Thursday, May 24, 2007

Kentucky v. Davis

George and Katherine Davis must be really big believers in geographical diversification. So much so that they decided to sue the state of Kentucky, alleging that the state's taxation of out-of-state municipal bond interest but not in-state interest was unconstitutional. The case is now to be heard by the Supreme Court some time either this Fall or next Spring. Its official name is Department of Revenue of Finance and Administration Cabinet, Commonwealth of Kentucky v. George W. Davis.

Lower courts had ruled for Davis, under the theory that Kentucky's taxation policy (which is similar in the majority of states) violates the so-called "dormant commerce clause." In essence, that clause prohibits the states from enacting laws that favor in-state commerce over out-of-state commerce, under the presumption that the Federal government has sole authority over interstate commerce. In this case, Kentucky is favoring in-state commerce by exempting its own bonds from taxation but not out-of-state bonds. I note that there is no "dormant commerce clause" in the Constitution itself, but it is a precedent that dates back to John Marshall.

The impact on the municipal market will be significant. Currently, most municipal bond investors have a strong incentive to own bonds issued in their own state. Bonds issued within higher tax states (California, New York, Massachusetts, etc.) are considerably more valued than bonds in low tax states (Texas). The difference between a similar structured bond from California versus Texas is typically 20-40bps. It will also have a major impact on the marketing of bond investment management services. A large percentage of municipal bond funds currently marketed are state specific. If there ceased to be a tax advantage, investors would obviously prefer the diversification of a national portfolio.

The prevailing opinion on Wall Street is that the Court will find some way to strike down the lower court ruling and uphold the status quo. I'm no lawyer, but I have read a fair amount on this case. And logic and precedent seem to be on the Davis' side. In a recent dormant commerce clause ruling, United Haulers v. Oneida-Herkimer, SCOTUS ruled that it's okay for local governments to discriminate against out-of-state commerce when it is intended to benefit a municipal authority, and the municipal authority is serving a legitimate public good which cannot be achieved otherwise. Some are saying that this case is precedent for the Davis' case being overturned, as it hinged on the public versus private sector.

I'm not so sure, and neither are law professors Ethan Yale of Georgetown and Brian Galle of Florida State. They note that the Court has historically been "skeptical of discriminatory laws that shield state officials from the pressure of competition with activities undertaken by other states." That is exactly what we have here. Bond issuers are competing with other issuers for lendable funds. A high-tax state has their lending rate subsidized through the state exemption, thus reducing dramatically the competition. Notice that many of the higher-tax states have weaker credit ratings compared with other states (California, New York, Puerto Rico). They can get away with this because their bonds are in high demand from local investors.

I note, however that two Justices don't believe in the dormant commerce clause at all: Thomas and Scalia. They said as much in their opinions in United Haulers. I would therefore say there are two automatic votes to overturn the lower courts ruling in the Kentucky case. Also in United Haulers, many observers thought that opinion written by Roberts, Souter, Ginsburg, and Breyer was actually complicating the dormant commerce clause.

If you have two voters who will strike no matter what, and four who are willing to venture out on a legal limb, then just maybe we will keep the status quo.

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