Supreme Court Muni-Bond Delay Has Lawyers, Markets Puzzling

April 9 (Bloomberg) -- Municipal-bond investors have a new question to ponder amid the turmoil in the $2.6 trillion market: What is taking the U.S. Supreme Court so long?

The court heard arguments Nov. 5 on the special tax breaks that 42 states provide to municipal bonds issued within their borders. At the time, many analysts and lawyers predicted a quick decision that would allow in-state exemptions and overturn a Kentucky court ruling that declared them unconstitutional.

Five months later, the bond market is still waiting -- and in some quarters wondering whether the holdup signals something other than a clear-cut victory for existing tax rules.

``The length of time to me means that there could be more subtlety to the decision, or that the decision itself might not be as cut-and-dried as we had expected,'' said Matt Fabian, managing director at Municipal Market Advisors, a Concord, Massachusetts-based research firm.

A ruling against Kentucky would force states to eliminate their tax exemptions for interest on in-state bonds -- or extend those breaks to out-of-state bonds. States would face billions of dollars in refund claims, and almost 500 single-state bond funds would lose much of their appeal.

Such a ruling might ripple through an already troubled bond market. Municipal bonds lost 0.82 percent in total return on average last quarter, their worst start since 1996, according to a Merrill Lynch & Co. index.

Stopping Short

One possibility, raised during arguments, is that the court might stop short of endorsing in-state tax breaks for private- activity bonds, those that finance private construction, while permitting exemptions for bonds financing government projects.

``I still think the result will be a reversal'' of the Kentucky court decision, said Leonard Weiser-Varon, a public- finance lawyer at Mintz Levin in Boston. ``The interesting question is going to be whether they punt on private-activity bonds.''

Of the 27 cases the nine justices heard before their Christmas recess, the bond dispute is one of only four yet to be decided. The court's next scheduled day for releasing decisions is April 15.

The odds still favor a decision upholding existing state tax rules, according to several lawyers and analysts watching the case. During arguments in November, the justices voiced reluctance to force changes on the market. Still, the longer the justices wait to issue their ruling, the more fuel they provide for speculation that the decision will be complex.

It isn't unusual for the court to take many months to resolve cases; still-pending disputes involving child pornography and money-laundering are even older than the bond fight. But delays often are a sign of behind-the-scenes wrangling.

Many Opinions

``This is highly likely to be one of those cases where you get a number of opinions,'' said Walter Hellerstein, a tax law professor at the University of Georgia Law School in Athens.

The issue for the court is whether Kentucky's tax rules, being challenged by two state residents, violate the so-called dormant commerce clause, a judge-created rule that bars states from discriminating against out-of-state businesses without congressional authorization.

In a 6-3 decision last year, the justices said the clause doesn't bar local governments from steering trash to designated, publicly owned disposal facilities.

That ruling -- and its implications for private-activity bonds -- drew the first questions at the hour-long hearing in the bond case. Justices Samuel Alito and David Souter pointed to a distinction the majority made when it allowed favoritism toward government-owned garbage facilities while barring preferential treatment for private landfills and recycling centers.

Ducking the Issue?

Alito, 58, and Souter, 68, said they disagreed with the public-private distinction. At the same time, their questions prompted Justice Ruth Bader Ginsburg to suggest that the court might duck the issue and leave open whether in-state tax exemptions for private-activity bonds are constitutional.

``As far as I understand, this is not a private-activity bond. It's not what's at issue here,'' Ginsburg, 75, said. ``And there was no adjudication with respect to that type of bond in the lower courts.''

Private-activity bonds represent about a quarter of the outstanding municipal bonds nationwide. They finance mortgages, student loans, small-scale industrial projects, airports, hospitals, redevelopments and a variety of other causes.

In some cases, states require that the bond issuer own the financed facility while leasing it out to a private entity.

Should the high court carve out different rules for bonds that finance private activities, the justices might find themselves trying to draw a thin line, Weiser-Varon said.

``There's gray as to what's a private activity-bond,'' Weiser-Varon said. ``It would be quite messy.''

The case is Department of Revenue v. Davis, 06-666.

To contact the reporter on this story: Greg Stohr in Washington at gstohr@bloomberg.net.

To contact the editor responsible for this story: Michael Forsythemforsythe@bloomberg.net.