Wednesday, October 28, 2009

So Many Unchecked Approval Boxes: Why Any Sensible Bond Buyer Should Probably Steer Clear of Buying Atlantic Yards Nets Arena Bonds

Pity the poor bond buyer who even thinks about buying bonds that might be offered on the market to finance the proposed Forest City Ratner Atlantic Yards Nets basketball arena. It is not your typical bond deal. Bond deals are usually really tight affairs, very “belt and suspenders.” We have never seen so many loose ends and approvals that are not in place. Many of those approvals may never be in place. Government officials may even try not to do what’s normally required. Do you remember when the subprime crisis resulted in underwater bonds across the commercial mortgage backed security industry? Everybody looked back in wonder and asked themselves how basic common sense requirements were ignored. The Atlantic Yards Nets arena bonds may be the municipal bond industry’s embodiment of the same kind of extreme folly: Basic standards of professional practices, dotting the i’s and crossing the t’s to protect the investor have simply been abandoned and one day everybody may wonder why.

Oh, by the way: We think we know whereof we speak. We used to oversee the legal aspects of bond issuances for six agencies that were the state’s largest issuers of municipal bonds. This is NOT the kind of show we ran. Far from it.

ESDC Board Didn’t Approve the Smaller Redesigned 675,000 Square Foot Arena

We have been unable to get out of our mind the startling information that the Empire State Development Corporation did not actually approve the issuance of bonds for the proposed new Forest City Ratner Atlantic Yards Nets basketball arena. (See: Saturday, October 03, 2009, Did the ESDC board members know they were approving a 675,000 sf arena? And should there have been opportunity to comment?- Image of document below from that article)
Sure, when the ESDC board met and voted on September 17, 2009, they approved the financing of an arena in Brooklyn but what they approved was the financing of a 850,000 square foot arena, not the 20% smaller 675,000 square foot arena that developer Forest City Ratner currently plans to build. Building the smaller arena based on the board’s approval of a larger one for the same price would be a classic example of shortchanging the approving public agency, no different from sending Jack to the store with the price of a ten-slice pizza pie and having him come back with only eight slices of that pie plus no change. (In a less classic way, the public is also being shortchanged in that the arena is projected to be a $220 million net loss to the public.)

And PACB Approval for Substantially Restructured Financing Is Missing

The fact that the current arena plan has NOT been approved by the ESDC board seems to match up perfectly with the fact that the issuance of the bonds for the arena has also NOT been approved by the New York State Public Authorities Control Board. (See: Friday, June 20, 2008, Given 50% arena cost increase, DDDB asks PACB to reconsider AY approval.) In December 2006 the PACB approved the issuance of bonds for the arena in the amount of $637.2 million (to finance an arena costing $528.9 million exclusive of financing costs), but the cost of the arena has shot way up so that even the much smaller arena is now projected to cost 45% more, an amount stated to come to $772 million (without financing costs) which will likely be $930 million when financing costs are included. (See: Wednesday, September 09, 2009, FAQ: the reason for a new architect; curiously unchanged arena costs; why Gehry was dropped; and "vaportecture".)

(PACB approval figures from 2006 above- click to enlarge- from Atlantic Yards Report article: Wednesday, June 06, 2007, Privately financed? Court documents finally specify the housing bonds behind Atlantic Yards funding.)

New Unapproved Principals in the Transaction

The list of approvals that haven’t been obtained to finance the arena is rather long. We wrote recently about how ESDC hasn’t approved, but ought to, the recently arrived on the scene Russian oligarch Mikhail Prokhorov:
as an integral part of the Atlantic Yards deal, including as the proposed owner of the Nets basketball team and arena. Mr. Prokhorov was proposed as part of the Atlantic Yards deal shortly after the board’s meeting in a seemingly orchestrated fashion.
(See: Tuesday, October 20, 2009, This Thursday’s ESDC Board Meeting (October 22, 2009): Atlantic Yards Is Not on the Agenda Though it Should Be.)

We were noting how that the Prokhorov approval was not on the agenda for the ESDC board’s meeting last week (October 22, 2009) and how ESDC may try to sidestep this approval (which approval it certainly should be doing) irrespective of whether it is actually a legal requirement. (Sidestepping reviews and approvals wherever possible is a tradition with the Atlantic Yards. Central to getting the megadevelopment approved was the use of an ESDC override of the city zoning process to avoid the community’s review and comment through ULURP.)

