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Dirt bonds muddy bankruptcy court

by Hayley Kaplan | Published October 20, 2011 at 2:16 PM

The collapse of the real estate market has left a trail of bankruptcy filings by developers in its wake and plenty more on the horizon. Along the way, it's shining a spotlight on a certain type of municipal bond.

Primarily found in development-heavy states, the tax-exempt bonds -- known colloquially as dirt bonds for their ultimate collateral -- are raised by state governments through entities whose names and stature vary from state to state. The governmental units then use the bonds to lay infrastructure on undeveloped land, with developers responsible for completing a project usually ultimately on the hook for paying off the bonds through real estate sales.

In Florida, for example, community development districts, or CDDs, raise dirt bonds. An indenture trustee represents bondholders, while the CDD itself has a board.

Other states have community facility districts, or CFDs (California); metropolitan districts (Colorado); sanitary and improvement districts, or SIDs (Nebraska); and local improvement districts, or LIDs (Nevada), to name a few of the issuers.

Richard Lehmann, publisher of the Distressed Debt Securities newsletter in Florida, which tracks CDDs and how many are in default, says the bonds are a pretty good investment because of their collateral, while their tax-free interest makes them appealing for developers.

The securities' appeal to both investors and developers led to the issue of billions of dollars of the bonds before the housing market cracked, although pinning down an exact number nationwide proves elusive. Florida, however, has more than 600 CDDs, Lehmann says. Bill Huck, until recently a managing director at municipal bond underwriter Stone & Youngberg LLC in San Francisco, says CFDs have issued nearly $25 billion of bonds in the past 25 years.

All of that debt, of course, means that some of the bonds will surface in the bankruptcies of real estate developers. Lewis G. Feldman, a real estate and public finance attorney at Goodwin Procter LLP in Los Angeles, named Fiddler's Creek LLC, South Edge LLC and Ritter Ranch Development LLC as the three most high-profile bankruptcy cases involving dirt bonds.

That the former two cases have come in the past two years and the latter nearly 13 years ago illustrates both the relative rarity of dirt bonds in bankruptcy cases and what could be a recent uptick in cases or controversy.

Fiddler's Creek, owner of an unfinished master planned community in Naples, Fla., filed for Chapter 11 on Feb. 23, 2010, owing $104.77 million in bond debt, thanks to two issuances by CDDs. South Edge owns the incomplete Inspirada project in Henderson, Nev., with $74.4 million in dirt bond debt issued by LIDs. Lenders pushed it into Chapter 11 on Dec. 9 in Las Vegas.

Both cases have proved contentious.

The reorganization plan of Fiddler's Creek took effect on Sept. 2 after a seven-day confirmation trial, during which the CDD bondholders argued Fiddler's Creek had led the CDD boards to accept the plans by improperly soliciting homeowners' votes. The bondholders alleged the plan lacked good faith in its intention to restructure the bond debt while leaving the bonds in default, but Judge K. Rodney May of the U.S. Bankruptcy Court for the Middle District of Florida in Tampa overruled all of their objections. The bondholders, through indenture trustee U.S. Bank NA, are appealing the decision.

ITG Holdings LLC chief financial officer Andrew Sanford, whose firm owns dirt bonds of Fiddler's Creek and other developers, highlights the unusualness of the dispute between bondholders and the CDDs. "No one ever pressed the issue" of restructuring before, he says. "The board just followed what the bondholders said, and there wasn't a divergence that there was with Fiddler's in the end."

Debtor counsel for Fiddler's Creek, Bart Houston of Kopelowitz Ostrow, says he and Fiddler's Creek co-counsel at Genovese Joblove & Battista PA attempted to research past bankruptcy cases with dirt bondholders as creditors, but they came up dry. Houston thinks most developers with dirt bonds haven't filed for bankruptcy in the past because they haven't had the money to sustain a long bankruptcy battle like Fiddler's Creek did.

Lehmann adds that real estate developers don't usually file for bankruptcy until they face a foreclosure action, which dirt bondholders usually are loath to pursue.

"Why would a mutual fund want to own land?" Sanford says. "Certainly they're hesitant from that approach."

Lehmann says the Fiddler's Creek fight will make CDD bondholders even less likely to foreclose, although other reasons could prompt a petition, of course.

