LOS ANGELES — Fitch Ratings’ recent guidance on school bond ratings won’t bring across-the-board higher ratings to California school bonds.
Fitch will require a special legal opinion in order to issue a general obligation bond rating on a California school district based on its assessed property values, as opposed to its general fund and operations.
Such opinions have led to Fitch assigning AAA underlying general obligation ratings to bonds issued by several California school districts that have notably lower issuer default ratings.
“At this point, in order to do a special revenue analysis based on assessed value versus operations, we do have to have a legal opinion (from the issuer),” Karen Ribble, a Fitch credit analyst, said in an interview.
That might change down the road, however, Ribble said.
The higher underlying GO ratings for those California districts bolstered by the legal opinion reflect Fitch’s opinion that the property tax revenues pledged to bond repayment would be considered special revenues under the bankruptcy code.
Fitch will still rate each school district on a one-off basis. It’s not as simple as checking off that a transaction has X,Y and Z, Ribble said.
Fitch issued a special report March 21 saying that the tax structure backing California school district GOs meets the high bar the rating agency set to consider whether pledged debt service funds are secure in a bankruptcy. It followed up with a conference call Wednesday to field questions about the report.
The rating agency began evaluating districts in this bifurcated manner after Orrick, Herrington & Sutcliffe, San Diego Unified School District’s bond counsel, provided rating agencies with legal opinions on bankruptcy risks ahead of a November bond sale.
Moody’s Investors Service, Kroll Bond Rating Agency and Standard & Poor’s all took the legal opinions into account, but Fitch gave the opinions the most weight. San Diego received AAA ratings from Fitch, while Kroll and Moody’s assigned the San Diego Unified bonds AA-plus and Aa2 ratings.
Fitch contrasted California school GOs with Chicago Public Schools, which asserted in offering documents its belief that the bonds’ pledged tax revenue stream could survive a Chapter 9 bankruptcy.
Fitch rates Chicago Public Schools GOs speculative grade B-plus with a negative outlook. Kroll gave the bonds a first-time rating of BBB-plus with a stable outlook. The Chicago school district provided Kroll with a special legal opinion, but did not provide Fitch with one.
Fitch analysts said during the call that having the special legal opinion would not have made a difference in rating Chicago.
“There were enough other concerns besides that lack of a legal opinion,” said Fitch credit analyst Arlene Bohner.
So far, the rating agencies are the only entities outside of the finance team who have been able to review the bond counsel opinions on special revenues.
“It would be good for us to be able to see the legal analysis in these opinions that are backing these ratings,” Amy Johannes of Fidelity said during the Fitch call.
Amy Laskey, a Fitch managing director, said investors need to bring the issue to the bond issuer, as it’s not Fitch’s decision to release the opinions.
Orrick did not include its bankruptcy opinion in the legal opinions it provided for the offering documents in the California school district bond sales.
“Firms don’t generally want their bankruptcy opinions to be part of the official statement, because bankruptcy opinions by their nature are fact specific and include numerous qualifications, assumptions and limitations,” said Lorraine McGowen, an Orrick partner, who specializes in bankruptcy and restructuring, and worked on San Diego USD’s opinion.
Fitch did a good job in summarizing what the challenges are in distinguishing special revenue streams that were created and secured by the San Diego GO bonds, McGowen said.
California has three prongs that provide reassurance in a bankruptcy, McGowen said.
First, there are limitations in California that would prevent a school district from entering bankruptcy.
The second is that Senate Bill 222, adopted in 2015, says that local GOs would be treated as a statutory lien in bankruptcy, which makes the bondholders a secured creditor.
The third is that the bonds would be treated as special revenues in bankruptcy, which means the bondholders could continue to receive payments during the pendency of the bankruptcy.
“I don’t think that Fitch said Chicago’s legal framework doesn’t offer the same protections; it is just not as clear, and therefore they were not willing to give it the Triple-A ratings on the bonds,” McGowen said. “I can certainly understand why Fitch is concerned; the framework is not the same as what exists in San Diego.”
The legal structure in California minimizes the possibility of the diversion of special revenues, Ribble said.
Those elements include the requirement under Proposition 39, a 2000 state constitutional amendment, that the specific projects for which bond proceeds are intended are listed in the ballot measure. There is also a constitutional prohibition against the use of bond proceeds for any purpose other than those specified capital projects.
“This construct creates a clear distinction between operating and capital levies,” Fitch wrote in its report.
The California Education code requires that county government collect the property taxes and hold them in a lockbox-like structure to be used only to make payments on the GO bonds.
California also has a statutory process that requires a state administrator to be installed if a school district nears insolvency, Ribble said. The administrator, rather than district management, would have responsibility for proposing any bankruptcy filing, Ribble said.
The legal framework in Chicago leaves concerns that there could be a challenge in the event of a bankruptcy, Boehner said.
On the Chicago school sale, a portion of the bond proceeds were set aside for swap termination payments and outstanding bonds, which Bohner said did not meet Fitch’s special revenues requirement of the proceeds being project-specific.
The original bond resolution also did not specify which series of bonds would be refunded, Bohner said. A later resolution added more specificity about which bonds were being refunded, she said, but it also raised more questions.
The Chicago bonds also carried a high coupon mix that is more likely to be challenged in a bankruptcy, she said.
Fitch needed more clarity around the idea that pledged revenues would be treated as special revenues in a bankruptcy, Boehner said.
“If we believed that was the case, we would have been able to ignore the general credit characteristics of the board,” she said. “If we did not have confidence it would be treated as special revenues, then we had to cap it at the general credit level.”
In the event that a California county ended up in bankruptcy, Laskey said Fitch views the revenues as belonging to the school district, not the county. As such, Fitch doesn’t think the revenue stream aimed at the school district bonds would be affected.
