Another Day Older and Deeper in Debt: Debt Limitation, the Broad Special Fund Doctrine, and Wppss 4 and 5

• Publication year: 1983

UNIVERSITY OF PUGET SOUND LAW REVIEWVolume 7, No. 1FALL 1983

Another Day Older and Deeper in Debt: Debt Limitation, the Broad Special Fund Doctrine, and WPPSS 4 and 5

Dennis J. Heil(fn*)

I. Introduction

In the late 1800's, most states imposed constitutional and statutory limitations upon the debt-incurring ability of state and local governments.(fn1) These restrictions were applied primarily in response to the financial debacles of the 1830's and early 1840's when governments engaged in heavy borrowing to finance internal improvements such as canals and railroads.(fn2) Soon after the limitations were imposed, however, it became evident that the measures were too rigid and did not allow local officials to provide for even a conservative level of improvements. Consequently, courts began to validate a number of devices whereby a city or other municipal corporation could evade debt limitations. The most important device to emerge was the Special Fund Doctrine.(fn3)

In its initial form, the Special Fund Doctrine was a simple concept consistent with the rationale underlying debt limitation. Briefly stated, the doctrine provided that an obligation which was to be repaid solely from a particular project financed was not debt subject to constitutional, statutory, or charter limitations.(fn4) In effect, the obligation became a "self-liquidating" project. However, as time passed and memories of the financial disasters of the 1880's grew dim, courts applied the Special Fund Doctrine in a variety of situations which stretched, if not totally escaped, the concept of self-liquidation. To determine whether a special fund existed, it became necessary to ask whether a debt was payable out of tax monies rather than whether a debt was payable solely from the proceeds of the particular project financed. In a sense, the doctrine was transformed from an exception to the rule to the general rule itself. So long as the source of repayment was related to the project funded, the obligation was not debt unless tax dollars were subject to liability.

This broad special fund concept worked well in the early and mid-1900's. There were relatively few local government defaults,(fn5) and the federal government assumed a more active role in the construction of highways and other large projects. Courts had no incentive to restrict the scope of the doctrine because by expanding the sources of payment for any municipal debt, the risk to the investor decreased. As a consequence, the borrowing costs to the municipality were reduced.

However, with the Reagan administration's revival of federalism, more and more financial responsibility will likely be placed upon local governments. Moreover, population increases and the energy situation have imposed upon city officials the burdensome task of raising the tremendous amounts of capital required to build mass transit and alternate energy facilities.

The weakness of the Broad Special Fund Doctrine becomes evident when viewed in light of its application to an enormous debt such as construction of a multi-billion dollar power plant. Furthermore, the doctrine is directly at odds with the purposes underlying constitutional and statutory debt limitations. This article will present a brief history of debt limitation provisions. Next, it will discuss the history of the Special Fund Doctrine and will set forth criticisms of the Broad Special Fund Doctrine. The article will conclude by recommending a concept for a Narrow Special Fund Doctrine and by applying it to the construction of two nuclear power plants by the Washington Public Power Supply System (WPPSS)(fn6) in order to illustrate the reconciliation of the conflicting goals of sound fiscal policy and practical flexibility.

II. History of Debt Limitation Provisions(fn7)

In the early 1800's, many states sold bonds backed by their general taxing power to finance improvements in transportation and other commercial projects.(fn8) The first such project was the Erie Canal, financed by the State of New York in the 1820's.(fn9) The canal was an enormous financial success as toll revenue quickly exceeded the interest payments on the debt.(fn10) More importantly, the canal established New York City as a leader in trade with the frontier, and raised land and farm prices in the state as well.(fn11) Other states looked with envy upon the benefits gained by commercial and agricultural interests in New York, and soon many other large scale public improvement projects were concocted.(fn12) Modeled after the Erie Canal, the projects were backed by the general credit and taxing power of each individual state. Unlike the canal, however, many of these projects were neither well-planned nor necessary.

With the advent of the financial panic of 1837, many of the speculative schemes produced little or no revenue although the indebtedness had been contracted and the proceeds spent.(fn13) When the tremendous debt service costs became due, state governments had no choice but to impose heavy taxes to pay the obligations. The taxpayer reaction was predictably bitter.(fn14) Moreover, in some states, the magnitude of the debts incurred exceeded the taxpayer's ability to meet these obligations. Thus, many states were forced to repudiate or suspend payment on their loans.(fn15) Between 1840 and 1850, in response to heavy political pressure from angry citizens, 19 states(fn16) amended their constitutions to include restrictions on legislative borrowing.(fn17) These provisions were largely copied by new states which subsequently entered the Union.(fn18)

In the years following the Civil War, interest in internal improvements, especially railroads, was revived. Local governments, generally unregulated by the original debt limitations, assumed an entrepreneurial role similar to that played by the states in the 1840's.(fn19) Because of the great economic and social advantages to be gained by securing a railroad line, many cities granted extravagant subsidies to railroads in the form of land grants, extensions of public credit, and public investment in railroad stock.(fn20) As with the Erie Canal, most of these subsidies were financed through bond sales backed by the general taxing power of the municipal government.

Contemporaneously, under the name of "public improvement," heavy, ill-considered expenditures were made for streets, sewers, waterworks, and many other projects.(fn21) The result was that by 1880 municipal debt had reached the sum of $728,000,000.(fn22) The excessiveness of the amount is illustrated when compared with a municipal debt in 1840 of scarcely $20,000,000.(fn23) Amid the financial panic of 1873, many cities defaulted on their debt payments.(fn24) The states reacted by imposing constitutional debt limitations on local governmental units similar to the "pay as you go" policy of state restrictions.(fn25) Additional limitations were applied in the wake of a new wave of municipal defaults which coincided with the panic and depression of 1893.(fn26)

The constitutional debt restrictions were generally of three types: (1) local units were forbidden to lend credit to or acquire stock in private corporations; (2) the amount of municipal debt was limited to a specified percentage of assessed value of property subject to tax;(fn27) and, (3) the amount of indebtedness incurred in any one year was limited to the income and revenue for that year.(fn28) These types of restrictions generally prevail today with a debt-to-property ratio being the most common type.(fn29) In addition, some states delegate the form and amount of the limitations to the legislature or city charters.(fn30) Most states exempt restrictions in situations where local voter approval has been given to a debt, although generally more than a mere majority is required. It is generally agreed that the primary purpose of the ceilings was to promote sound fiscal policy by preventing in advance the imposition of an excessive tax burden.(fn31)

When the taxpayers finally moved to enact debt limitations, they imposed excessively confining restrictions. One commentator explained that the debt provisions were apparently based upon the premise that strict standards would provide the surest protection and that the limits permitted enough room for local governments to provide for future needs.(fn32) However, both of these assumptions soon proved to be faulty. The limitation provisions were simply too rigid to accommodate the compelling demands of government. Pressures created by the public's desire for expanded services such as sewage disposal, garbage collection, parking lots, utilities, and other services served to convince individual courts that strict compliance with the limitations would impose substantial hardships.(fn33) Confronted by these practical realities, the courts approved a number of devices which enabled state and local officials to evade debt limitations.(fn34) The most commonly used of these devices today is the special fund.

III. The Special Fund Doctrine

The Special Fund Doctrine was first created by analogy to an earlier evasive device, the special assessment. Under the special assessment theory, obligations were issued by a city to cover the cost of an improvement and were payable solely from charges upon the property directly benefited.(fn35) Special assessment improvements were generally of a non-income producing nature, such as...