Victorville bond bust brings SEC lawsuit

Victorville post cardMay 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 BBBThis 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 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.


Write a comment
  1. Wayne Lusvardi
    Wayne Lusvardi 31 May, 2013, 22:29


    A thank you to Russell Ryan for saying what so many of us familiar with the ways of the Securities and Exchange Commission have been thinking (“Why the SEC Needs ‘No-Admit’ Settlements,” op-ed, May 22). Mr. Ryan raises several points that have been lost in the debate about this issue. The matter of SEC resources is most often cited as a reason for retaining the “no-admit” policy, and with good reason. The SEC simply doesn’t have the staff or the resources to litigate all of the matters that would go to trial absent the option for no-admit settlements. Parties in SEC cases, as with all legal disputes, settle for many reasons wholly unrelated to actual liability. The SEC staff often threatens to file cases even when its position isn’t as strong as the agency might like. Some of those cases settle anyway, giving the SEC opportunities to further its programmatic agenda and send messages about appropriate or inappropriate conduct.

    Absent the ability to settle these matters without admitting liability, those opportunities would be lost. The inevitable consequences would be fewer settled cases, fewer cases filed overall and many more trials, as defendants put the SEC to its proof rather than accept an admission of liability and the cascade of consequences such an admission might bring. No doubt, present critics of the no-admit policy would complain even more strenuously about that result.

    Amy J. Greer

    New York

    Ms. Greer was chief trial council at the SEC’s Philadelphia office 2003-2008.


    Reply this comment
  2. Queeg
    Queeg 1 June, 2013, 16:17

    I miss Rizzo!

    Reply this comment
  3. 007ESQ
    007ESQ 3 June, 2013, 19:22

    As someone once said: Be correct or be corrected.

    You have some facts stated incorrectly in this article. They are might result in some additional investigation on your part or corrections to your conclusions or theories.

    First you write: “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.” Not right. What you’ve described is a net equity concept — i.e., the value of leasehold for the the hangers is more than the principal amount of bonds outstanding, leaving equity to pay off the bonds in case the hangers need to be sold to cure a payment default on the bonds. Debt coverage is different and relates to the amount of lease revenues paid on the hangers above debt service on the bonds. Take a look in the Wall Street Journal’s glossary of business terms. It’s a handy tool. Security is always material to bondholders and needs to be clearly and correctly described to bond buyers.

    Second,you say that it’s normal for an underwriter to make ten percent of the bonds raised. You quote investopedia, which is not the best available source. So you end up with an incorrect conclusion about underwriter compensation. Municipal investment banking fees in the 1/2% (at the low end for variable rate securities) to just under 2% on the high end (for certain fixed rate revenue bonds) are within the market’s historic and customary parameters. Also, you need to correct the math associated with your incorrect conclusion about underwriter compensation, since according to your numbers, the underwriters received 20% as a “spread” between the bid and ask on $13.3 million in bonds — i.e., $2.3ml in fees on a $13.3 million bond issue. That amount is akin to a private equity promote value, generally given by a private equity source to a manager of investments and/or operator of businesses. You might want to dig some more into what the SEC is questioning here, because excessive compensation is definitely up for debate.

    Finally, BBB rated bonds are investment grade, not junk. Junk is below investment grade. Go online to Moody’s, S&P and Fitch and read the descriptions they each give for the dividing line between junk and quality.

    Reply this comment
  4. Wayne Lusvardi
    Wayne Lusvardi 4 June, 2013, 09:24

    Thank you for your comments

    Articles are written for a 10th grade reader level. The reader does not know the difference between a debt coverage ratio and net equity concept. The SEC prosecutors use the term debt coverage ratio so maybe you should direct your comments to them.

    The numbers you cite are not mine they are from other sources. But thank you for correcting them.

    I specifically used the word “borderline junk bond” not junk bond. I also clarified later that the bond was downgraded to junk bond.

    I believe you have misinterpreted the article. I have no idea what may come out in a court trial but the law is not only behavioral (you shot someone) but contextual (in self defense). I just tried to put what happened in context.

    Is the SEC on an IRS like witch hunt? I have no idea. But it is a newsworthy topic because it is something the public is talking about.

    Thank you for sharing your expert knowledge.

    Reply this comment

Write a Comment

Leave a Reply

Related Articles

Car-mileage fee debate accelerates

The debate over gas taxes or mileage-based user fees to fund road construction and maintenance is accelerating. Proponents of gas

A High-speed math problem

JUNE 24, 2010 By JT LONG A month after a report by the California State Auditor warned of possible delays

Micro-managed grid short-circuting CA market electricity

  In Germany, merchant-energy companies are considering moving to other countries where they can make a profit. Such companies are