Prop. 9 Anxiety Goes All the Way to Wall Street

With roughly $6 billion in bonds at stake when voters decide Proposition 9 on Nov. 3, anxiety is running high from California to Wall Street over the ballot measure designed to lower electricity rates for most of the state’s consumers.

The source of the concern is a provision of Proposition 9 that would halt the flow of money from ratepayers that is paying off nearly $6 billion in bonds. The bonds were sold late last year to finance a 10% rate cut for the nearly 10 million residential and small business customers of Pacific Gas & Electric, Southern California Edison and San Diego Gas & Electric.

At the time they were sold, the bonds received a AAA rating--the highest possible--and were snapped up so quickly by institutional investors that potential buyers were turned away.

But what was once seen as “an airtight cash flow,” according to one analyst, could come undone if Proposition 9 is approved. For the first time in memory, voters would effectively be using the initiative process to renounce a financial obligation.

“The state has never backed away from a pledge,” said Steve Spears, a former deputy state treasurer and now managing director of Metropolitan West Financial and Strategic Services, an investment and consulting firm in Sacramento. “A proposition has never been on the ballot that attacks a revenue stream on bonds. It is absolutely unprecedented.”

Proposition 9 is trailing in polls, but many voters are believed to be undecided. If it does pass, count on the measure to touch off a series of court battles. Both the California and U.S. constitutions also have prohibitions against impairing contracts. In past cases, the courts have held that government agencies could not come back to a bond issue after the fact and change payment pledges.

Bond repayments have been considered so sacrosanct that even during California’s financial crisis of the late 1980s, when money for welfare recipients, vendors and state employees was held up, bond payments were always made.

The ratepayer bonds still carry the highest rating. But Moody’s Investors Service announced in New York this week that if Proposition 9 passes and California courts fail to grant injunctive relief while the measure is litigated, the bonds’ rating could be downgraded, a move that would reduce their value.

“There is a lot of concern,” said Bruce Fabrikant, a senior credit officer with Moody’s. The worry stems from “the uncertainty--if it passes and a judge doesn’t issue a restraining order or preliminary injunction,” he said.

“Obviously we are following it very closely,” said Ellen Welsher, New York-based director of new assets for Standard & Poor’s, which also gave the ratepayer bonds their highest rating. “We aren’t making any comments until we see what happens [in the election].”

The bonds were issued by the three utilities through an obscure state agency as part of the 1996 law that began California’s program of deregulating electric utility service. The bonds allowed utilities to cut residential and small business customer rates by 10%; consumers are paying them off via a surcharge that appears on their monthly bills. The initiative promises a 20% electric rate reduction.

Peter Bianchini, western regional public finance director of Standard & Poor’s in San Francisco, tracks municipal bonds used by cities, counties and other government agencies to raise capital. He said that even though ratepayer bonds were privately issued, they could affect the municipal bond market.

“If you disrupt a debt service for any bond in California, it tends to have a broad effect,” Bianchini said, noting that when Orange County defaulted on bond payments, borrowing costs for cities and counties throughout the state went up.

No Risk for Bondholders

At this point, both sides in the Proposition 9 contest agree that the bonds will be paid off. The argument is over who will be responsible for doing so.

“It’s going to be a cold day in Hades before the bondholders are going to lose a penny,” said Michael Florio, an attorney for the Utility Reform Network, one of the sponsors of Proposition 9.

Utility executives and others who have studied the issue say the state and its taxpayers are ultimately responsible to pay off the bonds.

Some state officials disagree, but concede that there is a possibility, however remote, that California taxpayers could end up paying the bill.

The bonds carried a disclaimer that they were not backed by “the full faith and credit” of the state. But the Legislature, anticipating a problem, wrote into the bond prospectus a caveat that the state would do nothing to impair repayment of the borrowed money.

