“The quandary that the Gary School Corporation has put itself in is due in large part to the change of the tax structure and school funding formula here in the state of Indiana,” says Gary, Indiana Mayor Karen Freeman-Wilson.

DALLAS – The Gary Community School Corporation in Indiana is struggling to meet payroll after voters rejected a referendum to increase property taxes.

The corporation's struggle to meet payroll highlights a precarious situation that includes talk of dissolution.

For investors, Gary's school problems could test the mechanics of a state enhancement program that is designed to reassure bond investors.

It is the second time in 18 months that the Gary school corporation has lost a tax referendum. The referendum question Nov. 8 asked voters to approve about $8.7 million of new taxes annually over the course of seven years.

The school district was Indiana's first local government to have a financial specialist appointed to oversee it. The financial specialist process was written into statute specifically for the district.

To appoint the financial specialist, the state's Distressed Unit Appeals Board held a hearing to review the financial status of the School Corporation.

In Indiana, school corporations facing fiscal distress can petition the state's Distressed Unit Appeals Board to be declared a distressed political subdivision. Local governments in Indiana, including school corporations, are not able to declare bankruptcy.

In July 2015, at the direction of the DUAB, the school corporation picked Jack Martin, a former emergency manager of Highland Park schools in Michigan and Detroit Public Schools, as financial specialist. Martin presented a deficit elimination plan to the school board Sept. 23.

Martin said he has saved a little more than $3 million since August through managing grants better, restructuring employees and renegotiating contracts. He says that more employees will have to be fired and additional school buildings will need to be closed to help reduce spending.

Still the district remains more than $100 million in debt, including a $25 million hole in its operating budget.

According to Martin's deficit elimination plan, as of June 30, 2015 the school corporation had $3.8 million in tax anticipation warrants outstanding, $11.8 million in school bonds, $42.9 million in notes and loans and $16.5 million in common school loans.

Although it is current with debt-service payments, the failed referendum means it's uncertain if the district will be able to service its debt beyond December.

"The school board can't assume they can continue the same practices that have occurred over the last several years, and the state will provide funding to continue those inefficiencies," said Martin.

Debt of Indiana school corporations is subject to an intercept program run by the State Treasurer.

If a school corporation fails to make a bond payment, the State Treasurer shall pay the unpaid debt service from the funds that the State was to distribute to the school corporation.

"We believe bondholders should be aware of the kinds of risks that they are taking on given that Gary schools have been unable to release audited financial statements since 2014, and the last audit came with significant commentary from auditors that called into question the reliability of the disclosure," said Tom Schuette, co-head of investment research and strategy at Gurtin Municipal Bond Management..

Gary's overall credit profile is suggestive of distress, especially the fact that the disclosure that exists illustrates property tax collection rates far below what is typical, according to Schuette.

"Clearly, the tax base is exhausted and close to a quarter of the district's overall tax levy is going uncollected," he said.

Schuette also said bondholders who purchased debt relying on the Indiana school enhancement program may be in for a bumpy ride. The program has failed to perform before – just last year Munster Schools defaulted on debt and the enhancement failed to protect bondholders, though the district was able to catch up to its payments within a week.

Additionally, Schuette describes the mechanics of the program as "murky" and said it does "not guarantee timely payment."

"This is why we have always emphasized credit analysis of the underlying obligor, and not just relying on state enhancement programs," he said. "At this point, it is difficult to know how the state will react and whether they will intervene – but bondholders should not be banking on this as a guarantee."

However Jillean Battle, chief deputy treasurer and general counsel of the state treasury, said that Munster schools default was not a failure of the state intercept. Munster failed to follow the protocol that would have triggered the state intervention. The trustee disregarded the requirements of the legal documents and did not notify the Treasurer of State or make a request for an intercept of the school's funds. "Had the district notified the Treasurer that a default was eminent we would have stepped in," said Battle.

The chair of the state Senate Appropriations Committee, Luke Kenley, R-Noblesville, said that the state isn't ready to forgive the school corporation's debt and it's not ready to give the district an infusion of cash.

"I don't think that's the source of their problem, just to throw more money at them," Kenley said. "I think they need to have a whole different management structure there. The recommendations of the emergency manager with respect to cutting the costs of operations and restructuring debt are very feasible. That is where we need to start."

Gary Mayor Karen Freeman-Wilson says the city got involved a little too late in efforts to get referendum to pass. The referendum failed by 322 votes, with less than 51% voting "no."

The referendum can pass if put to the ballot again "as long as the school corporation properly explains how the revenue will be used," Freeman-Wilson said.

"The challenge has been to get the school corporation to articulate the details to residents about what would be done with the revenue," she said. "Had they been able to provide not just details about what would happen to the referendum revenue but to also look at what the solution was going forward, given the size of the deficit, it would have been successful."

Freeman-Wilson said the school corporation still has several options to explore before opting for dissolution, a fix she believes wouldn't really work because neighboring school districts are also struggling financially. "You don't want to saddle them with additional financial challenges," she said.

Instead, like Kenley, she believes the district must first look at the debt reduction practices the state–appointed financial manager recommended in the September deficit elimination plan. She also advocates that the city's charter schools, which compete with public schools for state funding, share some of the costs.

The city and school district is working with the Indiana General assembly to see if it can either get debt forgiveness or an infusion of revenue to help boost its funding. The General Assembly goes into session in January.

"Any long-term solution has to either be driven or at least have the support of the Indiana General Assembly as it relates to debt forgiveness, as it relates an infusion of dollars," Freeman-Wilson said. "The quandary that the school corporation has put itself in is due in large part to the change of the tax structure and school funding formula here in the state of Indiana."

Gary public schools have struggled since property tax caps were put in place in 2008 and Indiana legislators updated the state's school funding formula in 2015.

"With our dwindling student population and low property tax collection rate, the district has felt the impact of state policies implemented over several years and struggles with applying strategies and internal procedures required to operate more efficiently," said state Sen.-elect Eddie Melton, D-Merrillville, who will represent Gary.

The caps—which voters put into the Indiana Constitution—limit the total property taxes that homeowners, farmers and businesses must pay, which can in turn reduce revenue to all taxing units, including schools. Taxes can go above the caps only if the increases are approved in a referendum.

The General Assembly in 2008 also voted to eliminate property taxes as the revenue source for school district general funds. Instead the state funds costs of most day-to-day expenses and salaries with a 1 percentage point increase in the sales tax and money that had previously been used for property tax relief.

The Gary schools have also had to grapple with an enrollment decline and competition from the six charter schools that educate nearly half of the enrollment base.

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Corrected December 7, 2016 at 1:53PM: An earlier version of this story gave the wrong title for Jack Martin, and gave an inaccurate description of the events leading to a default by the Munster, Ind., school district.