Risky business? Understanding the biz of gov't bonds
Three law firms dominate the legal work that goes into issuing state and local government debt in Arizona, according to a review of bond documents done by the Goldwater Institute. That finding is consistent with what bond lawyers and government officials have said in interviews about the industry.
Near the end of the lengthy documents that describe government bond offerings to investors is a section called "relationships among the parties." This is where potential conflicts of interest among the law firms and bond houses involved in the deal are disclosed. The number of names that appear is small but the relationships are extensive.
The Goldwater Institute analyzed the official statements in 75 recent bond sales with a total value of almost $6.8 billion, issued by a variety of state and local governments, to determine who profits from putting the deals together. All but one of those issues involved at least one of the three law firms: Greenberg Traurig, Gust Rosenfeld or Squire Sanders. Two-thirds of the transactions involved more than one of the three firms in different roles. Two other firms were involved in far fewer transactions, but did work for agencies such as the City of Tucson and state universities that issue large amounts of debt. Those firms are Ballard Spahr and Kutak Rock.
There is nothing illegal or unethical about the close relationships among the law firms, the bond houses they work for and the governments that issue the debt, as long as those relationships are disclosed and conflict-of-interest waivers are obtained.
The reason so few firms show up in so many transactions is a function of the market in a very limited and specialized field, according to Clark Partridge, Arizona State Comptroller. Governments rely on bond lawyers for critical opinions such as whether a bond issue meets the Internal Revenue Service's rules for tax-exempt status, Partridge said. If the lawyer is wrong on a bond issue worth tens of millions of dollars, the ramifications are huge, both for investors and the agency that issues the debt.
Few law firms in the state have the level of expertise that brings protection for the agencies and confidence from investors, he said. Partridge agreed that bond lawyers profit substantially from issuing opinions on proposed transactions. "But there is a reason why they get paid those rates. They are the best at what they do and they are experts at what they do. One of the worst things we could possibly do is submit a bond deal that is supposedly tax-exempt, and we hire some shoddy bond lawyers, and it turns out they screwed things up and these things become taxable."
The same market forces limit the field of bond houses that do business in Arizona. If governments in Arizona issued more debt, it would attract more bond houses, Partridge said.
"It is what it is," he said. "I can't go out and create a bank just because I want more competition. I have to deal with the industry that's there."
A typical government bond sale involves three or four lawyers, depending on the type of agency issuing the debt. For instance, if a city issues a bond, it will be represented by its own counsel, normally the city attorney or a private law firm it has on retainer. A second lawyer hired by the agency acts as bond counsel, who renders an opinion on whether the bond will qualify as tax-exempt under federal rules, and helps prepare the documents that are used to market the securities to investors. The underwriter, which makes the initial purchase of the bonds and then remarkets them to investors, has its own lawyer. The attorneys are paid with money raised in the bond sale, which must be repaid by taxpayers or ratepayers.
In the past five years, five law firms were paid a total of $14.2 million for legal work done for various governments, including cities, state agencies and universities.
Certain types of districts will involve more lawyers than others. For instance, community facilities districts issue government debt to finance infrastructure costs for developers, who have their own legal representation.
The bond house is paid to handle the initial purchase of the bonds and sell them to clients, often making its profit on the difference in the interest rate it pays and what it charges its customers. The profit margin, called the underwriter's discount, is disclosed in the official statement, the document that outlines details of the bond issue to investors. In the 75 official statements analyzed by the Goldwater Institute, the bond houses were paid about $34 million in underwriter discounts.
Legal fees are not disclosed in bond documents. To get a sense of how much money lawyers are making from government bond issues, the Goldwater Institute filed public records requests for legal fees paid to the five dominant law firms by the state's twenty biggest issuers of government debt. All but one, the Arizona Department of Administration, was able to come up with the figures.
In the past five years, five law firms were paid a total of $14.2 million for legal work done for various governments, including cities, state agencies and universities. Greenberg Traurig got the biggest share of the work at about $5.6 million. Squire Sanders was paid about $4.9 million and Gust Rosenfeld about $1.7 million. The Ballard firm was paid about $1.5 million and Kutak Rock about $693,400.
