FINANCING LEASES VERSUS OPERATING LEASES/CONTRACTS - 6876

Operating leases/contracts used as security for third-party financings:

1. Background: A department may be limited to entering into an operating lease or contract for the use of real assets (i.e., no authority to enter into a financing lease to acquire assets).Typically such operating leases or contracts may be terminated before their maximum term if there is no legislative appropriation for their payment. In some cases, the vendor may elect to use the operating lease or contract as security for borrowing funds to acquire or construct those real assets. However, in this situation there is no authority to commit the state legally or morally to any obligation to appropriate funds beyond the current fiscal year.
2. Statutory reference: Same as for financing leases described in the preceding text.
3. Fiscal highlights for operating leases/contracts:
   1. The provisions of the lease must include:
      1. All restrictions applicable to a financing lease as stated in the preceding text; and
      2. Termination provisions, including the right of the state to terminate the lease before the end of the term. For example, the state may include the right to terminate the lease if the state is not satisfied with the condition of the building or the lessor’s compliance with the lease terms, may no longer need the space, or for any reason applicable in a commercial context. The exact terms will depend upon the specific factors applicable to each lease. Termination provisions may be short-term—i.e., the useful life of the leased property (e.g. 20 years) may be substantially greater than the stated maximum lease term (e.g. 10 years). In addition, the operating lease or a contract typically will terminate if there is no appropriation of rentals for a fiscal year (hence the name nonappropriation lease is sometimes used to describe these operating leases or contracts).

      Upon termination, the leased property must be returned to the vendor, who may sell or relet the leased property to someone else. In this case, however, the vendor or lessor cannot have the right to continue the lease in existence and sue the state for each installment of rent as it becomes due.

   2. The borrowing may not represent itself as an obligation of the state. Therefore, disclosure of state fund financial statements in an official statement or offering memorandum is generally not desirable since this may carry an implication of a state commitment greater than that of an operating lease. The official statement or offering memorandum must specifically acknowledge that the state’s commitment or credit relationship to the transaction is limited to what is appropriate for an operating lease.
   3. However, tax-exempt financing of operating leases may require State General Fund disclosure. In those cases, the financing becomes very similar to financing leases and the involvement of the Department of Finance (Finance), State Treasurer’s Office (STO), and other state agencies is necessary (refer to financing leases in preceding text.) All financing needs, including interim needs, must be provided by the vendor (i.e., the project is not eligible for state-funded interim financing).
   4. Most long-term operating leases require legislative notification before a lease can be executed. Because the state can terminate an operating lease/contract more easily than a financing lease, the market risk is greater, and financing costs charged back through the lease rates will be correspondingly higher.
   5. STO is not typically the agent for sale. STO, Finance, and DGS all have an interest in ensuring that non-state financings using a state lease or contract as security do not misrepresent the state’s credit relationship to the transaction.
   6. The key department responsibilities are:
      1. Verify authority to enter into the specific operating lease or contract;
      2. Verify that the public or private vendor has no expectations that the state will provide continuing disclosure relating to the financing transaction; otherwise, contact STO and Finance at least eight months in advance of the anticipated issuance sale date (preferably one year) to determine whether such disclosure requests are appropriate and whether STO will require being the agent for sale. As with financing leases, the department needs to consult with the STO before final financing terms are negotiated in the lease;
      3. Include in the lease or contract all provisions required to prevent the creation of constitutional debt;
      4. If the operating lease or contract is to include a tax-exempt interest component in the rental payments, be sure that a nationally recognized bond counsel firm has reviewed the terms of the operating lease or contract to confirm that it qualifies as “debt” for purposes of federal income tax laws and that appropriate arrangements have been made to satisfy the ongoing federal income tax requirements concerning arbitrage rebate and other tax rules; and
      5. Include in the lease or contract all termination provisions appropriate for an operating lease. Contact the Attorney General, as necessary, for direction on appropriate contract or lease requirements.

Depending on the nature of the lease or contract, the department may also be responsible for verifying project cost and financing information used as the basis for lease or contract payments. (For example, the agreement with the vendor may be that the state pays only actual construction costs, financing costs, or both.) In this situation, the department should participate in financing meetings and/or the preparation of audit financing documents. Depending upon the complexity and cost of the transaction, the department may benefit from the services of a financial advisor to protect the state’s interests, especially to assess what is included in the financing costs.

Other department responsibilities are summarized in Section 6886.