LEASE -REVENUE BONDS - 6844

 

Lease-revenue bonds are used in the state’s capital outlay program to finance projects, and are generally, issued by the State Public Works Board (PWB).  The revenue securing the debt service on the bonds comes from lease payments made by the occupying department. PWB issues bonds, and retains jurisdiction to the facility until the debt is retired.  PWB’s lease-revenue program is described in Section 6843.

Pursuant to the California Constitution, public agencies cannot enter into an indebtedness or liability without voter approval.  However, under the Offner-Dean lease exception rule, long-term lease-revenue bonds entered into by public agencies are not considered an indebtedness or liability under the debt limit if the lease meets certain criteria.

Nonetheless, bond rating agencies include lease-revenue payment obligations when calculating the state’s bonded indebtedness.  Thus, there is a distinction between the concept of California constitutional debt and debt as defined by the municipal bond market.

Key highlights:

1. In contrast to GO bonds, annual appropriations are necessary for rental payments that support lease-revenue debt service. However, the obligation to pay is not extinguished if appropriations are not provided. 
2. Government Code Section 15848 provides for debt service payment in the event of no budget and in certain situations when there is a budget that failed to include an appropriation for debt service. 
3. Generally, lease-revenue bonds pay interest at tax-exempt rates, which are slightly higher than tax-exempt rates for GO bonds.
   
4. Lease-revenue payments are due if there is “beneficial use and occupancy” of the facility. If all or part of the facility cannot be occupied, the rent will be abated proportionate to that part of the facility that is unavailable.
   
5. The term of the bonds cannot exceed the useful life of the facility.
   
6. Lease-revenue projects typically require interim financing for costs incurred before the bonds are issued.
   

INTERIM FINANCING

The purpose of interim financing is to meet project cash flow needs for expenses incurred after project authorization, but prior to the issuance of long-term debt instruments.

Interim financing for lease-revenue bonds may be necessary for preconstruction costs (preliminary plans and working drawings) as well as a portion or all of construction costs.  PWB lease-revenue bonds are typically sold upon project completion, at which point any costs related to interim financing are repaid.

Interim financing may be funded through a General Fund loan, pursuant to Section 15849.1 of the Government Code, or a Pooled Money Investment Account loan pursuant to Government Code Section 16312.  The Board determines the appropriate funding mechanism.

PWB agenda package for interim financing:  When submitting requests for interim financing, the department provides the following:

• All information requested in Section 6822, such as the standard fiscal reporting requirements, and the agenda package.
• Project Delivery Agreement, with department signature.
• Evidence of CEQA compliance (Section 6826) such as a copy of the filed Negative Declaration or a link to the project within the state clearinghouse at https://ceqanet.opr.ca.gov.
• A Summary of Conditions Letter or other document demonstrating the completion of Real Estate Due Diligence (Section 6827).
• Departments should contact their Capital Outlay Finance Budget Analyst for additional information related to PWB agenda packages for interim financing, e.g., the interim financing loan application and cashflow statement.

THE BOND SALE                    

The bond sale process begins months in advance of the actual sales, which occur twice a year; in the spring and in the fall.  Lease-revenue bonds may be issued to finance projects or to refund previously issued bonds at more favorable interest rates.  Lease-revenue bond sales are structured as competitive or negotiated, at the discretion of PWB and STO (see the pricing section below for more information).  The information below provides an overview of the bond sale process.

Agent For Sale:  Pursuant to Government Code Section 5702, the State Treasurer’s Office (STO) is the agent for sale for all bonds or evidences of indebtedness issued by the state, unless statute specifies otherwise. 

Bond sales calendar/timing restrictions:  STO prepares a sales calendar for when bond sales occur.  STO sets sales dates at its discretion, considering overall program priorities for access to the municipal bond market.  Bond sales usually require a minimum of eight weeks of preparation before pricing is conducted.  Closing (which is when funds become available) is typically one to two weeks following pricing.  No sales using state General Fund disclosure (Appendix A of the Official Statement) are conducted during the “blackout periods”—which are generally:  1) the beginning of December to the release of the Governor’s Budget, 2) the beginning of May to the release of the May Revision, and 3) the beginning of July through final budget enactment (if the budget is not enacted by June 30).

Appointment of members to the financing team; kickoff meeting:  For lease-revenue bond sales, the PWB retains bond counsel and disclosure counsel and STO appoints financial advisors.  For negotiated sales, STO will also appoint senior managers and underwriters.  These parties, PWB, the departments, STO, Finance and other state agencies (and DGS for projects it manages) convene at a kickoff meeting to formally initiate the sale and to establish a financing schedule (often referred to as the “time and responsibilities  schedule” or “T&R”) for the sale.

Document review:  Bond sales involve the preparation of a number of documents.  PWB, STO, Finance, SCO, the Attorney General’s Office, and the financing team jointly review bond sale documents, including Appendix A, ensuring that the documents are properly drawn and that disclosure requirements are fully met. 

Due diligence review:  Due diligence is the inquiry made to disclose all facts about PWB, the departments, the bond issuance, and the security for the issuance that would be material to a prospective bondholder.  In lease-revenue and financing lease transactions, the  department has an obligation to participate in the due diligence process and to disclose all material facts relating to the transaction. 

Structuring the issuance:  The structure of an issuance refers to the amount and timing of principal repayments (maturities) and interest payments.  STO, with the guidance of a Financial Advisor, determines the structure at the time of the bond sale based on a number of factors, including market conditions.  Lease-revenue repayment schedules may extend to 35 years but are also usually only 15 to 25 years in length.  STO solicits information from departments and PWB (or Finance) to assist in structuring lease-revenue issuances.