Litigation Highlighting Absence of Environmental Review for Revamped Transaction

Meanwhile, the mega-project is the subject of litigation for a number of other approvals and reviews that were not done. One new lawsuit challenges the fact that when the project changed substantially ESDC tried to sidestep a supplemental environmental impact statement to address all its significant changes. (See: Monday, October 19, 2009, AY doomed? New lawsuit targets ESDC over unrealistic project timetable, failure to issue SEIS, and failure to address renegotiated MTA deal.) That lawsuit was brought by twenty community groups, led by Develop Don't Destroy Brooklyn and the Council of Brooklyn Neighborhoods. There will also be a second lawsuit about the lack of an environmental review for the substantially revised transaction brought by a separate set of plaintiffs, 13 community and public interest groups comprising the Brooklyn Speaks coalition. That lawsuit with its complementary theme of a necessary review and approval work being circumvented is expected to focus on the mega-monopoly’s effect on traffic. (See: Saturday, October 17, 2009, DDDB: new lawsuit challenging Atlantic Yards environmental review will be filed on Monday.)

Litigation Highlighting Sidestepping of Compliance With Public Authorities Accountability Act

There is a lawsuit against the MTA that seeks to annul any attempted transfer by the MTA of half the land the developer is going to need if it is ever to build the arena. (See: Tuesday, October 13, 2009, MTA lawsuit, which might affect arena financing, charges that Public Authorities Accountability Act was violated.) That lawsuit was filed on the eve of oral arguments on the eminent domain case (brought in its original form in January 2006) that could (and should) result in the developer being unable to procure (through eminent domain abuse) the other half of the site it will need to build the arena. The lawsuit against the MTA points out that when the MTA approved numerous new concessions for the developer (worth hundreds of millions of dollars) last June, including a revised deal with the MTA taking less money for its land, the MTA essentially ignored the Public Authorities Accountability Act enacted in 2005 which has procedures requiring bidding and appraisals when authorities like the MTA dispose of authority land. Those procedures are specifically to prohibit sweetheart deals like the one put through.

Litigation Continuing From 2007 Highlighting Many More Steps That Were Skipped

We also should not forget to mention that there is another a case on appeal that has been awaiting a decision since oral argument on September 17, 2008. That case was originally brought in the spring of 2007 and cites, among a long list of other actions government officials failed to take, inadequacies of the original environmental review. This was before the project changed substantially. It also challenges as defective an agency determination of blight (in order to take the land required for the arena) that artificially shaped the boundaries of the “blight” around the prime real estate the developer coveted for his mega-monopoly.

Litigation You Need a Scorecard to Keep Track of (And You Need to Add More)

There are now so many lawsuits lined up against the Atlantic Yards mega-project for the things that were not done by government officials sidestepping requirements as they rushed the project forward that the Brooklyn Paper decided that it was necessary to publish a docket scorecard. (See below.) The problem is that the published scorecard isn’t even complete. It leaves out the upcoming lawsuit being brought by the Brooklyn Speaks coalition and it leaves out the legal actions that have been repeatedly won by Henry Weinstein, a developer and owner of property within the megadevelopment footprint who sued his tenant (developer Shaya Boymelgreen) and the Atlantic Yards developer for collusive behavior to deprive him of control over his property. Interestingly, ESDC itself has been implicated in the defendant developers’ collusion which was all tilted toward the goal of the megadevelopment’s site acquisition. (See: Wednesday, October 21, 2009, More maneuvering at the corner of Carlton and Pacific with Boymelgreen firms pushed toward bankruptcy by (alleged) tenant.)

The scorecard chart also doesn’t include a lawsuit that has so far been lost even though it was refiled once. That lawsuit was brought by tenants within the footprint of the project who asserted that they will be improperly removed especially in light of recently evolved and disclosed facts about how much longer the project will take than originally asserted by the public agencies promoting it. (See: Wednesday, May 07, 2008, Another win for Ratner; state appellate court denies appeal on relocation case.)

Wall Street Journal Dubious That Loose-end Deal Can Be Pulled Together

It is not surprising that even before all these lawsuits were filed pointing out the multiple deficiencies the Wall Street Journal was running an article assessing that issuance of the arena bonds is going to be really “tough” to pull off. We wonder if they even know the half of it. For the Wall Street Journal article and other commentary on it see: Sale of Nets' Arena Debt Is Tough Shot, by Serena Ng and Matthew Futterman, October 15, 2009, Sale of Nets' Arena Debt Is Tough Shot (on No Land Grab), The Wall Street Journal, by Serena Ng and Matthew Futterman, October 15, 2009, Wall Street Journal calls arena debt "a toss-up," given market for sports and apparent tension between bankers and bond insurers (Atlantic yards Report- Friday, October 16, 2009), Wall Street Journal: Atlantic Yards Arena Bond a Tough Sale, (DDDB- 10.16.09), WSJ: Atlantic Yards bond sale a "toss-up" (Field of Schemes- October 16, 2009).