Deals and disclosures
The consequences of such a small pool of professionals involved in billions of dollars' worth of bond deals is illustrated in the relationships sections of official statements. One particularly stark example is a $22.7 million bond issue made by the Vistancia Community Facilities District in Peoria in 2006. The district, which the city created in 2002, has issued a total of $67.5 million in bonds to finance the developer's cost of building water and sewer systems in the master-planned community. About $58.6 million is still owed. Greenberg Traurig was hired by the district as bond counsel. Squire Sanders represented the underwriter, RBC Capital Markets.
Both Greenberg and Squire have worked together representing various sides in other transactions underwritten by RBC, the disclosure statement says. They have also worked together in other transactions involving the City of Peoria and other government jurisdictions in the area.
Disclaimers like that are pretty standard.
In addition, Greenberg was also acting as the lawyer for the developer, now called Vistancia LLC, and the developer's parent company, Sunbelt Holdings.
The facilities district, which is governed by the Peoria City Council, Vistancia LLC and Sunbelt agreed to allow Greenberg to represent all three entities simultaneously. That situation was rare, but not unique, among the bond issues reviewed by the Goldwater Institute.
Waiving the conflicts
The Vistancia deal was unusual, said Peoria City Attorney Steve Kemp, who agreed to waive the conflicts of interest involving Greenberg in that bond deal. When the Vistancia district was formed, there was extensive negotiation between the city and the lawyers who represented the developer as to the conditions and guarantees that would be part of future bond issues, Kemp said. Greenberg was not involved in those negotiations, he said.
When the first bonds were issued in 2002, Greenberg acted as bond counsel. By the time the final bond was issued in 2006, the lawyers who originally represented the developers through their own law firm had been hired by Greenberg, Kemp said. When the 2006 bonds were issued, the substantive negotiations had been done between city lawyers and the developer, and two prior bonds had been issued, Kemp said. The work Greenberg did as bond counsel on the issue was a routine assessment of the tax-exempt status of the bonds and assistance in the preparation of the bond documents, he said.
"We viewed this as a conflict that would be acceptable waiving," Kemp said. "For us, the issue was Greenberg's involvement on the bond side would be extremely limited, which would simply be to assist the district in the formation process and to render the tax-exempt opinions on the bonds. What we do here in the city is even when we hire bond counsel, all of the agreements are independently reviewed by the city attorney's office and we have to be satisfied independently that the agreements are in the best interest of the city."
Tight relationships among bond lawyers, their clients and the underwriters are usually not a problem in good times. But when things turn sour, those relationships become critical.
Tight relationships among bond lawyers, their clients and the underwriters are usually not a problem in good times. But when things turn sour, those relationships become critical, especially if there is a default and investors sue to recover their money, said Richard Lehmann, publisher of the Distressed Debt Securities Newsletter, which monitors municipal bond issues for signs of trouble.
In Florida, where Lehmann is based, there have been more than 160 defaults on special development district bonds worth about $5 billion in recent years, he said. As those deals have wound up in court, investors trying to recover their money have discovered cozy relationships between government officials and the professional firms they hire.
"When things go wrong and people start digging into it, what was efficient suddenly becomes conflicted," Lehmann said. "When things break down, those things start looking corrupt when they are just the normal relationships."
Things certainly broke down in Prescott Valley in 2007 after a missed payment on a $35 million bond used to finance a 5,000-seat events center. That led to a lawsuit by investors alleging fraud and misrepresentation against the town of Prescott Valley; the Yavapai County Industrial Development Authority (IDA), which issued the bonds; and the various bond lawyers, underwriters, financial consultants and private interests involved in the transaction.
The investors claimed the official statement for the bonds was misleading because it did not disclose that two prior feasibility studies concluded the arena would not attract enough events to support the annual debt payments. The bonds were issued in 2005. They were supposed to be repaid through revenues from the arena. To boost the rating on the bonds, town officials agreed to provide an additional guarantee of sales tax revenues generated within a special district they created.
The Prescott Valley case illustrates the dangers governments face when millions of dollars in debt goes bad.
The industrial development authority reached a settlement, agreeing to cooperate with the bondholders in their lawsuit but not to any financial damages, according to Barry Cline, the authority's lawyer. By the time it settled, he said, about $100,000 in attorney's fees had been spent defending the IDA. Town officials sought to be dismissed from the lawsuit, claiming they had no role in drafting the official statement other than to provide historical and demographic information. The judge rejected the motion in 2010. It cost about $1.4 million in legal fees to defend Prescott Valley through December 2011, which was paid by the insurance pool the town uses, according to billing records. The case is ongoing.
