`You Sort Of Feel Like You've Been Had'Kelley Holland
To officials of the Pontiac (Mich.) school district in 1991, selling $36 million in deferred-interest bonds seemed like a painless way to borrow. Issuing the bonds would let the district delay paying interest for years, avoiding a politically painful tax-rate hike.
Now, though, the deal looks a lot less terrific. The unusual provisions of the bonds mean that interest costs will be more than twice what they would have been with conventional borrowing, and the district allegedly ended up taking on more debt than it needed. The district is suing its legal adviser, Detroit-based law firm Miller, Canfield, Paddock & Stone, which, unbeknownst to the district, also worked for a time for Kemper Securities Group Inc., which underwrote the bond issue.
Pontiac's woes illustrate what can go wrong when officials with limited understanding of muni finance enter into unorthodox, complex borrowings. They may rely too heavily on their lawyers and underwriters, leaving themselves vulnerable to what could later be viewed as poor advice and conflicts of interest. "We ended up doing something that was entirely different from what we thought we'd do in the beginning," says the district's financial adviser, Ronald G. Erickson. "You sort of feel like you've been had."
Pontiac school officials wanted to tap the muni market to raise money to cover the district's budget deficit and various operating costs. But they worried that the debt service could force Pontiac to raise the property-tax rate. The solution: deferred-interest bonds, also known as capital appreciation bonds, or CABs. Like zero-coupon securities, CABs are issued at a discount to their face value, and interest payments are deferred for years. Dozens of Michigan school districts have issued CABs in recent years, often using Kemper and Miller Canfield.
EXTRA DEBT. At first, Pontiac's bond issue looked like a success. School renovations got under way, and voters avoided a higher tax rate. But by the spring of 1992, district officials started to appreciate the CABs' long-term cost. While a traditional fixed-rate bond incurs the same interest costs every year, a zero-coupon bond entails rising, albeit deferred, interest costs. The interest, in fact, is effectively compounded. Pontiac borrowed less than $36 million with CABs, but in today's dollars, the district's total payments on those bonds will exceed $100 million, says Dennis R. Pollard, the district's attorney. What's more, Erickson says, partly because Miller Canfield attorneys allegedly told district officials they would receive extra state aid if they issued certain other bonds in addition to the CABs, the officials decided to borrow millions more than originally planned.
In July, 1992, the district sued Miller Canfield, claiming it relied on the firm's advice when planning its borrowing. And it alleged that, when it was working for Kemper and the district simultaneously, Miller Canfield didn't adequately warn district officials about drawbacks in its borrowing strategy. Says Pollard, "If they had an undivided loyalty to their client, we maintain they would have told us the pluses and minuses." He maintained in The Bond Buyer last fall that "the interests of Kemper prevailed over the interests of Pontiac schools."
Joel L. Piell, chairman of the public law department at Miller Canfield, concedes his firm did not disclose the link to Kemper to the district, which "should have been done." However, he says, "we did not act in any way which was conflicting with the school district." George T. Stevenson, the Miller Canfield attorney who worked on the deal, said in a deposition for the suit that advising on financial considerations is "primarily the responsibility of the financial adviser."
Richard Allen, the Kemper senior vice-president who worked with Pontiac, says it's common for a law firm to work for both issuer and underwriter to save costs. From the Pontiac school district's standpoint, that would seem to have been a false economy.