One of the major reasons the Wall Street Journal is reporting that the deal is very iffy is that the bonds must be issued by the end of December to satisfy an IRS deadline in connection with using a loophole to get around the (Senator) Moynihan amendment that prohibits the financing of sports stadiums and arenas with tax-exempt bonds. This deadline is one reason public officials were taking so many shortcuts to rush problematic revisions through at the last minute. To be fair, much of the last-minute rush was also fully attributable to the developer’s last minute brinkmanship as a tactic to wrest additional concession from public agencies that might not have been granted without this ploy. The proposed arena design was not revealed until day before the ESDC board meeting (after public hearings) and the orchestrated disclosure of the Russian oligarch’s involvement as owner and development partner was held back until a few days after that board meeting.

Riskiness Identified

It is not absolutely clear from reading the Wall Street Journal article what ALL the problems with the deal are but the riskiness of a deal full of holes is apparently a big part of what is going on. Problematic negotiations reportedly involve the rating agencies (who are supposed to assess risk) and the bond insurer (who gets paid to assume risk once they have done their own assessment of the risk they are taking on). The Journal notes that:
Goldman Sachs Group and Barclays bankers have spent weeks in discussions with three credit-rating services and bond insurer Assured Guaranty Ltd. over ratings and terms on the bonds. The developers are hoping for an investment-grade credit rating on the bonds and to issue them at annual interest rates of roughly 6.5%. Whether the debt will be insured -- which could be key to selling the bonds -- remains uncertain, as debates continue about the arena's revenue-earning potential.

* * * *

Not all the parties looking at the bonds are on the same page. Bankers recently balked at some of the terms that bond insurer Assured Guaranty wants before it will guarantee interest and principal payments on the bonds, according to a person familiar with the matter. Assured is effectively the only bond insurer still actively writing new guarantees after its rivals ran into financial trouble.
The Risk of Insufficient Arena Revenue

Lack of projected revenue is also reportedly an issue. The Journal puts it this way:
. . . the bond sale is coming at a time when consumers and corporations are cutting back on sports spending and competition in the arena business in the metropolitan New York region is as fierce as it has ever been.
Of course the risk of insufficient revenue could absolutely be a deal killer in itself, even if the deal was not so sloppily put together. The much higher admission prices at new sports arenas and stadiums together with the recession are resulting in price resistence by dissatisfied customers and lower attendance. (See: New Stadiums: Prices, and Outrage, Escalate, by Richard Sandomir,
August 25, 2008, Is This Seat Taken? In Front Rows of New Ballparks, No, by Ken Belson, April 21, 2009, Will $900 Baseball Tickets Sell? March 30, 2009, Sports Business: Help Wanted: Must Sit in Fancy Stadium Seats, by Richard Sandomir, April 22, 2009.)

It may be that fans, driven away by high prices, are changing their habits, for instance substituting visits to minor league teams instead of major league franchises. (See: Teams Get Their Day in Downturn, by Corey Kilgannon, June 12, 2009.)

Attendance is down for basketball in general. (See: In Some N.B.A. Arenas, the Crowds Are Thin, by Howard Beck, December 18, 2008.) And revenue for the Nets si down in particular. (See: Friday, July 10, 2009, While Nets' attendance went down 3% last year, ticket revenue went down 29%.)

Beyond the Economic Risk, Shortcuts as Red Flags for Real Risks

But the economic risk of poor attendance is not really what we are focusing on here. We will let bond buyers further assess that risk on their own. We are more concerned with the other risks being introduced by public officials intent on taking shortcuts to please a developer. Each shortcut should be considered a red flag for what is going on overall and it looks to us like some serious incompetence.

We note that at the very same meeting where ESDC negligently overlooked having its board approve the reduction in the arena’s size ESDC’s staff, attentive to apparently higher priorities, executed a slick maneuver that quietly slipped a last-minute authorization to advance another $25 million to the developer into the package of other concessions.

It will be interesting to see if ESDC ever decides to start clearing up at least a few of the many loose ends that exist and, if so, exactly which loose ends it winds up admitting through subsequent corrective action. For instance, one thing that could sink ESDC’s legal boat is that it hasn’t done any cost benefit analysis of Atlantic Yards or other related benefits analysis. Might ESDC one day come out with a cost benefit analysis? Or is ESDC likely to stonewall across the board, thinking that even some cleanup actions could involve a slippery slope of admitting defects?

We pointed out in an earlier post that Warner Johnston told us that the ESDC board “has pretty much finished with Atlantic Yards.” As such, the ESDC board did not approve Russian oligarch Mikhail Prokhorov’s involvement in the megadevelopment at the board meeting last week and perhaps just won’t. Being “pretty much finished with Atlantic Yards” could also mean that the board won’t be asked to actually approve the arena although the board has another meeting scheduled for November 19, 2009. (See: Thursday, October 22, 2009, Mark your calendars: next ESDC board meeting is November 19.)

