The Feb. 17 article "Indiana School Default a Warning to Investors" questioned the effectiveness of Indiana's intercept program in preventing a default. As a global matter, all investors should understand the security pledged to the payment of principal of and interest on any of the bonds that it owns, as well as the operation of the mechanism providing for such payment. However, when it comes to Indiana school bonds, any doubts as to the quality or effectiveness of Indiana's intercept program, or as to the justification of the high rating given to qualifying Indiana school corporations based upon that intercept program, are misplaced if based upon the default event highlighted in the article.
What is the intercept program? The intercept program is not a State guarantee of Indiana school bonds. The intercept is rather a mechanism to give debt service payments a priority position above other costs which may be paid out of a school corporation's general fund. The intercept program requires that the state treasurer withhold an amount sufficient to pay debt service from its general fund distributions to a school corporation when that school corporation does not make a required payment. All school corporations are eligible for an enhanced rating if its state aid levels meet certain debt service coverage requirements. Additionally, bonds receive a further enhanced rating provided coverage is sufficient and the authorizing documents include certain provisions.
Among these provisions is a requirement that the school corporation make its payment to the paying agent on a date prior to the date the debt service payment is due, or make payment to the trustee on its lease obligations prior to the date of debt service on the building corporation bonds are due. The time period must be at least five (5) days under the current rating methodology.
The default mentioned in the article was not a failure of the state intercept. Rather, the default in the article was the result of the mechanics in place under the transaction documents breaking down. The lease payments were due five days prior to the January debt service payment on the bonds. Upon the failure to pay the lease payment the trustee should have contacted the state treasurer to ensure payment on the bonds on the January due date. From the article it appears that the notice was never given. Such a default would have not occurred had the terms of the transaction documents been implemented.
The intercept legislation is not the only basis for the high credit quality of Indiana school bonds. In addition to the intercept, taxes levied to make debt service payments and lease payments are "protected" from the State's tax cap legislation. This means that any debt service levy will not be reduced, as would other funds, in cases where a school corporation is unable to recognize its full levy in other funds. Finally, the Department of Local Government Finance is tasked with reviewing debt service levies for bonds and leases and required to make sure that any such levy is sufficient to make debt service payments. The DLGF diligently performs that roll every year as a part of the annual budget process.
The takeaway from the recent default is that investors should understand how the intercept works, and perform diligence and document review to ensure that the requisite process is in place for the state intercept to work properly. Blind reliance is never justified, but neither is unnecessary fear based upon misunderstanding.
Jimmy Shanahan is a partner at Shanahan & Shanahan LLP.