Saturday, August 29, 2009


By David Dietz and Karen Gullo |

Aug. 26 (Bloomberg) -- With the temperature reaching 100 degrees Fahrenheit on an April afternoon, Alan Polee peers through a window into the locked-up gym at Vanguard Middle School in Compton, California. The cream-colored building is shut because of a decaying roof.

At Vanguard, 15 miles south of downtown Los Angeles, children play outdoors, no matter the temperature, on rutted fields and basketball courts with broken backboards.

“We shouldn’t have these conditions in this day and age,” says Polee, 46, a Los Angeles city truck driver who has sent five children to the Compton schools. “You wonder what’s going on.”

The Compton Unified School District could have repaired the gym. In 2006, the district refinanced $50.8 million in taxpayer- approved bonds, in a move its bankers said would save the district money. In the process, officials took out $6.5 million in cash, which they said would be used for school construction and repairs.

School board member Micah Ali says Vanguard’s gym and rundown facilities at other schools weren’t fixed. A Compton audit couldn’t track how school construction money was spent. In the meantime, total debt owed by taxpayers until 2022, instead of being reduced, has gone up by 15 percent.

Throughout California, the largest and most fiscally troubled state in the U.S., about 200 school districts have done similar refinancing deals -- all of which have been condemned by Attorney General and former Governor Jerry Brown as unconstitutional.

Ban on Deals

The Compton school board didn’t seek voter approval for the deal. From 2002 to 2007, California school districts collected a total of $1 billion for construction during a bond refinancing spree set off by falling interest rates.

None of these deals should have been done, Brown says. The constitution bans school districts from taking on additional debt in a refinancing of taxpayer-approved bonds without a public vote.

In every case, the prohibited transactions added to school district debt and increased property taxes for at least the next decade, bond records show. Banks pitched the deals to schools on the premise that refinancing would save taxpayers money and provide extra cash.

The deals were dominated by UBS AG and Piper Jaffray Cos., which collected fees up to four times the U.S. average for bond sales, public records show.

“This was a hell of a cute scheme,” says Lee Buffington, treasurer of San Mateo County, just south of San Francisco. “These guys had a gold mine going and thought nobody was watching.”

Financing Frills

Some districts spent millions of dollars from refinancing not to upgrade classrooms but to purchase administration buildings and build sports stadiums.

Those decisions overrode requests from school board members and parents to support more urgent needs -- such as fixing leaky roofs, replacing faulty electrical systems, modernizing science labs and increasing security at schools where student violence had flared.

The Moreno Valley Unified School District, a 39-school system in Southern California, used 90 percent of its $6.5 million in cash to build a 3,000-seat outdoor stadium equipped with a wireless videotaping system for football games.

Librada Murillo, a mother of three children in the district, says school officials didn’t ask parents for advice. She blames board members for building a stadium when schools needed new bathrooms and security systems.

“We have a right to know this information,” she told the school board in 2007. “What the school board has been doing is not legal.”

No-Bid Deals

Most districts arranged refinancings without competitive bidding, bond records show. The added taxpayer burdens come as communities across the country try to dig themselves out of debt quagmires brought on by the purchase of exotic financial contracts.

The U.S. Justice Department for the past two years has been conducting the largest-ever criminal investigation of public finance in the nation.

Jefferson County, Alabama, the state’s most populous county, has been on the brink of bankruptcy for more than a year, unable to meet payments on $3 billion in interest-rate swaps sold by a group of banks headed by JPMorgan Chase & Co. JPMorgan declined to comment.

California, where state and local governing bodies issue more bonds than anywhere in the U.S. outside the federal government, has already had its share of debt fiascoes. In 1994, Orange County, home of Disneyland, went bankrupt in what still stands as the biggest municipal failure in U.S. history.

Fiscal Mess

Now, the state is trying to escape from its own fiscal mess. Governor Arnold Schwarzenegger in July closed a $24 billion budget gap with cuts ranging from trims in child welfare services to furloughs for state employees. He faces more reductions unless the economy recovers.

Banks told California school officials that refinancing made sense because the new debt would cost less than the old bonds, according to district documents and tape recordings of school board meetings. Such promises are misleading, says San Mateo Treasurer Buffington.

If there are any savings, they typically wouldn’t occur for 15 to 20 years. In many cases, a district replaced a 23-year general obligation bond -- voter-approved debt backed by property taxes -- with debt of 15 to 20 years.

State law requires lower total debt when school districts refinance old taxpayer-approved bonds. To accomplish this, banks sell bonds at lower interest rates compared with old ones, and for shorter terms.

Tax Hikes

That decreases debt compared with the old bonds because property owners pay less interest over a shorter period of time.