No Pro Hockey

The size reduction of the planned (vs. “approved”) arena is not just quantitative, not just a 20% comparative reduction of 850,000 “apples” (of square feet) to 675,000 “apples” (of square feet), it also qualitatively affects function. The reduced 675,000 square foot arena that is now planned will still function as a basketball arena (the “apple” of the developer’s eye) but it will not function as an arena for a hockey team as the originally proposed 850,000 square foot arena would have. Simultaneous denoting the significance of this and of how sloppily irresponsible our public officials’ discussions of the arena has become, is the way that Brooklyn Borough President Marty Markowitz laughably issued an invitation early this month to the Long Islanders hockey team to play in Brooklyn despite the fact that the arena will now be too small and narrow to accommodate that sport. (See: Thursday, October 08, 2009, From hoops to hockey? Markowitz, contemplating Islanders' move to Brooklyn, disregards the planned arena's limitations.)

The inability to use the arena for hockey as previously proposed also undermines the already enfeebled economic viability of the arena. To wit, from a New York Post article covering Markowitz’s gaffe:
“To build an arena today without a second major tenant is really shortsighted,” said Robert Boland, a sports business professor at NYU. “If I were Bruce Ratner, I’d be on the phone with the architects to change the design because the finances work a lot easier with a second tenant.”
(See: Islanders are Brooklyn's Goal, by Rich Calder, October 8, 2009.)

Blowing Off PACB Approval

In addition to NOT having the board approve the smaller arena, ESDC officials have said that they don’t plan to get a new PACB approval for the changes that have occurred even though the arena (and the rest of the megadevelopment) has changed so substantially. (See: Thursday, July 23, 2009, ESDC, FCR face, answer, evade tough questions (subsidies, cost-benefit analysis, etc.); meeting marred by heckling and chaos.) When asked, ESDC Senior Counsel, Steve Matlin simply suggested that it wasn’t needed.

Our previous comment on his answer that approval was not needed was:
We do not believe that the answer is correct because the mega-project and its financing have changed dramatically from what received PACB approval in 2006, tilting ever more strongly towards a very substantial likelihood that the financing will fail and an increasing need for it to be propped up with more subsidy just as it in fact was by the most recent actions of ESDC and the MTA. To say that the PACB does not need to approve substantial revisions of projects careening off toward failure is to deny the PACB its purpose and veer away from past precedent. To suggest that there is an effort underway to have the PACB not approve the substantial rewrite of the project’s financing that has occurred since 2006 says something about the fear that politicians have of taking responsibility for this project. Politicians would rather set precedent in giving up this control and gate-keeping function than take responsibility for the project? Really now!
(See: Thursday, July 23, 2009, The Hit and Miss of Last Night’s Public “Information” Meeting on Atlantic Yards.)

PACB Was Set Up to Deal With a World Defaulting NYS Issuers Including ESDC (Before It Adopted a New Name)

The PACB was set up to approve financings during the financial crisis of the mid-1970's when defaulting state agency and city bonds had to be rescued. Defaults by one state issuer can affect the broader market for other state issuers. The PACB was set up to ensure financial stability and order and promote economic sobriety to counter the kind of activity that had led to defaults. ESDC, then known by its official statutory name of New York State Urban Development Corporation (“UDC” - It now uses a “d.b.a.”) was one of the main agencies that had to be rescued. A big part of why it had to be rescued was that it had pushed forward pell-mell, driven by politics. It exercised bad judgment doing deals that were not wise though they were politically desired. We know this quite well because we worked at the agency that was called upon to financially rescue them. Our agency was able to come to the rescue because it had avoided similar trouble by virtue of the fact that it was more conservatively managed. Our agency was still dealing with the aftermath of the cleanup when we arrived to work there at the beginning of the 80's. That was when UDC/ESDC was still unable to access the financial markets.

PACB Grabs The Public Policy Reins

Although the PACB was set up to ensure financial responsibility on the part of state finance agencies, its gate-keeping approval function has been taken advantage by political leaders so that projects that make poor public policy sense aren’t allowed to proceed. A case in point was Assembly Speaker Sheldon Silver’s blocking of Mayor Bloomberg’s West Side stadium in Manhattan. (See: Remarks by Speaker Sheldon Silver, PACB Decision Press Conference, State Capitol, Albany, NY, Monday, June 6, 2005 and Stadium opponents do sack dance over Silver vote, by Albert Amateau, June10 -16, 2005.)

PACB, The Legislative Branch’s De Factor Check On the Power of Governor-Dominated Authorities

Whether or not the PACB’s policy oversight was part of what was originally intended when the PACB was created, it has allowed representatives from the state’s legislative branch, the Speaker of the Assembly and the Senate Majority leader, to have a de facto check on authorities that are otherwise under the political control of the governor. For projects to be approved, votes of the PACB must be unanimous. The PACB, frequently referred to as “three men in a room,” consists of three voting members: the governor and the aforementioned two legislative body leaders. (Minority senate and assembly leaders are on the PACB but have no vote.)

