Default Studied as Last-Ditch Strategic Move

Orange County, searching for a way out of its pending cash crunch, is considering a last-ditch strategy that would entail defaulting on $600 million of its debts on the grounds that the borrowings were illegal.

The idea of a court-sanctioned default, which would involve asking a judge to declare specific debts a technical violation of the state Constitution, could help the bankrupt county repair its finances in the short term.

But the move also carries high risk for the county because it could spark a firestorm of protest on Wall Street and scare off investors who will be needed to buy future Orange County bonds.

“It would be very, very hard for Orange County to ever recover from that,” said Barbara Flickinger, a manager with the bond-rating agency Moody’s Investors Service in New York. “No investors would believe them again.”

Nonetheless, while the county is continuing negotiations with creditors on ways to refinance a total of $1.3 billion in notes and bonds that come due in June and August, sources said lawyers are researching court-sanctioned default as a strategy of last resort.

“The county has reserved its right to challenge the validity of the taxable notes,” said Lee Bogdanoff, a lawyer for the county, referring specifically to a $600-million note issue floated last year.

“We are just investigating the possibility,” he said.

As part of a plan to cover the $1.7 billion of investment losses that pushed the county into bankruptcy in December, Orange County has proposed rolling over certain maturing debts for one year. Creditors have asked the county to promise bondholders at least a 2.5-percentage-point boost in the yield they are earning if they agree to a one-year rollover of the debt.

Despite the rollover plan, sources said that the right to invalidate certain debt would be kept as an option, and could be invoked at any time--even after a rollover, if one is effected.

If the county follows through on the default strategy, it would argue that its sale of $600 million of notes with the help of Merrill Lynch & Co. last June 30 exceeded state debt limits and thus was invalid.

The county also would make the argument that the bonds were sold to further former county Treasurer-Tax Collector Robert L. Citron’s extraordinary interest-rate gamble and thus represent an illegal form of borrowing.

But such a legal maneuver poses a number of dangers. Not only does it invite lawsuits from bondholders who might charge the county with securities fraud, but it also could infuriate Wall Street and individual investors and thus inhibit the county’s access to financial markets in the future.

Some analysts also fear that declaring the debt unconstitutional could raise borrowing costs for other local governments throughout the state, as investors shied away from California municipal debt securities.

“It’s unthinkable. The people who bought these bonds were not gambling. It would send shock waves,” said Moody’s Flickinger.

“This is a huge concern,” said Jane Eddy, a director with Standard & Poor’s Corp., a bond-rating agency. “My understanding is that the county will only exercise its invalidation rights if push comes to shove. But keeping that option is a major concern.”

Sources said the county’s approach to invalidating the debt is similar to the argument currently being applied in a lawsuit against Merrill Lynch. In the suit, the county argues that the Wall Street giant “encouraged Citron to implement an investment program which violated the California Government Code and California Constitution.”

Merrill Lynch has denied the charges, arguing that the county is trying to make the investment firm a scapegoat for Citron’s losses.

Because bondholders, like the county itself, see the lawsuit against Merrill Lynch as a potential source of funds to repay county debts, the argument that the taxable notes were unconstitutional poses a dilemma. Used against Merrill Lynch, the legal gambit could help bondholders. Bondholders are loath, however, to have it used against themselves.

“There are still some ruffled feathers over this issue,” said Robert Moore, a lawyer who represents the creditors committee of bondholders. “But the bondholders don’t want to impair the county’s ability to collect claims in its lawsuit against Merrill Lynch.”

The county will also argue, sources said, that the borrowing violates a section of the California Government Code that stipulates that the county Board of Supervisors “shall not for any purpose contract debt or liabilities which exceed in any fiscal year the income and revenue provided for that year.”

Because the $600-million issue has a one-year term, but is not secured by any yearly fiscal revenues and was to have been paid back with proceeds of the pool, it may violate the statute, sources said.

Also, the bonds are due after the fiscal year ends on June 30, and must be repaid with revenues from another fiscal year, another possible violation, sources said.

“I’ve heard this argument on that $600-million Orange County deal,” said Peter Schaafsma, executive director of the California Debt Advisory Commission, the state agency that tracks municipal debt. “On that theory, the bonds don’t meet the legal specification of the statute that allows annual borrowing, so they would be unconstitutional,” said Schaafsma.

In California, local governments have previously sold millions of dollars of taxable bonds to make investments they hope will pay higher returns, but agencies have refrained from any new borrowings for that purpose in the aftermath of Orange County’s bankruptcy, Schaafsma said.

“That interpretation (by Orange County) would be a surprise to a lot of jurisdictions throughout California” that have borrowed money to invest, said Dean Misczynski, a bond expert and director of the state California Research Bureau. “Any time you sold taxable securities and invested the proceeds, you’d have illegal debt.”

Flickinger of Moody’s noted that investors who bought the $600-million issue relied heavily on legal opinions from the county’s lawyers, who said the bonds were legal debt for the county.

“If you can’t believe bond counsel, what does it mean for the whole bond market?” said Flickinger.

If Orange County decided to ask the court to repudiate its debt, it would mirror the 1983 bond fiasco involving the Washington Public Power Supply System and its default on $2.25 billion in debt.

“This would be an exact replay of WPPSS,” the largest municipal bond default in the nation, said Richard Lehmann, president of the Bond Investors Assn., a group that represents individual bondholders.

Bondholders filed several suits, including one unsuccessful challenge against the state of Washington that argued that the state had a “moral obligation” to make good on the debt. Bondholders later received a settlement--but one worth just pennies on the dollar--in a case filed against the local utility districts for securities fraud.

Lehmann argued that Orange County, one of the richest counties in the nation, also has a moral obligation to make good on its debt and honor its agreement with bondholders, who bought the bonds based on assurances from the county that they were legal debt.

“Are they trying to say that bondholders should have known what crooks they were in Orange County? It’s outrageous.” Lehmann said. “Default is a lawyers’ solution because it will mean years of litigation. They delay paying bondholders while their lawyer meter keeps running.”