think that the court has to take that seriously, especially where that includes states that do not currently follow that practice,” Roberts said. In its briefing, Kentucky argued that the municipal market is essential to the day-to-day financing of municipalities and that changing the status quo could have major repercussions for bond issuers and buyers. “A $2.4 trillion municipal bond market essential to the states’ ability to finance not only capital projects but their daily operations has functioned smoothly for decades on the business assumption that disparate treatment of state bond interest is constitutionally permissible,” Kentucky told the court. “It’s bad business to push a 2.4 trillion pound gorilla out of its cage without any idea of where 11he’s headed or what he’s going to do when he gets there.” While many of the briefs cited a number of legal precedents, a majority, including Kentucky’s, urged the high court to follow its reasoning in a recent 6-to-3 decision to uphold the so-called flow control ordinances in a case called United Haulers Assoc. v. Oneida-Herkimer Solid Waste Management Authority. In United Haulers, a trade association and individual trash haulers in Oneida and Hermkimer counties in upstate New York challenged the counties’ “flow control” laws, which require that garbage generated by local households and businesses be delivered to facilities that are owned and operated by a governmental entity. The haulers argued that the flow control ordinances stifled competition. Without those ordinances a nd their associated “tipping fees,” the haulers said they could dispose of solid waste at out-of-state facilities for far less money. But instead, the court ruled that the ordinances did not violate the dormant commerce clause because, although they granted a monopoly to local processing facilities to the exclusion of privately-owned facilities outside the counties, the ordinances were designed to benefit a “clearly public facility, while treating all private companies exactly the same,” the court ruled. “United Haulers demonstrates that the dormant commerce clause was not intended to forbid statutes designed to protect a state’s own public interests, even if an effect of such statutes comes at the expense of the interests of private market participants,” SIFMA wrote in its brief. The Multistate Tax Commission noted that there could be discrimination against interstate commerce if the states’ tax schemes were structured to exempt interest earned by its residents on bonds issued by in-state private companies such as car manufacturers, while taxing the interest on bonds issued by out-of-state car manufacturers. “But here, where the beneficiary of the tax differential is the state itself in its provision of government services, there is no differentiation between in-state and out-of-state business interests engaged in a competitive national market, and thus no discrimination against interstate commerce,” the commission told the court. Kentucky argued that its bonds are not “similarly situated” to other states, and therefore cannot violate the commerce clause by discriminating against interstate commerce with its taxing practices.The Supreme Court ruled in previous commerce cases such as General Motors Corp. v. Tracy that “any notion of discrimination assumes a comparison of substantially similar entities.” However, Kentucky claimed that since its bonds only finance public projects for the state, it cannot be considered “substantially similar” to other states, and therefore cannot discriminate against them. “For these purposes, sister states are no more 'similarly situated’ to Kentucky than the government of Egypt,” it stated. Several briefs cited the 1881 Supreme Court case of Bonaparte v. Tax Court. In the case, the high court ruled that one state could tax interest earned by its own residents on the debt of another state. Kentucky argued that this ruling established the precedent of taxing practices favoring states’ interests, and that current tax practices grew from that ruling over a century ago. Both NFMA and Aquila contended in their briefs that single-state mutual funds found in 42 states could be jeopardized if the court rules against Kentucky. State-specific mutual funds play a specific role, giving attention to smaller issuers that are overlooked by large national mutual funds, they said. If preferential state tax treatment is revoked, the demand for state-specific mutual funds, which are largely invested in by state residents interested in the tax exemption, will disappear, and issuers and investors alike will suffer as national mutual funds lack the resources to adequately manage the smaller issuers that make up the majority of the market. In its brief, GFOA noted that a ruling against Kentucky would force state treasuries to “absorb billions of dollars in transition costs” and create “a large-scale financial disruption that is manifestly unfair given the reasonableness of the state’s reliance on the validity of a ubiquitous tax policy.” GFOA noted, as others, that Congress has the authority under the commerce clause to regulate the states’ taxation of interstate commerce, but it has failed to regulate states’ preferential tax treatment of muni bonds. “Although this court is generally reluctant to draw inferences from congressional silence, in this particular context Congress’ inaction warrants significant consideration, especially given the extensive evidence of Congress’ awareness of the practice,” GFOA told the court. The brief filed on behalf of all fifty state attorneys general also asserted that managing state taxation practices are the responsibility of Congress, not the court. “Respondents are asking this Court to dramatically alter how the States have taxed bonds for the past hundred years. Such a change is best left to Congress,” they stated. SIFMA also urged the court to rule in favor of Kentucky, and to rule narrowly, stating the court “should not prejudge discrimination in other areas that involve greater participation by private market participants.” The association pointed out that state bonds finance public needs like schools and highways and therefore states should encourage residents to purchase their bonds, stating that “any possible burden imposed by the Kentucky tax scheme upon interstate commerce could not possibly outweigh the compelling public benefit it serves.” The Davis’ and any parties that want to file briefs on their behalf must do so in roughly one month. Each side will be permitted to file rebuttals. The court is expected to hear the case sometime after it begins a new session in October. The Supreme Court took up the case for review in May at Kentucky’s request. The state made the request after Kentucky Court of Appeals ruled in favor of the Davis’ in January 2006 and the Kentucky Supreme Court refused to hear the case last August.