PACB Statute Including Its Duties

The statute governing the PACB (Article 1-A of the Public Authorities Law, sections 50 and 51) calls for the PACB to approve financings by the state’s public authorities including specifically UDC/ESDC (and its subsidiaries). ESDC, as noted, led the state into the financial difficulties the PACB was constituted to address. The statute actually states that those approvals “shall be” the PACB’s “duty.” (emphasis supplied):
§ 51. Powers, functions and duties of the New York state public authorities control board; limitations. 1. The New York state public authorities control board shall have the power and it shall be its duty to receive applications for approval of the financing and construction of any project proposed by any of the following state public benefit corporations:

* * * *

e. New York state urban development corporation

* * * *

Any application made concerning a project shall include the terms, conditions and dates of the repayment of state appropriations authorized by law pursuant to a repayment agreement.

* * * *
No public benefit corporation subject to the provisions of this section shall make any commitment, enter into any agreement or incur any indebtedness for the purpose of acquiring, constructing, or financing any project unless prior approval has been received from the board by such public benefit corporation as provided herein.

2. The board may require as part of such application such information as it deems necessary and shall act upon such application within a reasonable time. The board shall furnish the state comptroller with a copy of each such application within three days following receipt thereof by the board. The board shall not approve any such application prior to the earlier of (a) seven days following the receipt by the state comptroller of such application or (b) the receipt by the board of the state comptroller's comments on the application or his consent to an earlier determination by the board. Reference to the state comptroller in this subdivision shall include any authorized representative of the state comptroller.

3. The board may approve applications only upon its determination that, with relation to any proposed project, there are commitments of funds sufficient to finance the acquisition and construction of such project. In determining the sufficiency of commitments of funds, the board may consider commitments of funds, projections of fees or other revenues and security, which may, in the discretion of the board, include collateral security sufficient to retire a proposed indebtedness or protect or indemnify against potential liabilities proposed to be undertaken. A copy of such determination shall be submitted to the chief executive officer of the appropriate public benefit corporation and the state comptroller.
PACB, Not Just Bonds: Any “Commitment,” “Agreement” or “Financing”

Bottom line, ESDC through its subsidy is proposing to issue bonds requiring PACB approval. Further, the approval required from the PACB is not just with respect to issuance of the authority’s bonds. It applies to any state authority financing of a project, “any commitment. . . any agreement . . . indebtedness for the purpose of acquiring, constructing, or financing any project.” The required PACB approval therefore applies to the ESDC administration of the hundred million dollars the state is making available to the project and the ancillary financing agreements, probably even including the state’s allowing the developer to use naming rights to finance the mega-development.

PACB Approval Required (Like Board Approvals)

How do we know that the 20% reduction in the size of the arena, its functionally diminished and changed potential use coupled with its 45% increase in cost (and its shift to being a clearly identified net loss for the public) mean that the arena’s financing needs to go back to the PACB for approval? Because we have experience in obtaining billions of dollars of approvals from the PACB and have seen the many other deals that the PACB routinely requires go back to it for approval when there are significant changes in the parameters of what is being financed. One pretty good indicator in itself is that even though ESDC screwed up and didn’t have its board approve the smaller arena, it was felt that the deal had changed so substantially in other aspects that a new ESDC board approval was needed. The two approvals, board and PACB, tend to go hand in hand.

Riskier New Financing Involves Almost Double the Burden

The public is getting a lot less for what it is putting into the deal and the current transaction is much more likely to be headed for a default. In the original transaction that the PACB approved, each square foot of arena (850,000 square feet total) had to generate income to support a cost of $749 p/s/f of construction and financing costs ($637.2 million total). In the new transaction, each square foot of arena (675,000 square feet total) now has the much more onerous burden of supporting the cost of $1,378 p/s/f of construction and financing costs ($930 million total). That’s almost double the burden. Doesn’t that sound like a deal that has become much more financially precarious?

Can Riskier Financing Get Around PACB’s Approval?

Is ESDC thinking that it will be able to avoid going back to the PACB by keeping down the amount of the bonds actually issued? The Wall Street Journal reports that despite the hugely escalated overall and p/s/f costs of the arena that the bonds issued might be only about $700 million:
Right now, the planned sale of as much as $700 million in bonds to finance the project's centerpiece -- a $900 million basketball arena to be called the Barclays Center -- looks like a toss-up. The U.S. municipal-bond market, while in much better shape than six months ago, has been in a rout since the start of October. The Nets arena offering, expected to launch next month, would be the largest bond sale tied to a sports venue in more than a year.
$700 million would be almost exactly a 10% increase over the originally authorized $637.2 million in bonds. Keeping the bond amount down so that it doesn’t exceed the originally approved amount by 10% could create an argument that a new PACB approval for the revised deal is not required but that argument would carry only if one ignored (the way the ESDC board did) the decrease in the arena size and all the other aspects of the financing deal whereby the public is getting much less for the funds it is putting into the project. It would carry only if one were willing to be completely blind to the escalating risks the transaction is facing. That’s exactly what the PACB is NOT supposed to do.