Obtaining the bond rating:  The state generally sells only investment-grade municipal securities.  An investment rating is secured prior to the bond sale from one or more independent third parties, called rating agencies. 

Generally, an investment rating is associated with lower interest rates by giving investors additional comfort and increasing the universe of buyers.  Ratings are based on an analysis of the relative strengths and weaknesses of the various factors potentially affecting the likelihood of debt repayment for the specific obligation.  (The ratings applies only to that obligation.)  Investment ratings are typically obtained from three rating agencies:  Moody’s Investor Services, Standard & Poor’s and Fitch Investor Services.

Pricing:  Lease-revenue bonds are sold either on a competitive basis (i.e. low bid establishes price) or a negotiated basis (i.e. STO negotiates interest rates and any discounts with the market).  PWB delegates pricing to STO, which generally occurs a week after the release of the POS.

Bond closing:  Moneys are not exchanged in a bond sale—and interest rates are not effective—until the bond sale closes, typically one to two weeks after pricing.  The department (in the case of lease-revenue bonds) and issuer must review and sign all pre-closing documents prior to closing to ensure a smooth conclusion to the sale.  Net proceeds are normally transferred by the underwriter to the State Treasury by wire in immediately available funds. 

Continuing disclosure and post-issuance compliance:  During the life of the bonds, all departments are obligated to notify PWB of certain specified information which may be material to investment decisions on the securities.  This is a major responsibility for issuers and departments, with serious legal ramifications for failure to perform.  Continuing disclosure is made through annual reports and notices of certain events.  Material misstatements or omissions in the annual reports or event notices may be the basis for claims of securities fraud under federal or state securities laws, actionable by the SEC or private plaintiffs, with substantial potential liability for issuers or other obligated persons.  Mandatory post-issuance compliance training is provided to departments and tenant departments annually by PWB and bond counsel.

All departments are obligated to seek PWB consent for arrangements affecting the use of the facility and for encumbrances on the facility.  Departments are also obligated to retain all project documents for the life of the bonds plus three years.

Brief definitions of key documents are provided in the following text: 

1. Authorizing resolution: The resolution authorizes the issuance of bonds and the execution of major legal documents, which is executed by PWB.
   
2. Indenture: The indenture pledges certain revenues and other property as security for the repayment of the bonds, sets forth the terms of the bonds, contains the responsibilities and duties of the trustee, and the rights of the bondholders. The indenture contains a form of the bond that will be issued. A supplemental indenture is an indenture that amends or supplements a prior indenture. The indenture is executed by PWB and STO.
   
3. Official statement (including preliminary official statement):Provides all information that would be “material” to a prospective purchaser of the bonds, including descriptions of the issuer, terms of the bonds, security for the bonds, major legal documents, risk factors and tax matters, and financial statements.
   

   The preliminary official statement is a version used by the issuer or underwriters to inform the marketplace of the terms of the bonds being issued prior to receipt of bids at a competitive sale or prior to the determination of interest rates and purchase price in a negotiated sale.
   The official statement is of particular interest to the  departments administering lease-revenue bond programs because it contains departmental disclosure requirements and project descriptions, as well as debt service requirements and the cost of issuance.

4. Bond purchase agreement: In a negotiated sale, an agreement is made between PWB and STO and an underwriter or group of underwriters (i.e. a syndicate) who have agreed to purchase the bond issue. The agreement sets forth the purchase price, interest rates and other terms of the bonds (often by reference to the official statement), date and time of closing, representations and warranties of the issuer, conditions to underwriters’ payment for bonds, and underwriter duties. In a competitive sale, the notice of sale serves the same function, specifying the factors used to determine the winning bid; the notice, the underwriter’s bid, and the issuer’s acceptance of the bid together constitute a bond purchase agreement.
   
5. Continuing disclosure agreement: This agreement defines procedures for continuing disclosure, the contents of the annual report, and specific events to be disclosed. Parties to the document may include PWB, STO, the department, and bond holders as third-party beneficiaries.
   
6. Tax certificate and certificates to the tax certificate: The tax certificate is signed by the issuer and sets forth the facts and covenants necessary for the tax-exempt treatment of interest on the bonds. Obligated parties provide the issuer certificates upon which the PWB relies for the tax certificate.
   
7. Lease Agreements: Lease-revenue financings are based on a series of leases, with the rental payments under one of the leases securing the debt service of the financings. The following describes the lease structure utilized for PWB lease-revenue bonds, but they can apply to other lease-revenue financings. The leases require careful review by the department because they outline departmental obligations to PWB.
   
   1. Site lease: The department leases the site on which the project will be constructed to PWB for the term of the bonds. PWB agrees to use the site solely for the purpose of constructing the project. It then leases the facility and site back to the department (see following facility lease).The site lease terminates upon retirement of the bonds.
   2. Facility lease: PWB leases the facility, defined as the project and the site, to the department including, without limitation, the terms and conditions of the site lease. The department covenants to use the facility during the term of the lease solely for public purposes and to take no actions related to the facility that would jeopardize the tax-exempt status of the bonds. The facility lease terminates upon retirement of the bonds. The rental amount is equal to the annual principal and interest on the bond debt, plus any additional rental amounts ordered by PWB (such as trustee fees, accounting fees, PWB costs, etc.).The lease includes a requirement for the department to maintain replacement insurance for loss, damage, and earthquake (the latter only if available at a reasonable cost), liability insurance, and rental interruption insurance (normally to cover an interruption of up to two years).  
8. Closing documents: Numerous documents must be executed prior to closing in order to complete the bond transaction, including but not limited to, closing certificates and legal opinions.