The Prescott Valley case illustrates the dangers governments face when millions of dollars in debt goes bad, and how much governments rely on bond lawyers to ensure official statements and other documents are properly prepared, said Colleen Auer, the former deputy city attorney who worked on the case until she left the town in late 2011. Prescott Valley did not issue the bonds and did not prepare the official statements. Yet as a government agency, it has the kind of "deep pockets" that plaintiff's lawyers go after when they sue, she said.
"Securities cases are expensive and parties can get [dragged] into that, whether or not they have immunity waivers or no real hand in the documents themselves," Auer said. "If they touched it in any way or have any part at all, they are vulnerable. They can be named and there is a price to pay for that, which is defense costs.
"You can't make any document bulletproof from litigation, so there is always some risk. The most you can hope for is to try to put the document together in the most solid way that you can to try to limit your risk and avoid risk, but you can never completely ensure yourself that there is no risk."
That risk helps explain why there are so few law firms that do municipal bond work, said Fred Rosenfeld, whose practice includes government finance at Gust Rosenfeld. Governments rely on bond lawyers to ensure the documents related to the transaction clearly and specifically describe the extent of their commitment, and which revenues will and will not be pledged, said Rosenfeld, who has been practicing law in Arizona since 1961. Investors rely on the legal opinions of the bond counsel to ensure the securities they buy are indeed not subject to taxation under federal and state laws.
If the lawyers make mistakes, there are huge liabilities for the issuer, investors and the law firm, Rosenfeld said. That risk, coupled with the specialized nature of municipal finance, is why many law firms, both large and small, choose not to get into the municipal bond field, he said. "There is a possible liability of the firm if you are wrong, and many law firms do not want that," Rosenfeld said. "You're very liable to put the whole firm out of the bond business if you're not careful."
Beyond the legal issues, market forces tend to winnow the field for bond lawyers, Rosenfeld said. Having a firm with a history and good reputation in the municipal bond field gives investors confidence and makes them more likely to buy the securities, he said. As to whether the small pool of bond lawyers creates the potential for conflicts of interest, especially with the same firms representing governments and bond houses in different transactions, Rosenfeld said, "We have to be very, very cognizant of that. The most important thing to the bond lawyer is keeping his standing. To do that, you have to be neutral and work to create the best financing that you can get for all the parties."
There are no national rules governing conflicts of interest of bond lawyers. They are governed by the same laws and standards as other lawyers in each state, said Kristin Franceschi, president of the National Association of Bond Lawyers. The job of the bond counsel is normally to "paper the transaction" by ensuring all of the documentation is correct, not to engage in negotiations between the government agency issuing debt and the bond houses marketing the securities, Franceschi said.
There are no national rules governing conflicts of interest of bond lawyers.
The rules apply to individual lawyers and entire firms alike, meaning if an individual lawyer has a potential conflict of interest, then the whole firm would have to abide by the same obligations, said Lynda Shely, an Arizona ethics lawyer. "If you are in a law firm, you are one giant brain, so if one of you could not represent somebody because of a conflict, none of you can represent that person because of the conflict," Shely said. "If anyone or anything could materially limit a lawyer's independent professional judgment on behalf of a client, then there's a possible conflict. That's pretty broad."
The model guidelines of professional conduct published by the National Association of Bond Lawyers stress the importance of making it clear to all parties where the bond counsel's loyalties lie. Historically, the bond counsel has been viewed by many as a "counsel to the transaction," rather than to a specific client, typically the government agency issuing the bond, according to the association. So it is important that everyone involved in the transaction, as well as investors who buy the bonds, understand who the bond counsel is representing and are aware of any potential conflicts.
That is the reason the section in bond documents describing the relationships among the parties is so important, Franceschi said. "The job of the lawyer is to represent their client," Franceschi said. "They are not ombudspeople for the industry or for the markets or the bondholders or the government. So assuming proper waiver and proper notice, the buyer who sees that in the disclosure documents should beware. That's the reason that's there, is to tell them 'you should consider this because you may not trust this as much.'"