Something to Take With Equanimity?

Keeping the total bond amount down to $700 million would substantially increase the equity (or other debt) that would need to be furnished to finance the arena, probably by about $230 million. An increased cushion of equity is often considered to reduce risk but it is far from a panacea when the financing numbers don’t otherwise work. When the numbers don’t work the extra equity can just be part of the set-up for all sorts of litigation against and between the overstretched principals when cash flow runs short. That litigation can itself formidably strain project resources.

One thing to note is that the developer, Forest City Ratner, is not financially strong at this point and, depending on what happens, may actually go under. That, plus the need for equity and cash infusions to close the financial holes in the deal, is the reason that Prokhorov has been introduced to pour in his Russian cash.

Atlantic Yards as Political Poison Ivy: Are Politicians Rashly Sacrificing the Power of Precedent?

We think it is interesting that politicians are so afraid of the political poison ivy that Atlantic Yards represents that they would be willing to let Atlantic Yards set a precedent for the future, a precedent that a project with very substantial revisions potentially “careening off toward failure” does not require PACB approval. That precedent, if it is allowed to be established, could give any governor virtually unfettered latitude to continue unchallenged with degenerated projects substantially altered from their original underwriting and originally assessed public benefits. The senate and assembly leaders and state comptroller would thereby lose all future say.

What if the PACB does not, as it needs to, approve the substantially revised mega-project? The PACB statute does not set forth a remedy although it would put the state and its future administrations at a substantial moral remove from any defaulting bonds. It would also make the project vulnerable to clawback of funds theoretically “committed” by the state. Notably, though many other statutes dictating state procedures have them, the PACB statute does not contain a savings clause that says that actions (like bond issuances) taken without required PACB approval remain valid once taken. Since these kinds of things have never been put to the test there is no litigation to help predict future outcomes. Yet our public officials are so wedded to serving the developer here that they are willing to push the envelope to an extraordinary extent.

Bond Counsel Front and Center: The Tradition of Defaulting Issuers Skipping Away Because of Skipped Approvals

The role of bond counsel in municipal bonds transactions was created in the 1800's when bond issuers across the nation were disavowing and refusing to pay (defaulting) bonds, saying that proper procedures had not been followed and that required approvals for the issuance of bonds had not been obtained. Those claims allowed the issuers to walk away from the bonds, leaving the bond holders without recourse. These days, bond counsel participates in transactions to assure bond buyers that all required procedures have been followed and approvals obtained. The thinking is that the bond counsel law firm can be sued if the firm’s opinion is legally and negligently wrong and the bonds default as a result. No doubt some poor bond counsel will have to opine that arena bonds are being properly issued despite the lack of all the various approvals we have been talking about. For what it’s worth, the bond counsel itself will probably want to rely on an opinion from the agency’s in-house lawyers that all necessary approvals have been obtained, even though the agency staff is pushing the envelope far as possible for political reasons.

Will Tax-exemption Shortcuts Lead To Declaration That Bonds Are Taxable?

There are more hazards that bond buyers will probably want bond counsel’s help in sorting out. One is the issue of whether the Nets arena bonds can be considered safely tax-exempt. Bond counsel normally provides an additional opinion (not a guarantee) with respect to municipal bonds as to whether the interest on the bonds is tax-exempt. For the arena bonds that opinion is going to be especially important because of some of the shenanigans going on in New York involving the New York City Department of Finance and the way it has set real estate tax assessments in anticipation of supporting the tax exemption of municipal bonds. The originally responsible Finance Commissioner, Martha Stark, resigned her post, probably not on good terms, at a time when multiple scandals were going on. (See: Tuesday, April 28, 2009, Finance Commissioner Stark resigns, but the Yankee Stadium issue is ignored.)

One of the scandals with respect to the commissioner and her department was her participation in the apparent manipulation of real property tax assessments documented in e-mails with respect to bonds for Yankee Stadium. (See: Sunday, April 19, 2009, Keeping up with Bloomberg and Friends: Stark New Scandals and Is it True WSJ Readers Don’t Commit Murder?) That raises questions about whether the bonds whose tax exemption is based upon the validity of those figures are truly tax-exempt. (See: Saturday, November 8, 2008, Does Questionable Assertion of Attorney-client Privilege Point to Yankee Stadium Bond Taxability?) The same concerns apply to the Nets arena bonds and many of the same cast of characters were involved. It is not clear where further congressional investigation into the conduct of New York public officials is likely to lead. In time, it could lead to a declaration that the Nets arena bonds are not tax-exempt. Such a declaration would likely be retroactive to the bonds date of issuance.

Dual Purpose Strategy Acknowledging Deal Vulnerabilities?