However, that type of financing leads to immediate property tax increases, in many cases for 20 years, because annual payments to bondholders are larger than they had been with the longer-term bonds, transaction records show. Once the refinancing is paid off, if tax rates don’t rise, property owners would see lower real estate taxes.

Attorney General Brown said in a January legal opinion that a possible benefit to taxpayers that could come in about two decades is “irrelevant.” What counts, he said, is that taxpayers have been improperly hit with higher taxes now.

For the Compton deal, county finance officials analyzed the amount property owners would have to pay bondholders after the 2006 school refinancing. In the three years following the transaction, the finance office doubled Compton’s real estate tax rate on those bonds.

More Declines

The economic meltdown that began in 2007 may add to taxpayer burdens of paying off cash-out refinancings. The state Legislative Analyst’s Office has forecast a 3.5 percent decline in property values in California in the next year, which might force counties to increase tax rates.

Attorney General Brown wrote in his opinion that school districts are prohibited from using a refinancing “for any purpose other than refunding the district’s targeted indebtedness.” Brown hasn’t taken any actions against banks or school districts. He said taxpayers could file lawsuits in their communities.

Brown, 71, is campaigning to be elected governor again after holding the office from 1975 to 1983.

Lost Savings

San Mateo Treasurer Buffington says millions of dollars in new debt owed by California taxpayers could have been avoided if Brown or his predecessor Bill Lockyer had moved faster on complaints and halted cash-out refinancings.

Scott Gerber, Brown’s spokesman, says the legal opinion stopped the practice.

“Individual school districts may still take action to address past wrongdoing related to the practice,” Gerber says. “If evidence of widespread wrong-doing emerges, the Attorney General’s office will look into it and determine the most appropriate course of action.”

Lockyer declined to comment.

The rewards to banks for managing cash-out deals trickled down to lawyers and insurers. Total fees paid by schools -- as a percentage of the cash they received -- reached 41 percent in the Acalanes Union High School District, a suburban system east of San Francisco. Fees came to 82 percent in the Ravenswood City School District near Silicon Valley.

In the San Mateo Union High School District, 20 miles (32 kilometers) south of San Francisco, fees totaled 117 percent of the $500,000 the school system got in cash on a $56 million refinancing in 2004. Advisers led by UBS arranged the financing and took $582,747 for their efforts.

‘Very Angry’

“Fees like that make you sad and very angry,” says Christopher Taylor, former executive director of the Municipal Securities Rulemaking Board, an industry-tied regulator in Alexandria, Virginia. “It’s unbelievable greed.”

The public doesn’t know that cash-out refinancings increase tax burdens because of lax notice by school officials, a local government oversight group said last year.

The San Mateo County Civil Grand Jury, which makes recommendations about government improvements, found that student needs were cheated because fees ate up substantial portions of cash proceeds. The jury criticized school districts for giving insufficient notice to the public.

“The main concern was about the notification of voters and the transparency of the process,” says jury foreperson Virginia Chang Kiraly. “Taxpayers wound up on the hook for more than they voted for.”

‘Valid and Binding’

UBS and Piper Jaffray teamed up on at least 32 of the 50 largest refinancing deals in 2004 and 2005 with a single bond lawyer, David Casnocha of San Francisco-based Stradling Yocca Carlson & Rauth. He wrote legal opinions vouching for deals from 2002 to 2007 that brought districts cash windfalls of up to $30 million.

“The bonds constitute valid and binding general obligations,” Casnocha wrote in legal opinions that backed the sale of cash-out deals. Casnocha, UBS and Piper Jaffray declined to comment.

In Compton, no school board member asked for details when a cash-out refinancing came up on a meeting agenda in March 2006.

Compton, a community of 96,000, is struggling to improve schools and public safety. Over a four-year period that ended in 2008, half of Compton’s high school students dropped out, more than twice the state average.

Barred Windows

While the city homicide rate in 2008 was the lowest in 25 years, Compton battles gang violence that’s been glorified in rap songs about the community. Compton streets are lined with a mix of palm trees and check-cashing outlets, fast food chains and liquor stores with barred windows.

In the early months of 2006, the Compton school system ran into a financial fix. It had nearly exhausted a $200 million construction fund, with many schools still in need of repair. RBC Capital Markets Corp., which had handled four previous Compton debt sales, came up with an answer: refinance old debt and deliver $6.5 million in upfront cash.

New York-based RBC, part of Toronto-based Royal Bank of Canada, managed the transaction. The lead banker, Los Angeles- based managing director Roderick Carter, 54, had experience in such deals. In 2005, he handled four refinancings, of $46.8 million to $75.7 million, that provided districts with a total of $20 million in cash, according to bond documents.