“At the heart of this is whether the state, through the initiative process, can walk away from financial obligations,” said attorney Dean Criddle, who advises PG & E for the national law firm Orrick, Herrington & Sutcliffe.

John E. Bryson, chairman and chief executive officer of Edison International and Southern California Edison, said he and other utility officials are preparing to be in court the day after the election should Proposition 9 pass.

Bryson told a packed luncheon meeting of Town Hall Los Angeles this month that he believes utilities are off the hook. Should Proposition 9 pass and be upheld by the courts, the bonds “would then become due and payable with interest by California taxpayers,” Bryson told the business group.

But the state legislative analyst’s review of Proposition 9, reprinted in the pamphlet distributed to voters, found that the issue was clouded by so many legal questions “it is not clear whether the measure would have any impact on the repayment of these bonds or, if it did, what the impact would be.”

Mac Taylor, deputy legislative analyst, said that position remains unchanged. Taylor said the chance that California taxpayers would be left responsible for repaying $6 billion--roughly one-tenth of the state’s general purpose budget--was “too remote” to warrant speculation.

But Harvey Rosenfield, one of the consumer advocates who helped write the proposition, has no doubts who will be responsible for the debt. “Our guess is the utilities will have to pay,” he said.

Anticipating that judges might balk at disrupting bond payments, the proposition’s authors included a provision saying that if courts require ratepayers to continue making payments, the utilities must offset that with credits to consumers.

Sponsors of Proposition 9 are also challenging the legality of the original bond sale.

“[The state] never had the legal authority to create the bonds in the first place,” Rosenfield said. “The California Constitution says voters have to approve any debt created by the Legislature. There was never a vote.”

Rather than file a lawsuit or launch a referendum to repeal the entire 1996 law that set the ratepayer bonds in motion, the consumer coalition that sponsored Proposition 9 drafted the initiative in a way that would surgically remove parts of the law. These included provisions authorizing subsidies for nuclear power plants and creating the ratepayer bonds.

Other features of the law, such as subsidies for environmentally friendly energy production, were left intact.

There is a widespread belief among those in the utility and investment community that the contractual obligation is ironclad.

But Criddle said if the state does the unthinkable and walks away from the bonds, it would shake Wall Street’s confidence in California bonds, which are used to raise money for building prisons, schools, highways, water projects and other public works needs.

“You have to ask yourself what kind of comfort an investor would have that the state would meet its obligations,” Criddle said.

But Criddle, Fabrikant and others say the Legislature will probably never be faced with the problem. They believe that the courts will find Proposition 9 unconstitutional.

“We examined the potential ramifications of Proposition 9 passing prior to issuing the rating,” Fabrikant said. “It is our view that Proposition 9 is inconsistent with both state and federal constitutional protections against impairing bonds.”

Measure Trailing in the Polls

Sponsors of the initiative insist otherwise. They contend that a state law is the source of the dispute, not a contract.

“This is not a contract, it is just a law, and like any other law it can be amended. There is no such thing as a law that can’t be changed,” said Florio, the TURN attorney.

Of course, the measure’s defeat Nov. 3 would end the debate. Polls show that it is trailing, although political observers say they believe many voters are undecided. And the electorate is expected to be bombarded with heavy advertising in the final days of the campaign.

Utilities have been able to outspend the proposition’s supporters by roughly $30 million to $1 million, a margin that is expected to grow even wider in the closing days of the campaign.

Municipal utilities, including the Los Angeles Department of Water and Power, remain outside the scope of Proposition 9, which is aimed only at privately owned utilities regulated by the California Public Utilities Commission.

Even so, David Freeman, general manager of the Los Angeles Department of Water and Power, is a vocal opponent.

Concerned about the ripple effect its passage could have, Freeman fears that Los Angeles taxpayers may be forced to pay for a bailout if one becomes necessary.

“For people who live in Los Angeles, the Department of Water and Power customers, this is a very easy decision,” Freeman said. “There is absolutely zero upside.”