We noted that the Wall Street Journal reported that the bond issuance may be kept down to $700 million. The decision to restrict the amount of bonds being issued to a lower number such as that may be tactical decision with a two-fold purpose. It can bolster ESDC’s hope not to be summoned back the PACB as noted before. It also throttles back on the chance that the bonds will be deemed taxable because they are being supported by artificially inflated real estate property assessments and tax equivalency payments.

“Public Purpose” vs. “Public Purpose”

Once upon a time a core component of every bond counsel opinion was that the bonds were being issued for a “public purpose.” Theoretically that is still true and it may be turn out to be unusually true in the case of any arena bonds that get issued. Unless public agencies were issuing bonds for a public purpose states and localities didn’t have authority to issue them. Theoretically that could even go to the bonds’ tax exemption since a valid state or local government issuance was at the heart of the original theory of why municipal bonds could be tax-exempt. The tax law has been greatly affected and made much more complex in recent decades by a distracting overlay of federal legislation designed to take away tax exemption where it was once readily recognized.

The concept of “public purpose” for the purpose of issuing valid municipal bonds is separate and distinct from the concept of “public purpose” for the purpose of having a valid taking or condemnation under the laws applicable to eminent domain. Nevertheless the two concepts can have some overlap. The latter eminent domain concept is being litigated right now in one of the project litigations before New York’s highest court. One of the arguments before the court goes to whether ESDC actually has the power to exercise the eminent domain it is exercising given that ESDC’s exercise of its powers is specifically pursuant to the restrictive provisions of Article 18 of the constitution which links eminent domain use to affordable housing. Conceivably, the court will find that Article 18 has not been complied with and that ESDC therefore has not properly exercised its powers. This is one theory under which ESDC’s eminent domain abuse seizure of property would be prevented. Would this also negate ESDC’s power to issue (or have issued) any bonds? We don’t know. We haven’t looked at it but we are sure it is one more thing bond counsel will need to look at as they rack up a bill.

Postponing the Day of Reckoning For Dealing With Loose Ends

How is it possible that arena bonds could be issued with so many loose ends and the uncertainly of the litigation? The developer has been publicizing the fact that he has a plan. Essentially his plan involves postponing the day of reckoning for dealing with the loose ends. He is proposing to divide the transaction into two parts. The bond transaction would be separated from the real estate transaction in order to issue the bonds before the end of the year. The real estate financing which involves the majority of the loose ends that need to tied up would defer having to deal with any loose ends by “closing the transaction in escrow.” Bond proceeds held under the bond resolution would not be advanced to fund the real estate transaction unless and until identified loose ends are cleaned up. More typically big single project financings involve a simultaneous closing of both the bond and real estate side of the transaction. Since the two need to mirror each other that is the best way to minimize risk.

(BTW: We have sometimes heard people refer to the “bonds being issued in escrow.” Do not expect anything like that to be the case. Among other things we doubt it would qualify as meeting any deadlines for IRS purposes.)

Close But No Cigar

If you can’t close the two sides of the transaction simultaneously it is good to close them as close together as possible. There is always the risk that loose ends won’t be cleared up and that bonds will have to be redeemed (`origination risk’- we’ll get back to this in a moment) but if there is a long interregnum between the closings the risks rise that other unidentified problems will crop up during the delay or even because of it.

PR For The Times?

Interestingly, in coverage by the New York Times the developer apparently with some bravado (and bluff?) indicated to the reporter that bonds might be issued much earlier than necessary to meet the tax deadline and therefore probably much further in advance of the possibility of the actual real estate closing that would break the “escrow.” Here is how the Times described the awkward scenario this summer:
The developer’s bankers or underwriters are visiting bond rating agencies and a bond insurer to outline their plans for about $586 million in tax-exempt bonds and another $30 million in conventional financing, they say. The bonds would be issued by the state development corporation, possibly in early October, with the developer responsible for the annual debt payments, which are expected to be about $45 million.

The bond proceeds would be placed in escrow until the state got court approval for condemnation, notified dozens of tenants on the site to vacate and conveyed the property to the developer.

Although it is nearly impossible to get financing for large real estate projects today, the bankers say a bond sale should go smoothly.
(See: Private Equity: Ratner’s Atlantic Yards Project Enters a Crucial Period, June 25, 2009

“Should go smoothly”? Do we detect some more bluffing PR? We also note that this article written just three and one half months before the Wall Street Journal article has a very different (lower) figure for the amount of bonds that are supposed to be issued.

Bond Mechanics: Risk of Non-Origination (Enter Mr. Prokhorov?)