The transactions earned RBC $1.6 million, the records show. At an evening meeting in Compton in March 2006, the seven-member school board took a total of five minutes to approve the refinancing, a videotape of the session shows.

‘In Their Throats’

Just one trustee, Mae Thomas, a financial analyst at a Los Angeles hospital, objected among the six voting members. She said the community hadn’t been consulted about what to do with the $6.5 million.

“Why don’t we have hearings so the community can have input on these bonds?” Thomas asked. “We sit up here and shove it in their throats.”

The new bonds shortened the maturity of the district’s debt by seven years, to 2022 from 2029. The 10-year interest rate on the new bonds dropped to 4.66 percent from 5.25 percent. Still total debt increased to $58.2 million, from $50.8 million. As a result, county officials set higher tax rates.

Compton property owners are being billed a total of $3.7 million for 2009, 46 percent more than the $2.5 million they would have faced for the old bonds, district records show. If the school district doesn’t borrow more money, the public could see a drop in real estate tax bills in 2022, when the new bonds are paid off.

‘Saves Money’

Compton board members didn’t delve into the workings of the refinancing or ask about fees, which totaled $912,126. RBC collected $749,588. David Huff, a Los Angeles lawyer who gives legal advice to the district, recommended that the board approve the transaction.

“This is sound fiscal management,” he said at the board meeting. “As your counsel, I cannot think of a reason why not to do it. It saves money.”

In an e-mail, Huff stands by his statement at the 2006 board meeting. He says taxpayers will save in the long run. Former School Superintendent Jesse Gonzales and former district business manager Teresa Santamaria, who backed the refinancing, declined to comment.

RBC says its fees on the Compton refinancing met market levels for bond sales.

‘Multiple Law Firms’

“Refinancings were completed at client direction by virtually every major underwriting firm, with written legal opinions from multiple law firms affirming their compliance with state law,” spokesman Kevin Foster says.

At the time Compton was scrambling to rescue its construction program, the district moved into a new $10 million administration building. It was funded by lease revenue arranged through the Los Angeles County Schools Pooled Financing Program. When board members attend meetings, they sit in high-backed burgundy leather chairs that cost $750 each, public records show.

While school districts such as Compton did just a single refinancing, the Acalanes district in the San Francisco Bay area was hungrier. The school board used the technique four times in 2004 and 2005. Acalanes, a district populated mostly by white- collar professionals, collected cash totaling $3.8 million.

Its bank, Piper Jaffray, and bond lawyer, Casnocha, assured the district that the transactions violated no laws, according to bond documents.

Increased Debt

In the largest sale in 2005, Acalanes refinanced $46.4 million in 2002 bonds. Yields on the 10-year portion of the new 20-year bonds dropped to 4.45 percent, from 5.62 percent, according to data compiled by Bloomberg. Still, the debt increased to $48.7 million after the district took cash of $1.2 million and paid costs of $663,048, or 55 percent of the new money.

Piper Jaffray collected $450,866, a fee equal to $10 for each $1,000 issued, about three times the national average. The new 20-year bonds required a jump in annual payments to $2.2 million a year from $1.2 million in the first two years of the debt, beginning in 2005, bond documents show.

County tax officials more than tripled the tax rate on the refinancing in the first two years after the transaction. The public could pay out less after 20 years, when the bonds are paid off, if the county holds property tax rates steady.

In the four Acalanes sales, the district spent an average of 41 percent of its upfront cash -- $1.6 million -- on fees, bond documents show.

‘Absolutely Ludicrous’

“That’s absolutely ludicrous,” says Ken Hambrick, chairman of the Alliance of Contra Costa Taxpayers, a county organization that watches local government spending. “No one was apparently aware of this.”

Christopher Learned, who handled all of the transactions as the district’s chief financial officer, declined to comment.

In Southern California, the Moreno Valley Unified School District needed improvements ranging from upgraded roofs to new security systems in 2006, according to school records.

Moreno Valley, a community 75 miles east of Los Angeles, has a violent crime rate that’s increased each year since 2005, according to Federal Bureau of Investigation statistics. In 2007, a student was shot and killed within a block of a city high school.

The district, with 35,000 students, decided on a refinancing for upgrades, which allowed it to get $6.5 million from Kansas City, Missouri-based bank George K. Baum & Co., records show.

School officials decided to use most of the cash from the transaction -- $5.8 million -- to build the new stadium at a district high school.

‘Extreme Violence’

Chris Huhs, a former parent-teacher association president at a Moreno Valley school, says security and academic needs overrode the need for a sports stadium.

“Providing the high school with a stadium is ludicrous,” she told the board before it voted on the deal in 2007. “We have extreme violence at that school.”

