Victorville bond bust brings SEC lawsuit

May 31, 2013

By Wayne Lusvardi

A recent lawsuit filed by the Securities and Exchange Commission alleged Victorville city officials and bond underwriters defrauded bondholders of $13.3 million in 2008 due to failure to disclose actions and risks of “inflated property values” backing redevelopment bonds.  SEC prosecutors alleged Victorville and its bond underwriters failed to disclose these risks to bond investors in the bond prospectus. 

Another charge made by the SEC is that Victorville undertook a so-called “ill conceived” gas-fired power plant project financed with redevelopment bonds.

The president of Inland Energy Tom Barnett, developer of the proposed Victorville 2 Hybrid Power Plant, had his personal bank account records subpoenaed on Jan. 26, 2013 to peek into his political campaign contributions. 

Victorville: Texas West

Victorville is a community of about 115,000 people in the high desert area of inland Southern California. It is about 100 miles east of Los Angeles. It has a Texas-like feel to it due to its desert topography, former military residents, libertarian newspaper and pro-growth policies.

Victorville was the second fastest growing area in the U.S. in 2008.  Its economy is dependent on the conversion of the former George Air Force Base into a cargo transport airport, rail transport hub and warehousing center for wholesale goods.

In 2006, California mandated a shift to 33 percent green power by 2020 under AB 32, the Global Warming Solutions Act of 2006.  Victorville poised itself to benefit from this shift toward cleaner power.  In 2008, Victorville and Inland Energy had obtained permits to build a 563-megawatt hybrid natural gas-solar power plant on the land near the former George Air Force Base, now called the Southern California Logistics Airport.

In 2007, BNSF Railway Company, the largest railroad company in the U.S., had also tentatively picked Victorville for the site of a new regional transport hub.

The boom in Victorville took about 5 years to emerge but only about a month to bust. 

Inflated or deflated property values?

At the heart of the SEC’s complaint is that Victorville and its consultants inflated property values on four airport hangars that served as collateral for redevelopment bonds.  However, prior to issuance of the bonds during a worsening credit market, the bond markets demanded a higher debt coverage ratio of 1.25 from the 1.10 ratio of prior bonds issues.  A debt coverage ratio is the amount of the prospective future rental income from the four hangars above the amount of bonds issued.  It serves as a cushion in the event of an unanticipated downturn in the economy.

As a result of the higher debt coverage ratio, Victorville hardly had any resources left to continue redevelopment activities. So it borrowed $35 million, of which $13.3 million was to be paid back in debt (e.g., bonds).  The $13.3 million bond was secured by the $65 million value in four airport hangars.  The SEC claims the value of the hangars was only about $28 million.  But the bond underwriter — Kinsell, Newcomb and DeDios — claims it spent $56 million just to build the four hangars, let alone the value of the land.  But did the underwriter inflate the value or did market values plummet?

Reportedly, the County Assessor’s office assessed value for property tax purposes fell far short of $65 million for the hangars.  A sufficient assessed value was needed to issue tax increment bonds used in redevelopment.  The assessor’s low valuation ran against Rule 6 (a) of the State Board of Equalization’s “Assessor’s Handbook 410, Assessment of Newly Constructed Properties,” which states on p. 19:

 “The reproduction or replacement cost approach to value is used in conjunction with other value approaches and is preferred when neither reliable sales data nor reliable income data are available and when the income from the property is not so regulated as to make such cost irrelevant.  It is particularly appropriate for construction work in progress and for other property that has experienced relatively little physical deterioration….” 

How could the bond underwriter have reasonably foreseen that the assessed value would fall 57 percent less than $65 million? The state’s own assessment rules would have indicated a much higher value based on the cost to construct the hangars.   And the assessor’s valuation reportedly did not come until after the bonds were issued.

Moreover, Standard and Poor’s bond rating service originally rated Victorville’s $13.3 million tax increment redevelopment bond BBB.  This is considered a borderline non-investment speculative grade bond (“junk bond”). Victorville’s subordinated bonds involved in the lawsuit were given a “CC-” rating by Moody’s bond rating service in 2009 (on a scale of Aaa1 is best and C worst).

Backdrops and contexts

A backdrop totally ignored in the SEC lawsuit was the effect of the sudden collapse of credit, bond and real estate markets in 2008.  What drives land values in Victorville’s import-based economy is the amount of incoming goods at the Ports of Los Angeles and Long Beach.  Container counts at the Port of Los Angeles dropped from 8.4 million in 2007 to 6.7 million by 2009.  That had a ripple effect that could be felt 100 miles away in Victorville.  Demand for wholesale warehouse space and a regional air and rail hub suddenly vanished.

With the deep depression also came an unplanned decline in the consumption of electricity in California.  Electricity use dropped by 19,564 gigawatts from 2007 to 2011.  A gigawatt is enough to supply the demand of about one million average homes.  California used 264,234,911 gigawatt hours in 2007, but only 250,384,248 by 2010.  Demand for the 563-megawatt Victorville 2 hybrid power plant vanished almost at the flip of a switch. A megawatt is 1/1,000th of a gigawatt.

Power plants in California are not built “on spec.”  The California Energy Commission and the California Independent System Operator schedule new plants to fill growing demand and the loss of power from the decommissioning of older, dirtier power plants.

The California Energy Crisis of 2001 was partly caused by not issuing enough permits for new power plants and banning power plant operators from coordinating power demands during the crisis. How could Victorville’s proposed power plant have been “ill-conceived,” as the SEC alleges, when the market for new power plants is so highly regulated?

Probable cause for prosecution? 

There remain a lot of questions about the SEC action.

For example, why has the SEC singled out Victorville, a Republican-run city, and not bond deals in the Democratic-leaning City of Stockton with its $59.6 million in nearly defaulted redevelopment bonds?

Or why has the SEC not delved into the widely known conflicts of interests involved with the California Communities Development Authority and its creation of Public Financing Authorities that are being copied throughout the country?  California State Treasurer Bill Lockyer has opened a conflict-of-interest probe.

But the SEC seems obsessed with $2.3 million in “management fees” used by Victorville’s bond underwriter Kinsell, Newcomb, and DeDios.  The SEC is concerned that a 10 percent bond-underwriting fee is excessive. But even Investopedia.com says 10 percent is a typical fee for issuance of a revenue bond.

The attorney representing Victorville and the Airport Authority is Terree Bowers, a former U.S. Attorney for the Central District of California. He said, “It’s a mistake for the SEC to treat municipalities the same way they treat corporations.”  Bowers added, “These actions [the SEC lawsuit] are somewhat questionable given the city’s emerging recovery from the Great Recession.  It is certainly worth debating whether this lawsuit is in anyone’s best interest.”

The SEC’s case could be rendered unneeded by the same forces that brought about the bondholder’s losses.  Port of Los Angeles container volumes are up significantly in 2013.  But redevelopment bonds are no longer available after Gov. Brown shut down redevelopment agencies in Feb. 2011.  Victorville’s 2007 and 2008 bonds were reported by the SEC to be currently trading in bond markets around 45 cents to the dollar in value.  Perhaps a settlement could be reached with bondholders?

The SEC wants to protect bondholders from further losses. But given the backdrop of the Obama-administration’s IRS scandal, and the circumstances surrounding Victorille’s $13.3 million redevelopment bond loss, the public will surely be debating whether there is any merit to the SEC’s case.