Indeed, three new cases involving CDDs have hit Florida bankruptcy courts since the battle over Fiddler's Creek heated up: Landmark Club at Doral LLC of Fort Lauderdale, Fla., developer of the 120-acre Landmark at Doral project, which filed on Sept. 19; Cordoba-Ranch Development LLC of Tampa, developer of the 803-acre Cordoba Ranch master planned community (Aug. 25); and Southeastern Consulting & Development Co. in Tallahassee, developer of the East Bay Preserve and Heritage Park, Manor and Plantation communities in northwest Florida (May 17).

Lehmann foresees "a whole slew of [bankruptcy cases] in the next 12 months [involving CDDs]. The wave is just starting." He thinks as many as 50 bankruptcies with dirt bondholders as creditors will kick off in the next year.

Some 168 of the more than 600 CDDs have bonds in default, representing $5.2 billion in securities, he says. The Sunshine State dirt bonds get a lot of attention, he says, because of the "permissive legislation" that allowed for the "easy formation of CDDs, which was abused."

South Edge, meanwhile, has slowly resolved disputes between its lenders and homebuilder owners, with Judge Bruce A. Markell of the U.S. Bankruptcy Court for the District of Nevada in Las Vegas on Sept. 7 approving a disclosure statement proposed by lender J.P. Morgan Chase Bank NA and four shareholders. Those parties, the debtor's Chapter 11 trustee and another shareholder later reached a settlement, leaving only one homebuilder owner opposed to the plan.

Unlike South Edge and Fiddler's Creek, Ritter Ranch, owner of a namesake project in Palmdale, Calif., passed through bankruptcy years ago. It filed for Chapter 11 on Oct. 30, 1998, in the Central District of California. Huck says that after the property was sold during the lengthy bankruptcy in September 2004 to SunCal Cos., it changed hands several times.

Huck, who left S&Y to start his own firm after S&Y's sale this month to Stifel Financial Corp., says he believes Ritter Ranch's CFD debt remains outstanding.

The property, now owned by bankrupt SunCal affiliate Palmdale Hills Property LLC, would be handed to affiliates of bankrupt Lehman Brothers Holdings Inc. under a reorganization plan proposed by the lender.

Feldman points out that real estate prices have fallen in hard-hit California, Florida and Nevada by an average of 40%. He believes, however, that dirt bond defaults have been exaggerated, estimating that only a total of 1% to 3% of the bonds nationwide are in default.

California, for example, only has $250 million of CFD bonds in distress, a very small fraction, Huck says, of the nearly $25 billion issued in the past 25 years.

A.L. Byrnes, CEO of broker-dealer R.H. Investment Corp. in Encino, Calif., says the downturn in the housing market has reduced the issuance of CFD bonds over the past few years, but he anticipates seeing more developers with CFD debt default due to the delay in defaults becoming public in California.

"I think there will be some defaults from the bonds issued in 2006, 2007, 2008," Byrnes says. "In 2007, the majority already defaulted if they were going to; 2008 is iffier; [in] 2009 there weren't many [issued]."

A hot spot for dirt bond distress could be Colorado, as Sanford sees the state's metropolitan districts as having the toughest time economically among dirt bond issuers due to limited tax obligations in the state's dirt bond law.

One final wrinkle is the ability of some dirt bond issuers to file for protection under Chapter 9, the portion of the Bankruptcy Code reserved for municipalities. CFDs, for example, cannot submit such a petition under California law, Byrnes says. Centerton Municipal Property Owners' Improvement District No. 3, on the other hand, filed for Chapter 9 in the Western District of Arkansas on Oct. 12 to sell its real estate, and five SIDs have filed petitions since Sept. 28, 2010.

Debtor counsel for three of the SIDs near Omaha, Brian Doyle of Fullenkamp Doyle & Jobeun, says he has found Chapter 9 to be a good tool to reorganize SIDs' debt. Doyle says most of the SID cases he's had have not been contentious and have been worked out primarily before filing for bankruptcy. "Chapter 9 has a bad stigma because it's used so rarely, but for these small districts, it's a great tool," he says.

Because SID bonds mature five years after they're taken out, Doyle expects more SID filings in the near future, since most SID bonds were issued before the downturn in the housing market. He says because a significant amount of subdivisions were under construction in Nebraska when the housing market peaked, inevitably some SIDs will default once the bonds mature. "More of those SIDs will have to make that decision [of whether to file for bankruptcy]," he says.

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