During school deliberations about the deal, advisers told school officials that Attorney General Brown was considering the legality of cash-out refinancings. Moreno Valley’s lawyers, Newport Beach, California-based Bowie Arneson Wiles & Giannone, said Brown’s opinion wouldn’t jeopardize the debt.

“The bonds are valid, binding and enforceable,” the lawyers wrote.

The board approved the deal, refinancing $43 million in bonds issued in 2004. Three of the five board members backed it.

‘A Loophole’

“I felt it was a loophole,” says Victoria Baca, a trustee who balked. “You get free money without voter approval and without taxpayer knowledge? It’s crafty, and no one understands it.”

Robert Crank, head of business services at Moreno Valley Unified, says the district’s legal counsel approved the deal and taxpayers weren’t kept in the dark because all school board meetings are televised.

“We have funds in the pipeline to complete the other projects,” Crank says.

Moreno Valley homeowners today are paying $1 million more on the district’s debt compared with the original bonds, according to an analysis prepared for the district by Causey Demgen & Moore Inc., Denver-based financial consultants.

$1 Million More

Instead of owing just under $2 million in annual taxes, property owners are on the hook for $3 million, the firm found. The interest rate on a new 10-year bond is 3.91 percent, down from the 4.15 percent on the old debt, Bloomberg data show.

Property owners have to wait until 2029 to learn if the deal then decreases their taxes.

The board paid the bank and advisers fees totaling $725,104, which equaled about 11 percent of the upfront cash and $17 per $1,000 of bonds sold. Baum’s cut was $481,139, and the rest went to attorneys, credit-rating companies Standard & Poor’s and Fitch Ratings and bond insurers.

Charles Youtz, senior vice president and manager of Baum’s California public finance practice who worked with Moreno Valley on the deal, didn’t respond to messages seeking comment.

In Northern California, 15 miles from San Francisco, the 21-school San Mateo-Foster City Unified School District came up with a novel maneuver to raise construction cash from a refinancing in 2006.

Old Grocery Store

The district, home of the headquarters of Franklin Resources Inc., manager of the Franklin and Templeton mutual funds, has a median home value of $469,200.

That’s more than twice the national average. The district moved its executive offices out of an old grocery store it was renting for $300,000 a year to a 34,000-square-foot (3,160- square-meter) building in Foster City, on San Francisco Bay.

San Francisco-based Orrick Herrington & Sutcliffe LLP, the nation’s leading legal adviser on municipal debt, had concluded that the cash-out financings of the type done by Acalanes and Compton were illegal, says John Hartenstein, a lawyer at the firm.

So the firm devised a technique to avoid a district’s direct receipt of cash. Working with school systems such as San Mateo-Foster City, Orrick created a public entity affiliated with a district, known as a joint powers authority, or JPA, to provide cash through a bond swap to use for school projects.

$30 Million More

In 2006, the San Mateo-Foster City district sold $76 million in bonds to refinance old debt. The so-called San Mateo School Facilities Financing Authority, created by Orrick, purchased the securities with money the authority raised from selling $83 million in revenue bonds.

The authority then provided the $5.7 million for the administration building and school repairs. Piper Jaffray collected $600,000 to underwrite the bond deal. Paying off the new bonds will cost taxpayers $30 million more by 2023 than it would have if the old debt hadn’t been refinanced.

The interest rate on a new 10-year bond is 3.8 percent, down from 5.1 percent on the debt it replaced. If the district issues no other debt before 2031, the deal would save taxpayers $3.1 million over 33 years.

“The district received an unqualified legal opinion from Orrick Herrington & Sutcliffe in regards to the bond issuance,” says Micaela Ochoa, chief business official at San Mateo-Foster City Unified.

‘Scheme is the Same’

In his January opinion, Brown said the JPA approach isn’t justified under the law. Such transactions violate California’s constitution and tax laws, the attorney general said.

“The JPA scheme is the same as a cash-out,” Brown said.

San Mateo Treasurer Buffington says he’s disturbed that advisers who supported the deals have collected extraordinarily high fees with impunity.

“I don’t think they should be allowed to just walk away,” he says.

Before California school districts succumb again to these kinds of transactions, officials need to better scrutinize bank pitches and taxpayer costs, says Robert Brooks, a finance professor at the University of Alabama.

“Issuers have to wake up to their fiduciary responsibility to manage the public money responsibly,” he says.

Polee, the truck driver in Compton, stands on a grime- crusted breezeway near the closed Vanguard gym. He compares the school’s condition to the new $10 million school administration building with leather seats.

“The community gets short shrift,” he says. “The bureaucrats live high on the hog.”

Editor: Jonathan Neumann, Gail Roche

To contact the reporters on this story: David Dietz in San Francisco at

Last Updated: August 26, 2009 00:01 EDT

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