Once the bonds were issued interest on the bonds would have to paid to the bond holders. This could be done out of the capitalized interest account under the bond resolution (essentially the bond holder’s own money paid back to them) and earnings from the escrowed bond proceeds. The Times article states something else: That “the developer” would be “responsible for the annual debt payments.” That might be the what is being arranged but we suspect it is a PR slant. The slant might be based on the concept that the developer was “borrowing” money from the resolution to pay the debt service. However, to the extent that the earnings on the short term investment of the bond proceeds (in taxable markets) during the escrow period don't cover the (tax-exempt) interest rate on the (long term) bonds (the possible negative arbitrage) that deficiency is a cost that will ultimately need to be covered if the bonds are redeemed early.

Unless and until the real estate side of the deal closed there would be no assurance that there would be income to pay bond holders long term. If the real estate side of the transaction didn’t close within a reasonable period of time the bonds would have to be redeemed without ever financing the arena. ESDC’s board materials set March 31, 2011 as that outside date.* That means the `origination risk’ would have materialized. Then the only way that the bond holders would be paid in full is if someone came up with the cost of the bond issuance that would have been spent, likely out of bond proceeds, at the time of bond issuance. In other words someone (Mr. Prokhorov?) is likely to have lost their gamble and be out of pocket about $20 million. Mr. Prokhorov, or his equivalent, will also have to pay to cover any negative arbitrage by that time too. What could make that additional amount a comparably very large would be whatever the spread is between the investment and bond rate and the extended length of time occurring since the bond closing. Having someone associated with the borrower face these risks is an important part of minimizing the possibility that the developer might at some point decide to just walk away. (Bankruptcy of the financially weak Forest City Ratner could pose similar problems.)

(* See: Wednesday, October 21, 2009, As AY endgame approaches, would judges stop the MTA/ESDC from proceeding? Or might the pending cases affect bond sale?)

Shifting Around to Cover Risk

We have heard that Mr. Prokhorov is facing restrictions on getting his capital out of Russia for this transaction. If Mr. Prokhorov is the one who shoulders this risk then the non-origination based redemption will be the time when whatever collateral he has put up gets accessed and converted into (probably) U.S. currency. It could be that there is some risk with respect to accessing this collateral in which case the bond insurer will probably be asked to cover it. This could be one of the things the proposed bond insurer is balking at in the negotiations.

Fixed on Redemption Risk

The forfeited cost of issuance is not a loss that rating agencies should let the bond holders be exposed to, but the bondholders will face what is known as redemption risk. One has to ask why a bond buyer would want to get involved in a transaction as ugly and warty as this one. Why not just buy something clean? The answer is that as with “junk bonds” the buyers might see some compensation in a higher interest rate. The Wall Street journal article indicates that the bonds being issued will be issued at a fixed “annual interest rates of roughly 6.5%.” If the real estate side of the transaction never closes, the bond buyer’s investment, including the buyer’s transactional hassle and expense, will be for naught. The bond buyer would have done better by investing in alternative investment opportunities that would have locked in longer term advantages. The “ouch” factor is greatest if interest rates are down and the redeemed bonds were trading at a premium.

Variable Risks

The implications of redemption risk are less significant when variable rate bonds are issued. They always trade at par. But those bonds are harder to issue since the financial meltdown and they don’t reward buyers with a higher interest rate to help buyers overcome a “why bother” reaction when they consider what a bad case of the uglies these bonds will likely have. Another problem with a variable rate structure is that any liquidity provider who stands ready to buy the bonds at par becomes a defacto guarantor who pays off if the bonds are declared taxable (and in other comparably negative situations). These bonds will probably face enough of an concern about taxability that no one will want to deal with that possibility.

What Inconsiderate Shortcuts Signify

That nearly sums up why we think any sensible bond buyer would want to steer clear of this arena bond transaction if it ever issues. The pervasive odor of shortcut and developer accommodation should put buyers on notice that the tip of this iceberg betokens deeper problems that have not yet been duly considered or adequately protected against.

A Sales Pitch: A Duty to Put the Public Interest First When Buying Bonds

One other thought we’ve had is this. We remember the advertisements for municipal bonds by firms like Lebenthal that conveyed the message, rather like World War II savings bonds (which bore very low interest rates), that it is good to buy municipal bonds because bonds also benefit the community. Similarly a lot of people used to be attracted to government and the field of public finance because of the possibility of doing good for the community. The proposed arena bonds are antithetical to that notion. This arena and the mega-monopoly scheme of which it is a part harms the community. The panoply of lawsuits brought by many groups representing the community and their elected local representatives are one testament to that. The list of other proofs is long indeed. If once it was possible to persuade people to buy municipal bonds in the name of a public good, certainly in this case the argument is reversed. Those who consider the public good will have one more good reason not to buy these strangely concocted bonds.
(Above, the ESDC Board meeting room on September 17, 2009, the day of its last "approval" of Atlantic Yards, right before the mega-project changed again substantially. )


bobbo said...

And if the bond ratings agencies certify the bonds as investment grade...or if Prokhorov and Forest City throw more money in the pot, none of this matters.

brokeland2003 said...

stick to hoops and NJ, Robert. "If" is not a strategy.