WASHINGTON-Market participants hailed last Tuesday's long-awaited but widely expected Supreme Court decision that upheld 42 states' preferential tax treatment of their bonds as a "resounding victory" for the municipal securities market.
The near-unanimous support for the 7-to-2 decision in Department of Revenue of Kentucky v. Davis-from fund managers, attorneys, state officials and industry groups, including the Investment Company Institute alike-reflected the dire consequences for the market had the high court ruled differently. (Please also see "State Muni Tax Cases Threaten Funds," MME, 4/29/08.)
"It's a resounding victory for the existing structure of the municipal bond market," said Len Weiser-Varon, an attorney at Mintz Levin Cohn Ferris Glovsky and Popeo PC in Boston, who wrote a friend-of-the-court brief on behalf of the National Federation of Municipal Analysts, which didn't take either side in the case but highlighted the dramatic upheaval that would have occurred if the court ruled against Kentucky.
"The court decided to give the states a long leash on this issue, principally because it's been this way for decades and all 50 states have said, This is fine by us.' The majority also made it clear that the court doesn't want to do anything that might be disruptive to the municipal market," Weiser-Varon said.
The court in effect upheld the status quo in the muni market by overturning a Kentucky appeals court's 2006 decision that said the state's long-standing practice of taxing the interest on bonds issued out of state while exempting from taxation the interest on bonds issued in state was unconstitutional. Forty-nine states filed friend-of-the-court briefs in support of Kentucky, a factor that appeared to weigh heavily on the court's thinking.
Among other things, the ruling saves states from having to consider as much as $3 billion in potential tax refunds, said Christopher Trower, the solo practitioner who argued the case before the Supreme Court on behalf of Kentucky.
G. Eric Brunstad of Bingham McCutchen LLP, who argued on behalf of the married couple, George and Catherine Davis, who sued Kentucky for trying to tax the interest from their out-of-state mutual fund bond holdings, could not be reached at deadline.
$156 Billion in Muni Funds
Even though the ruling was widely expected, fund managers said they were relieved because it would not force a fundamental reshaping of the roughly 450 state-specific mutual funds, which held about $156 billion of munis as of May 31, 2007, according to the ICI.. In a brief statement, the mutual fund trade association said it welcomed the ruling.
John Mousseau, a vice president portfolio manager at Cumberland Advisors in Vineland, N.J., said the decision alleviated one more potential problem in a market that has weathered enough turmoil in a short amount of time.
"Here's a market that's been banged up beyond recognition," Mousseau said. "We have been assaulted by failed auctions, hedge funds going under, bad [variable-rate demand notes], bond insurers getting downgraded, and no liquidity, so this was just one more thing hanging over the market.
"It's nice to see some clarity-even if it was something that was expected," he added. "Most people felt that the court would probably head in this direction and had no desire to upset a capital market that usually works very well, especially since states exempting their own bonds [from tax] is something that has worked for more than 100 years."
Dan Loughran, senior vice president and portfolio manager at OppenheimerFunds, agreed, saying: "Our market has had a stream of bad news over the last nine months and it just removes one major uncertainty that has been overhanging the market.
"If it had gone the other way, there would be no reason for state-specific funds to exist," said Michael Smith, a shareholder at Butzel Long here, who wrote a friend-of-the-court brief on behalf of 13 single-state funds urging the court to overturn the Kentucky court's decision.
Tom Spalding, senior investment officer at Nuveen Investments in Chicago, said the decision validates the heftier price tag investors pay for specialty states, and should allow them to continue to outperform the national market now that a cloud of uncertainty is gone.
"Now the specialty state market will go along just like it was ... the New Yorks and New Jerseys, and North Carolinas will command a premium price in the market place," he explained. Typically, specialty paper from high-taxed states, such as New York and New Jersey, trades 10 to 15 basis points higher in price than non-specialty state paper, according to Spalding.
Demand for these bonds weakened in recent months as investors awaited the outcome of the case, according to Spalding, who added that trading should resume its normally healthy pace.
Had the decision favored the Davises, "We would have changed the matrix on how we traded" specialty and non-specialty states, Spalding admitted. "Bonds in states that have out-traded the national market would have given ground and we would have had some new spread relationships that we have never seen before," he explained.
The Securities Industry and Financial Markets Association applauded the ruling, saying it "benefits both state governmental entities and [their] citizens."
From a legal perspective, several attorneys noted that the decision reflected the court's thinking in its 6-to-3 decision last year in another case involving the dormant commerce clause, United Haulers v. Oneida-Herkimer Solid Waste Management Authority, in which the court expressed a willingness to allow governments to exhibit a preference for themselves over out-of-state private competitors. The dormant commerce clause suggests that only Congress can erect barriers to interstate trade.
In the United Haulers case, the court found that a New York county could force private waste haulers to use a publicly owned processing facility, even if the haulers could use a private facility in another state for a lower cost. The court found that a government could show preference to itself if it serves a public good.
Some attorneys who had closely followed the case wondered why it has taken so long to decide, noting the ruling came out 196 days after oral arguments were held on Nov. 5. Some speculated that additional time may have been necessary given that yesterday's majority was fragmented-only Justices John Paul Stevens and Stephen Breyer consented to the full opinion, written by David Souter, while Chief Justice John Roberts and Justices Ruth Bader Ginsburg and Antonin Scalia agreed with it only in part, and Justice Clarence Thomas filed a separate opinion concurring with the judgment.
Still, none of the justices adopted any radically new positions, several attorneys said.
"My guess is it just went on the backburner because they had other cases to get out first," Weiser-Varon said. Another attorney called the tax-free status of municipal bonds "an anachronistic-style arrangement, from when 19th century communications and transportation necessitated that borrowers and lenders had to be close to each other."
Ted Phillips, Christine Albano, Yvette Shields and Michael Scarchilli contributed to this story.
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